Author: Geoff Riley Last updated: Sunday 23 September, 2012
What is meant by demand?
Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period.
Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming it. Economists give this a term - utility
Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an ability to pay for it
Latent demand exists when there is willingness to buy among people for a good or service, but where consumers lack the purchasing power to be able to afford the product.
The demand for a product X might be connected to the demand for a related product Y – giving rise to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for new vehicles and other manufactured products, so that when an economy goes into a recession, so we expect the demand for steel to decline likewise.
Steel is a cyclical industry which means that market demand for steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate.
The demand for new bricks is derived from the demand for the final output of the construction industry- when there is a recovery in the British building industry, so the market demand for bricks will increase
Zinc is a good example of a product with a strong derived demand. It has a wide-range of end uses such as galvanised zinc used in cars and new buildings, die-casting used in door furniture and toys, brass and bronze used in taps and pipes. And also rolled zinc (used in roofing, guttering and batteries) and in chemicals used in making tyres and zinc cream.
The Law of Demand
There is an inverse relationship between the price of a good and demand.
As prices fall, we see an expansion of demand.
If price rises, there will be a contraction of demand.
Ceteris paribus assumption
Many factors affect demand. When drawing a demand curve, economists assume all factors are held constant except one – the price of the product itself. Ceteris paribus allows us to isolate the effect of one variable on another variable
The Demand Curve
A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. There are two reasons why more is demanded as price falls:
The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain the same consumption for less expenditure. Provided that the good is normal, some of the resulting increase in real income is used to buy more of this product.
The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and some consumers switch their spending from the alternative good or service.
As price falls, a person switches away from rival products towards the product
As price falls, a person’s willingness and ability to buy the product increases
As price falls, a person’s opportunity cost of purchasing the product falls
Note: Many demand curves are drawn as straight lines to make the diagrams easier to interpret.
Tastes and preferences: A successful social media campaign increased sales of Old Spice by >100% in just one week!
Changes in the Conditions of Demand – Shifts in the demand curve
There are two possibilities: either the demand curve shifts to the right or it shifts to the left.
D1 – D3 would be an example of an outward shift of the demand curve (or an increase in demand). When this happens, more is demanded at each price.
A movement from D1 – D2 would be termed an inward shift of the demand curve (or decrease in demand). When this happens, less is demanded at each price
Remember - a change in price leads to a movement along the curve not a shift.
The conditions of demand for a product in a market can be summarised as follows:
Changing prices of a substitute good
Substitutes are goods in competitive demand and act as replacements for another product
For example, a rise in the price of Esso petrol should cause a substitution effect away from Esso towards competing brands such as Shell.
Changing price of a complement
Two complements are in joint demand – e.g. DVD players and DVDs, iron ore and steel.
A rise in the price of a complement to Good X should cause a fall in demand for X. For example an increase in the cost of flights from London Heathrow to New York would cause a decrease in the demand for hotel rooms in New York and also a fall in the demand for taxi services both in London and New York.
A fall in the price of a complement to Good Y should cause an increase in demand for Good Y. For example a reduction in the price of the new iPhone should lead to an expansion in demand for the iPhone and a complementary increase in demand for download applications.
Changes in the income of consumers
Most of the things we buy are normal goods. When income goes up, our ability to purchase goods and services increases, and this causes an outward shift in the demand curve. But when incomes fall there will be a decrease in the demand, except for inferior goods
Discretionary income is disposable income less essential payments like electricity & gas and mortgage repayments. An increase in interest rates often means an increase in monthly mortgage payments reducing demand. In recent years we have seen a sharp rise in the cost of utility bills with a series of hikes in the prices of gas and electricity. This has eaten into the discretionary incomes of millions of households across the UK.
The effects of advertising and marketing: Heavy spending on advertising and marketing can help to bring about changes in consumer tastes and fashions. In 2009, online advertising spending in the UK overtook television expenditure for the first time.
Interest rates and demand
Many products are bought on credit using borrowed money, thus the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the Bank of England decides to alter interest rates – the demand for many goods and services may change.
Examples of “interest sensitive” products include household appliances such as washing machines and fridge freezers, electronic goods, new furniture and motor vehicles. The demand for housing is affected by changes in mortgage interest rates.
Exceptions to the law of demand
There are two reasons why more might be demanded even when the price of a good or service is increasing.
A higher price may be regarded as a reflection of product quality and some consumers are prepared to pay this for the “snob value effect”. Examples might include perfumes, designer clothes, and top of the range cars.
Goods of ostentatious consumption are known as Veblen Goods and they have a high-income elasticity of demand. That is, demand rises more than proportionately to an increase in income or an increase in price.
With speculative demand, a buyer hopes for a rise in price leading to a profit
Speculative demand for housing and for shares comes into this category and we have also seen, in the last few years, strong speculative demand for many of the world’s essential commodities.