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Microeconomics Pt.2: Factors Effecting Demand 1. Companies realize that, over time, consumer demand constantly changes. Because of this change by consumers, companies have to change too, or they risk losing profits to competitors that are better at meeting these customer’s new demands. 2. Such changes in consumer and business demands have an effect on both the demand schedule and the demand curve graph. When it comes to the demand graphs, there are two very distinct types of changes. 3. When the price of a product changes, while all other factors remain the same, we have a change in the quantity demanded. 4. When the price of a product drops, consumers pay less, and a result, have some extra income to buy more of the item; thus the Quantity increases. If the price goes up, consumers feel a bit poorer and buy fewer of the items, thus Quantity decreases. 5. This is called the Income Effect, which is a change in quantity demanded because of a change in price because it alters consumer’s real income. 6. A lower price also means that an item, like a CD, will be relatively less expensive than other something else; like concerts and movies. As a result, consumers will have a tendency to purchase a less costly item than a more expensive one. This is called Substitution Effect. 7. Whenever a price change causes a change in quantity demanded, the change appears graphically as a movement along the demand curve. The change in quantity demanded can be either an up or down movement up or down on the graph line. 1. 2. 3. 4. 5. 6. 7. 8. When it comes to goods, sometimes other outside factors change while the price remains the same. When this happens, people may decide to buy different amounts of the product at the same prices. This is known as a Change in Demand. As a result of this change, the entire demand curve shifts – to the right to show an increase in demand, or to the left to show a decrease in demand. When demand changes, a new curve must be added to the graph to reflect the new quantities of an item demanded at different level of prices by consumers. Demand of an item can change like this because of changes like: Consumer income, consumer tastes, the price of related goods, failed expectations of a good and the number of consumers changes. A change in demand can also happen if consumers stop buying one brand name of an item and instead buy a similar but cheaper competitive item. These items are known as Substitutes because they can be used in place of other more expensive products that consumers usually buy. This change of the demand curve can also affects the market demand curve, if there has been a significant change in the number of consumers purchasing the same item. C) Elasticity of Demand 1. 2. 3. 4. 5. 6. 7. 8. Consumers react to a change in price by changing the quantity that they demand of an item, although the actual size of a consumers change in demand can vary; sometimes small and sometimes big. This consumer change of quantity demanded for an item is known as Demand Elasticity, which is the extent to which a change in price causes a significant change in the quantity demanded. Economists say that demand is Elastic when a given change in price causes a much larger change in quantity demanded. To illustrate, look at Figure 1 and how price and quantity demand changed between points A and B on the demand curve of the graph. As we move from point A to point B, we see that price declines by one-third, or from $3 to $2. At the same time, the quantity demanded doubles from two to one units. Because the change in quantity demanded is much larger than the change in price, the actual demand between those two points is considered to be Elastic. This type of Elasticity is typical of the demand for products like green beans, corn, or other fresh garden vegetables. Because prices of these products are lower in the summer, consumers increase the amount they purchase during that time. When prices are considerably higher in the winter, consumers tend to buy canned or frozen products instead. Demand Elasticity 1. 2. 3. 4. 5. For different types of products, demand may be Inelastic, which means that a change in the price of an item may cause a relatively smaller change in the quantity demanded of that product by consumers. We can see the case of inelastic demand in Figure 2. In this case, the one-third drop in price from point A to B on the graph only causes quantity demanded to increase by only 25%. This is typical of the demand for a product like table salt. A change in the price of salt does not bring about much change in the quantity purchased by consumers. Even if the price of salt was cut in half, the quantity demanded by consumers would not increase much because people can consume only so much salt. Similarly, if the price doubled, we would still expect consumers to demand about the same amount of salt, because people only spend such a small portion of their budget on salt (but is a much wanted item). 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. E) The Total Expenditures Test To estimate elasticity of an item, it is useful to look at the impact of a price change on Total Expenditures, or the amount that consumers spend on a product at a particular price. This is sometimes called the Total Expenditures Test. We can find total expenditures by multiplying the price of a product by the quantity demanded for any point along the demand curve. To illustrate the total expenditure look at point A on the graph for Figure 1, which is $6. The $6 is determined by multiplying two units times the price of $3. Likewise, the total expenditure under point B in Figure 1 is $8, or $2 times four units. By observing the change in total expenditures when the price changes for a product, we can then test for elasticity. The Demand Curve in Figure 1 is elastic. When the price drops by $1 per unit, the increase in the quantity demanded is large enough to raise total expenditures from $6 to $8. The relationship is simple, when the price goes down, total expenditures go up. The demand curve in Figure 2 is inelastic. In this case, when the price drops by $1, the increase in the quantity demanded by consumers is so small that total expenditures fall below $6. This is why the demand curve is an inelastic demand, because the total expenditures decline when the price declines. The relationship between the change in price and the change in total expenditures is shown if Figure 3. If the changes in price and expenditures move in opposite directions, demand is elastic. If they move in the same direction, demand is inelastic. While this discussion about elasticity may seem somewhat unnecessary to you, knowledge of demand elasticity is extremely important to most businesses. What would happen if you sold a product with elastic demand? If you raise the price, your total profit – which is the same as consumer expenditures – will go down instead of up. This outcome is most definitely the exact opposite of what you intended to happen. This is exactly why some businesses experiment with different prices when they introduce a new product to the market. They may adjust prices repeatedly to see how customers respond to new prices. If a business can determine a new product’s demand elasticity, it will be able to find a set price for the new product that will maximize a very large profit for the company. This is why demand elasticity is more important to the world of business than most people realize.