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Topic 2: Demand
1
Consumer behaviour
1.1
Consumers gain satisfaction from consuming goods and services. Economists
call this satisfaction utility. The utility gained from consuming a product is
difficult to measure accurately but three possible ways of m easuring it are by
noting:
• how people react when they are consuming
• how much of the product people consume
• the price that people are willing to pay for it.
Note that none of these measures is totally reliable, but the third is the most
commonly used.
1.2
Total utility is the total satisfaction gained from consuming a product in a
period of time. Marginal utility is the satisfaction gained from consuming an
extra unit of a product. Total utility, then, is the total of the marginal utilities
gained from each unit consumed.
1.3
Diminishing marginal utility. As a person consumes more of a good or
service in a certain period of time, the utility gained from each extra unit (the
marginal utility (MU)) decreases. Total utility will continue to increas e,
although at a decreasing rate, until a maximum is reached. At this point there
is no further satisfaction to be gained from consuming more of the product.
Marginal utility will be zero.
Example
Using the price the consumer is prepared to pay as a measure of utility:
Pints of beer (per night)
First
Second
Third
Fourth
Bannerman High School
Higher Grade Economics
Unit 2 Summary (Theory of Demand)
Marginal utility
£2.00
£1.80
£1.50
£1.10
Total utility
£2.00
£3.80
£5.30
£6.40
1
This is the same as saying that:
• if price were £2.00 the consumer would be willing to buy 1 p int because he
gets £2 worth of utility
• if price were £1.80 the consumer would be willing to buy 2 pints because
he gets £2 worth of utility from the first pint and £1.80’s worth from the
second
• if price were £1.50 the consumer would be willing to buy 3 pints
• if price were £1.10 the consumer would be willing to buy 4 pints.
Marginal utility of pints of beer
1.4
Total utility of beer consumed
The information in 1.3 can be converted into a demand schedule:
Price
£2.00
£1.80
£1.50
£1.10
Quantity demanded
per night (in pints)
1
2
3
4
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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1.5
The same information can be shown on a graph as a demand curve.
Demand for beer
Note that the demand curve and the marginal utility curve you drew in para.
1.3 are the same curve.
1.6
Consumer surplus is the difference between how much a consumer would be
prepared to pay and what is actually paid, e.g. if beer were £1.80 per pint, 2
pints would be bought. The consumer was prepared to pay £2 for the first pint
so he gets 20p of utility free i.e. he gets a consumer surplus of 20p. If the
price were £1.50, he would gain consumer surplus of 80p (50p + 30p) of
utility free.
1.7
Rational consumer behaviour. Economists assume that consumers act in a
rational way i.e. they spend their money in the way that gains them maximum
utility or, in plain English, best value for money. Of course, in practice, this
does not always happen. Several factors may prevent this, e.g.:
• imperfect knowledge of the product or of rival products
• the actions of other people (both positive and negative)
• lack of self-control – the consumption of some addictive products may be
involuntary.
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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Assuming rational behaviour, a consumer will achieve maximum utility in the
spending of their income when the marginal utility (MU) per p, spent on the
last unit of each good is equal, i.e. when:
MU of last unit of good A
MU of last unit of B
=
Price of A
MU of last unit of C
=
Price of B
Price of C
Example
A student has £10 to spend one day on her lunch. There is only beer and
sandwiches available. She gives a score out of 100 for the utility she thinks
she would gain from each pint and each sandwich. Beer costs £1 per pint and
sandwiches cost £1 each. How should she spend her £10 in order to gain
maximum satisfaction? See the following table.
Beer
(pints)
1
2
3
4
5
6
7
8
9
10
Marginal
utility
100
90
80
70
60
50
40
30
20
10
Marginal
utility per p
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
Sandwiches
1
2
3
4
5
6
7
8
9
10
Marginal
utility
50
45
40
35
30
25
20
15
10
5
Marginal
utility per p
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
At 7 pints of beer and 3 sandwiches, satisfaction is maximised. If she were to
buy an eighth pint of beer she would gain 0.3 units of utility per p, but this
would have an opportunity cost of 0.4 units of utility per p from the third
sandwich given up. If a fourth sandwich were bought, 0.35 units of utility
would be gained but at an opportunity cost of 0.4 units of utility from the
seventh pint of beer given up.
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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2
Demand
2.1
Definition. Demand (sometimes called effective demand) is th e quantity of a
good or service which consumers are willing and able to buy at a particular
price in a certain period of time.
2.2
Individual demand and market demand. Individual demand refers to the
demand of an individual consumer for a product. Market demand is the sum of
all individual consumers’ demand for a product, i.e. total demand.
2.3
The Law of Demand states that the demand for a product varies inversely
with its price.
2.4
As the price of a commodity goes up then there is a fall in the quanti ty which
consumers are willing and able to buy. This happens for two main reasons:
• The income effect. As the price of a good rises then a person’s real income
(i.e. their buying power) falls. They are not able to buy the same quantity.
• The substitution effect. As the price rises then the marginal utility per p of
the last unit(s) consumed falls. The rational consumer would switch to
substitutes which would give a higher marginal utility per £ (better value
for money). They are less willing to buy.
Remember from para 1.7 that a consumer will arrange his spending until:
MU of last unit of good A
MU of last unit of B
=
Price of A
MU of last unit of C
=
Price of B
Price of C
If the price of apples were to rise then the MU per p gained fro m the last apple
would fall. The consumer would switch that spending to bananas or chocolate
until equality of MU per p was restored. By consuming fewer apples the MU
per p from the last apple will rise and by consuming more bananas or
chocolate the MU per p from the last unit of these will fall.
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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2.5
Exceptions to the Law of Demand
• Goods of prestige or ostentation, e.g. the demand for certain brands of
jeans, training shoes or cars may rise as their price rises.
• Assumption of link between price and quality – consumers may equate a
rise in the price of a product as meaning that its quality has improved.
• Expectation of future price rises, e.g. speculators may react to a rise in the
price of shares by buying more, expecting them to rise even further.
• Giffen goods – Giffen, a nineteenth-century economist, observed that
during the Irish potato famine, the demand for potatoes rose as their price
rose. This was because living standards were so low that most people spent
nearly all their income on potatoes, a filling food, so that when the price
rose they had so little money to buy meat, etc., that they bought more
potatoes. This effect can apply to any basic foodstuff in conditions of
poverty.
The demand curve in any of the above situations will slope u pwards but note
that above a certain price it will resume its normal shape, as the income effect
will reduce people’s ability to buy the product.
Notice that the demand curve resumes its normal slope above a certain price.
This is because the income effect will come into force.
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Unit 2 Summary (Theory of Demand)
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3
Changes in conditions of demand
3.1
Ceteris paribus. One difficulty in economics is predicting the effect of a
change in a variable because there may be a number of different causal
factors. The economist’s way round this is to assume ceteris paribus. ‘Ceteris
paribus’ is a Latin phrase meaning other things remaining the same. Ceteris
paribus is assumed so that the effect of one changing variable can be
predicted.
Example
Price is only one of many factors which determines the demand for a product –
others include changes in income, prices of other goods, population, etc. With
all these conditions affecting demand, one cannot predict a fall in demand as
price rises unless these other conditions remain the same. Ceteris paribus is
therefore assumed in the Law of Demand, i.e. the only changing influence is
price, and all other conditions which could cause demand to change have not
changed. Of course, in real life things are not so simple!
3.2
What are the conditions of demand? These are the factors, other than the price
of the product, which may cause demand to change. They include:
• number of consumers (think of the effects of a change in total population
and of a change in age distribution)
• disposable income (think of the effect on normal goods and on inferior
goods)
• prices of other goods (think of complementary goods e.g. central heating
and gas, and of substitute goods, e.g. gas and electricity)
• tastes and preferences, e.g. the influence of fashion and advertising.
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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3.3
Note the different ways of showing the effect of a change in price on a demand
curve and the effect of a change in a ceteris paribus condition. A change in
price is shown by a movement along the demand curve, whereas a change in a
condition is shown by a shift in the curve.
Change in price
Change in a demand condition
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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Higher only
4
Elasticity of demand
You need to know about two types:
• price elasticity
• income elasticity.
Note that when writing or talking about elasticity of demand you should sta te
what kind of elasticity of demand it is, i.e. price or income.
4.1
Price elasticity of demand (PED). This is a measure of the responsiveness of
demand to a change in price. Price elasticity measures the reaction of
consumers to a change in the price of a product. It is measured by comparing
the percentage change of demand to the percentage change in price, i.e.
% change in demand
Price elasticity of demand =
% change in price
• If PED is greater than 1, i.e. if the % change in demand is greater than the
% change in price, then demand has been very responsive to the change in
price. Demand is said to be price elastic.
• If PED is less than 1, then demand is price inelastic.
• If PED is 0, then demand has not changed at all. Demand is perfectly
inelastic.
• If PED is equal to infinity (meaning that demand changed without a price
change) then demand is perfectly elastic.
• If PED =1, then demand has unitary elasticity. This means that the %
change in demand and the % change in price are the same.
Note that the value of PED will usually be negative because an increase in
price will cause a decrease in demand and vice versa. PED would only be
positive in cases where demand does not follow the normal law of demand.
This would be when demand increases as price rises (see para. 2.5).
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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4.2
Effects of price elasticity on sales revenue
Graph A
Graph B
Revenue gain
Revenue gain
Revenue loss
Revenue loss
Graph A shows that demand is price
inelastic. A rise in price from P to P 1
leads to a fall in demand from Q to Q 1 .
The % fall in demand is less than the %
rise in price. The revenue gained as a
result of the rise in price is greater than
the revenue lost as a result of the drop
in demand so that revenue rises. You
should also be able to say what would
happen to revenue if price fell.
4.3
Graph B shows that demand is price
elastic. A rise in price from P to P1
leads to a fall in demand from Q to
Q1. The % fall in demand is greater
than the % rise in price. The revenue
gained as a result of the rise in price
is less than the revenue lost as a result
of the drop in demand so that revenue
falls. You should be able to explain
what would happen to revenue if
price fell.
Factors affecting price elasticity of
demand
• Availability of substitutes. The closer the substitute the more elastic is
demand (the more responsive are consumers).
• Price relative to total spending. If low then consumers take little notice of
a change in price, e.g. the demand for a box of matches will tend to be price
inelastic – consumers will take little notice of a 10% (1p or 2p) change in
price.
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• Habit. The more a commodity is considered to be a necessity then the more
demand will be price inelastic, e.g. petrol, cigarettes, a newspaper.
• Fashion. Products which are in fashion will tend to have a price inelastic
demand, e.g. certain brands of jeans, toys, hairstyles.
• Frequency of purchase. Products that have to be bought frequently have
price inelastic demands, e.g. fresh milk. Where purchase can be postponed,
e.g. consumer durables (TVs) demand tends to be price elastic, in the short
run at least.
4.4
The importance of price elasticity of demand
(a)
Businesses will want to know the effects on sales revenue if they change
their prices.
• raising the prices of goods that have an inelastic demand will raise
revenue
• lowering the prices of goods that have an elastic demand will raise
revenue.
Note that firms cannot predict exactly what will happen to revenue since
they cannot predict accurately the response of consumers to a change in
price, and of course ceteris paribus does not exist in the real world.
(b)
4.5
Government will want to know the effect on tax revenue if they change
an expenditure tax. An increase in an expenditure tax increases the price
of a good. Whether revenue increases depends on demand for the taxed
product being price inelastic.
Income elasticity of demand
Income elasticity of demand measures the responsivenes s of demand to a
change in income. It is calculated by:
% change in demand
% change in income
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Higher Grade Economics
Unit 2 Summary (Theory of Demand)
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If a person’s income rises by 10%, it does not follow that he will buy 10%
more of all that he was previously buying.
4.6
(a)
Some commodities will still be out of his reach – 0 income elasticity.
(b)
Some commodities he will buy no more or no less of, e.g. a newspaper –
0 income elasticity.
(c)
Some commodities he may buy only a little more of, e.g. food – income
inelastic demand. The demand for necessities in a high-income economy
such as the UK tends to be income inelastic.
(d)
Some he may buy significantly more of, e.g. meals out, entertainment –
income elastic demand. Luxury goods/services tend to have an income
elasticity of demand greater than 1.
(e)
Some he may buy less of, i.e. inferior goods such as bread, cheap brands
of clothing – negative income elasticity.
The importance of income elasticity
(a)
If sellers know the income elasticity of demand for their products they
will be able to predict what will happen to their total revenue in times of
changing incomes, e.g. if demand for a product is income elastic then in
times of rising incomes sellers can expect a significant rise in demand
and in revenue. For products which have an income in elastic demand
then the rise in incomes will increase demand but not by much – sellers
can expect a small rise in revenue. For inferior products which have
negative income elasticity demand then demand would fall and so would
revenue. On the other hand in a period of falling incomes, say in a
recession, the demand for inferior goods and services should rise.
(b)
The Government would also be able to predict changes in revenue from
taxes on products.
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Unit 2 Summary (Theory of Demand)
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