Consumer Demand Theory
In this lesson, you’re expected to learn:
– what factors affect buyers’ demand for goods
– how the Law of Demand and price elasticity govern consumer demand
– how changes in the factors that affect demand influence the market price and quantity
Last week, we briefly covered the market forces of demand and supply.
Now it’s time to look at these concepts in more detail in order to better understand how consumers and producers make consumption and production decisions.
Let’s quickly recap the conditions that must be met in order for markets to function efficiently.
Typical conditions for an efficient market include:
• a large number of buyers and sellers acting independently according to their own self-interest.
• perfect information about what is being traded.
• freedom of entry and exit to and from the market.
Markets & Competition
Remember the five types of market structures that were mentioned last week?
In these lessons, we will assume that markets are perfectly competitive as this will help you to understand real-world conditions.
Why are perfectly competitive markets preferable to other types of markets? Perfectly competitive markets are what economists call allocatively efficient.*
Consumers get the most benefit at the lowest price without creating any loss for producers. Perfect competition is also productively efficient because in the long run, firms produce at the lowest total cost per unit.
As you know, Price is a reflection of supply and demand.
The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good.
As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more.
1) Diminishing Marginal Utility
2) Income Effect
3) Substitution Effect
As you consume more and more of an item, each successive unit provides less utility than the previous unit. As a result, the only way that you will buy more of an item is if the price is lower.
You consume until the marginal benefit (utility) equals the marginal cost (price).
Income effect is based on your budget constraint. As the price of a good drops, your purchasing power increases. As the price increases, your purchasing power falls.
Income effect explains the logic behind discounts and sale prices. When goods go on sale at a lower price, your limited income is able to purchase more, so that is what you do.
For example, imagine you’re at the grocery store to buy food for five days worth of meals – three chicken dinners and two dinners with beef. If the store happens to have beef on sale, you might substitute one day’s chicken with beef (since the price was lower).
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For example, suppose Helen and Ken are the only two buyers in the market for apples.
Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases.
Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product is too high.
Elasticity = (% change in quantity / % change in price)
• If, however, the purchase must be made immediately, no close substitutes exist, or the purchase does not take a significant percentage of income, demand is price insensitive or inelastic.
Consumer tastes for goods and services are subject to change and when these changes happen, demand shifts.
The demand curve shows how price affects quantity demanded, other things being equal.
These “other things” are non-price determinants of demand (i.e. things that determine buyers’ demand for a good, other than the good’s price).
• Price of Related Goods
• Tastes & Preferences
An increase in demand leads to a rightward shift while a decrease in demand leads to a leftward shift of the demand curve.
Increase in the number of buyers increases quantity demanded at each price, shifting the demand curve to the right.
• Demand for a normal good is positively related to income. Increase in income causes an increase in quantity demanded at each price, leading to a rightward shift.
• Demand for an inferior good is negatively related to income. An increase in income shifts the demand curve to the left.
Related goods are classified as either complements or substitutes. Recall that complements are goods used in conjunction with other goods, and substitutes are goods used in lieu of each other.
• Two goods are complements if an increase in the price of one causes a fall in demand for the other.
E.g. – computers and software
• Two goods are substitutes if an increase in the price of one causes an increase in demand for the other.
E.g. – laptops and desktops
Anything that causes a shift in tastes toward a good will increase demand for that good and shift its demand curve to the right.