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(a) State the law of demand and distinguish between movements along the demand curve and shifts of the demand curve. (b) Explain with the help of diagrams the effect that an increase in the price of petrol is likely to have on (i) the market for cars (ii) the market for coal (a) The law of demand states that as price increases, quantity demand decreases, ceteris paribus, and over a given amount of time, based on rational behaviour. A movement along the demand curve is caused by a change in price (shown in the diagram to the right), whereas a shift of the demand curve is caused by factors which affect demand such as advertising, substitutes, complementary goods, population (demographics), fashion/trends, incomes etc (shown in the diagram below). When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand. This increased demand can be represented on a graph as the curve being shifted to the right. At each price point, a greater quantity is demanded, as from the curve D1 to the new curve D2. Examples of an increase in demand are as follows: successful advertising will cause an increase in demand and therefore there will be an increase in price. If the number of substitutes fell, then demand would increase. If a good was in fashion, or a ‘trend’ at the time then demand would increase, causing an increase in price. Also, if people were earning a higher income they would be more inclined to spend money to purchase more luxury goods, therefore demand would increase. If the demand decreases, then the opposite will happen - a shift to the left of the curve. If the demand starts at D2, and decreases to D1, the price will decrease and the quantity demanded will decrease. The quantity supplied at each price is the same as before the demand shift (at both Q1 and Q2). The equilibrium quantity, price and demand are different. At each point, a greater amount is demanded (when there is a shift from D1 to D2). (b) (i) An increase in the price of petrol is likely to result in a fall in demand for cars because petrol and cars are considered complementary goods. Some buyers may decide that cars are too expensive an item to maintain in the long term since petrol prices are so high. So car suppliers may therefore decrease prices for cars in order to create a larger demand for cars. (ii) As petrol can be substituted for coal, the demand for these two goods will be bound together by the fact that consumers can trade off one good for the other if it becomes advantageous to do so. Thus an increase in the price of petrol (ceterais pairbus) may result in an increase in demand for coal as coal can be a substitute for petrol e.g. in heating or electricity. Consumers would probably react by buying less petrol and replacing it with coal in this case. This can be shown on a demand diagram. Price D D1 P D Q Q1 D1 Quantity The demand curve for coal in the above diagram is D. A rise in price of petrol leads to a rise in demand for coal. This means that at any given price a greater quantity of coal will be demanded. The new demand curve D1 will therefore be to the right of the original demand curve. It is important to note that when speaking about substitute goods we are speaking about two different kinds of goods. So the substitutability of one good for another is always a matter of degree. A good is only a perfect substitute if it can be used in exactly the same way, at exactly the same cost, and with exactly the same quality of outcome. It is much more common for goods to be imperfect substitutes for one another. In this case, for example, petrol and coal can both be used for the same purpose (for heating and electricity), but there are significant differences between the two. As a result the two can be substituted for one another, but there are significant trade-offs involved in deciding to substitute one for the other. However, there may be some cases, e.g. vehicles such as cars and aircrafts that have petrol engines where no alternatives can be used besides petrol. This would mean consumers would have no choice but to continue buying petrol despite the increase in price.