Download With this lesson, we begin building the most important

Understanding Markets
Demand
Understanding the Determinants of Demand
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With this lesson, we begin building the most important model in economics – the model of the market. A market is a
place where buyers and sellers trade some good or service, and their interaction will determine the price at which that
good trades, and the quantity of the good that’s actually traded. In order to build this model, we’re going to break it into
pieces. First, we’re going to examine the motivations of buyers. What determines the quantity of a good or service that
people want to purchase in a given period of time? This is called “demand.” Then we’ll look at the motivation of
sellers. What determines the quantity of a good or service that businesses are willing to sell in a given period of time?
This is called “supply.” Then we’ll put the buyers and the sellers together, and look at how their interactions establish a
stable price and quantity traded. This is called equilibrium. So – demand, supply, and equilibrium.
Let’s start with demand. Demand describes the behavior of households, and answers the question: How much of a
particular good or service do households purchase in a given period of time? Let’s take some explicit example.
Suppose we’re talking about the good “bread” and suppose we want to answer the question: How much bread does a
typical household purchase in a week? Well, what we want to do in order to answer this question is make a list of all of
the factors that influence the quantity of bread that a household would be willing and able to buy. And probably chief
among the factors that influence people’s quantity of bread purchased is the price of bread.
We can also consider the price of other products like cheese or bologna that people enjoy along with bread. We can
also consider the price of substitute goods like bagels that provide the same satisfaction in a different way. We can
also consider the purchasing power, or income, of the household. Tastes and preferences probably play a role also,
as well as expectations of what’s going to happen to the price of bread in the future.
If we want to see how any of these variables influences the quantity of bread that a household purchases in a week,
we’ve got to examine it in some orderly fashion. That is, if we want to know how changes in the price of bread
influence the quantity of bread demanded, we’ve got to isolate the effect of the price of bread by holding all of the
other variables constant.
This “holding constant” is accomplished by an assumption that economists call “ceteris paribus,” from the Latin phrase
that means “everything else held the same.” So if we want to know how a change in the price of bread influences the
behavior of the household, we’ve got to say “ceteris paribus” all of the other factors that might influence the quantity
demanded. If we hold these other things constant then, what do we expect will happen when the price of bread rises?
Likely what will happen is the quantity of bread demanded will fall. This is what economists call the law of demand –
that an increase in the price of a good typically leads to a reduction in the quantity of that good demanded.
And, if you think about it, it does kind of make sense. After all, if the price of bread goes up, then people’s income now
can buy less bread; so the reduction in their purchasing power is going to leave them able to purchase less. Also,
when the price of bread goes up, the opportunity cost of bread, measured against other goods, has increased as well.
This is what economists call the substitution effect – people buy less bread because they’re willing to buy less. They’d
rather buy other goods that provide the same satisfaction at lower opportunity cost. So the law of demand says that
there is an inverse or opposite relationship between the price of bread and the quantity of bread demanded.
What about another factor, like the price of a complementary good? A complementary good is a good that is enjoyed
along with the good in question. So a complementary good for bread might be butter or cheese or bologna or peanut
butter, or anything else that you enjoy along with bread. See, you’re buying bread not for its own sake, because bread
is one element in creating something that you really want, like a peanut butter sandwich. And if the price of peanut
butter goes up, or if you’re after a grilled cheese sandwich and the price of cheese goes up, then, overall, the price of
the good that you really desire – the sandwich – has risen. And, by the law of demand, you’re going to then want
fewer of these sandwiches, or you’ll be able to afford fewer of these sandwiches. And since you want fewer
sandwiches, that means less bread. So we have the rule that an increase in the price of a complementary good leads
to a reduction in the quantity of this good demanded. A decrease in the price of that complementary good, on the
other hand, will lead you to buy more bread, because now cheese sandwiches are a bargain, you’re going to want
more of them, and that means buying more bread as well as more cheese.
Let’s consider now the effect of the price of a substitute good, holding constant everything else. A change in the price
of a substitute good – ceteris paribus – is going to lead to a change in the demand of our original good in the same
direction. So if the price of bagels goes up, all of a sudden bagels don’t look like such a good way to get your
carbohydrate satisfaction, and you switch to bread instead. On the other hand, if the price of the substitute good falls –
Understanding Markets
Demand
Understanding the Determinants of Demand
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if bagels are now less expensive – go buy bagels instead, and the quantity of bread demanded will be reduced. So
ceteris paribus – an increase in the price of a substitute good increases the quantity demanded of the original good;
and a decrease in the price of the substitute good causes a decrease in the quantity of the original good demanded.
What about income? And here things are a little bit more complicated, because an increase in your income can have
either effect, really, on the amount of a good you purchase, depending on what kind of good it is. Most goods – what
we call “normal goods” – see that when your income increases, you’ll actually purchase a larger quantity; your
purchasing power is increased, you feel wealthier, and you buy more bread.
On the other hand, there’s a certain category of goods called “inferior goods” for which the opposite is true. When your
income goes up, you actually buy less of these goods – some goods like public transportation, potted meat products –
things that people can’t wait to have enough money so that they can buy something else instead. For example, beans
– poor people tend to spend more money on beans than people at higher income levels, and when your income level
rises, you may typically buy less beans and more meat instead. In that case, beans are acting as an inferior good; an
increase in your income leads to a reduction in the quantity of beans demanded. So the effect of income – ceteris
paribus – depends on whether the good is a normal good or an inferior good. A normal good, an increase in income
leads to an increase in the quantity of the good demanded; an inferior good has exactly the opposite effect – an
increase in income leads to a decrease in the quantity of the good demanded.
What about tastes and preferences? And here the relationship is pretty straightforward. We don’t really have a
number to put on tastes and preferences, so we describe this qualitatively. We say that if people just suddenly decide
they like bread better than other things, they’ll buy more bread – ceteris paribus. On the other hand, if people decide
that they don’t like bread, or they’re concerned about the effect of bread on their health, or something like that, than
tastes and preferences shift away from bread, and people will buy less bread – ceteris paribus”
Finally, there’s the effect of the expectation of future prices. What are households going to do if they think the price of
bread is going to be rising in the future? Well, ceteris paribus – the expectation of a higher future price for bread leads
people to buy more bread now. Either they’re going to stock up, or they’re going to enjoy bread before it moves out of
their price range. On the other hand, if people expect that the price of bread is going to fall in the future, they’re going
to reduce the quantity of bread that they purchase today, and hang back and wait for the lower price.
So we have these factors, then, that influence people’s purchasing behavior. And we can now collect these factors in
a mathematical way, and build what we call a demand function. The demand function describes the quantity of bread
that the household is willing and able to purchase in a given period of time as a function of all of these variables that
influence that decision. It will look something like this: The quantity of bread demanded is the variable that we want to
explain. So we’re going to say that that is determined by, or equal to, a function of all of those variables that we just
listed. I’m going to use here the letter “D” to represent the function, kind of like sometimes we say “F” of “X” is a
function. This time it’s going to be “D” – or demand – as a function of the variables that influence people’s buying
behavior. So here’s the price of the good in question, and remember ceteris paribus – a higher price means a smaller
quantity demanded; a lower price means an increase in quantity demanded.
The next variable that influences this decision is the price of complementary goods, and remember the higher price of
complements – ceteris paribus – the lower the quantity demanded. And the lower the price of complements, the
higher the quantity demanded.
The next factor is the price of substitute goods. Remember the price of substitute goods moves in the same direction
as the quantity of the good demanded. So a higher price for substitutes – ceteris paribus – leads households to buy
more of the good in question. A lower price of substitutes leads households to buy less of the good.
The next factor is income, and the effect of income depends on whether the good is a normal good or an inferior good.
For a normal good, more income leads to more quantity demanded – ceteris paribus. For an inferior, more income
leads to a lower quantity demanded – ceteris paribus.
The other variables that influence people’s behavior are tastes, and preferences, and the expectation of what the price
is going to be in the future. At this point I can put a parenthesis on the other side, and indicate that I’ve collected all of
the variables that I’m going to be concerned about.
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Understanding the Determinants of Demand
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There may be other things that influence people’s behavior, but we can probably lump those things under tastes and
preferences – the little idiosyncratic things that may affect one household but not affect another. So here we’ve got a
range of variables – a collection of factors that influence people’s willingness and ability to purchase bread.
So what do we do next? Well, what we’re going to do next is we’re going to focus our attention on the variable that’s
most important for our building the model of the market. Remember the market is going to explain the quantity of the
good traded and the price at which those trades occur. So we want to focus our attention now on how the price of the
good itself influences the quantity of the good that people are willing and able to buy. And to focus our attention on the
effect of the price, we're going to hold constant – and that’s what I mean when I draw this horizontal bar above the
name of the variable – we’re going to hold constant everything else that influences people’s behavior – the price of
complements, the price of substitutes, income, tastes, and expectations. Ceteris paribus all of these variables. We’re
now going to focus our attention on the way in which changes in the price of bread influence the quantity of bread
demanded. And this is how we begin to construct what economists call “the demand curve.”