Consumer Demand Theory

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. 

Market Efficiency

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.

Advantages of Competitive Markets

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.

* Allocative Efficiency: a state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing.
[Optional] Allocative Efficiency
The relationship between demand and supply underlie the forces behind the allocation of resources.
Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship.

As you know, Price is a reflection of supply and demand.

Law of demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded.

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.

Enlarged version: http://bit.ly/2kqw3w7
Reasons for the Law of Demand

Three reasons explain why the law of demand exists:

1) Diminishing Marginal Utility
2) Income Effect
3) Substitution Effect

1) Diminishing Marginal Utility

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).

2) Income Effect

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.

3) Substitution Effect

The substitution effect states that you substitute relatively less expensive items for relatively more expensive items.

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).

What is a Demand Curve?
Economists graphically represent the relationship between a product’s price and quantity demanded with a demand curve. Typically, demand curves are downward sloping, because as price increases, buyers are less likely to be willing or able to purchase whatever is being sold.

Enlarged version: http://bit.ly/2maNfpN

Demand Schedule
A demand schedule is a table that shows the relationship between the price of a good and the quantity demanded. Notice that a consumer’s preferences obey the Law of Demand.

Enlarged version: http://bit.ly/2lc9Xtr

Demand Curve
Based on the demand schedule above, the demand curve can be drawn as such.

Enlarged version: http://bit.ly/2lcdk3J

Market Demand vs. Individual Demand

The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.

For example, suppose Helen and Ken are the only two buyers in the market for apples.

Qd = Quantity Demanded

Enlarged version: http://bit.ly/2lceNXL

Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of demand after a change in a product’s price.

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.

To determine the elasticity of demand, we can use this simple equation:
Elasticity = (% change in quantity / % change in price)
Elastic vs. Inelastic Demand

• When you can delay the purchase of a good, if it has many close substitutes, or if it takes a large percentage of your income, demand is typically price sensitive or elastic.

• 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

Enlarged version: http://bit.ly/2lISvA1
[Optional] Explaining Price Elasticity of Demand
What Causes Changes in Demand?

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).

Factors Affecting Demand

Changes in the following factors lead to a shift of the demand curve (while price remains the same):*

• Number of Buyers
• Income
• 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.

* It’s important to note that a change in price causes a movement along the demand curve (not a shift).
1) Number of Buyers 

Increase in the number of buyers increases quantity demanded at each price, shifting the demand curve to the right.

Enlarged version: http://bit.ly/2mfOEIp
2) Income

• 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.

3) Prices of Related Goods

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

4) Tastes & Preferences

Anything that causes a shift in tastes toward a good will increase demand for that good and shift its demand curve to the right.

Jim Rohn