Download Lecture 2 The Law of Demand

Lecture 3
The Law of Demand
■ Our objectives:
► Explain individual choices among unlimited
wants in a world of limited resources
► Develop a theory that helps us better
understand and predict human actions
►What do people (our customers) want?
Simple(?) Application of Law
of Demand Saved Pepsi
1931 Pepsi was bankrupt.
It and Coke both produced 6 oz (1/6th liter)
bottles of sodas.
Years of advertising had not worked for Pepsi.
It then made and sold 12 oz (1/3 liter) bottles
of soda for twice the usual price—no results.
It then sold 12 oz (1/3 liter) bottles for same
price as Coke’s 6 oz bottles.
Sales sky rocketed; the company was saved.
A Very Difficult Issue




What we measure in demand is a reflection of
individual desires.
Daniel Bernoulli, a mathematical genius who
lived in Switzerland, noted, in 1738, that people
seek goodness or pleasure (utility).
We do not seek smartphones because they are
smartphones but because they are useful and
give us pleasure. Use and pleasure cannot be
measured, only approximated.
This is behind the law of demand.
A Note on Value, Scarcity,
and Price as Related to Demand
Why do people want what they want?
 The diamond-water paradox.
 Scarcity need not ≠ highly valued (snake meat)
 Low cost need not ≠ low value (lock box key)
 Markets reflect what people value in relationship
to current availability.
 Demand is our best understanding of what
people value—given current conditions.
The Law of Demand
■ Holding all other relevant factors constant, the
lower (higher) the price of a good, the greater
(lower) will be the quantity demanded.
► Like all scientific propositions, it is a ceteris
paribus (“other things equal” or “other things
constant”) statement
► Note: - Price means opportunity cost;
- Good means anything people value
Why focus on the Law of Demand?
This is the most powerful proposition in economics.
► Irrigation design in arid and wet climates
► Building heights in cities compared to small towns
► The seasonal pattern of vegetable prices
► The shape of waterfront properties
► Electricity prices and automatic switches
► Etc., etc., etc.
Example

Law of
Demand
applies to
all
“goods” –
legal or
illegal
Some common notations
D = Demand
S = Supply
P = Price
Q = Quantity
MC = Marginal Cost
AC = Average Cost
MR = Marginal Revenue
TR = Total Revenue
The Demand Function:
Some Definitions
The relationship between quantity consumed and the
factors determining that: D = f (P, PS, PC, I, E, T, etc.)
■ Price of the good in question—determines the location
along a demand curve
■ Other variables (relevant factors) determine the
placement of a demand curve:
► Prices of related goods (substitutes and complements)
► Income of buyers
► Tastes (preferences) of buyers
► Expectations held by buyers, regarding the future
► Other matters particular to a certain good
The Role of Tastes
■ They are very hard to measure, so we
generally ignore them, but we know they
exist.
■ Look to marketing and psychology for
guidance here, not economists!
■ For economists, tastes are often the
unexplained portion of consumption
Expectations
■ Difficult to measure or operationalize — but real.
■ When measurable, include in the analysis. But
experience shows—measures are very poor
predictors of actions. The Consumer Confidence
Index (Conference Board) was at 115 in June
2007; down to 26 in March 2009. Ex post. (59 in
July 2011)
■ Like tastes, these can be used to “explain”
anything
“Consumer Confidence” or Expectations
tends to lag the economy.
After recessions ended, still low confidence.
University of Michigan
Consumer Sentiment Index
This or that?
■
Substitutes:
Essentially, goods used in place of each other—
same geographic market; similar performance
characteristics. What is a substitute in one market
may not be seen by consumers as such in another
market—orange juice and orange soda.
► Different brands of gasoline; robots in Renault
factory in France v. workers in Renault factory in
Russia (former Lada) paid $1,200 mo.; movie
theater v. downloads; corn or sugar in ethanol.
Related Goods
■
Complements:
Essentially, goods used together
► Computer hardware and software;
tennis balls and rackets; airplane
travel and hotel rooms; Google maps
and discount coupons; growing corn
for ethanol and Deere tractors
Changes in the Price of Related Goods
■ Goods X and Y are substitutes if:
► A change in price of X changes demand for Y in same
direction
- Px up implies Dy up (Dy shifts to the right)
- Px down implies Dy down (Dy shifts to the left)
► Effect of change in Py on Dx is also in same direction
More on the Prices of Related Goods
■ Goods V and W are complements if:
► A change in price of V changes demand
for W in opposite direction:
- Pv up implies Dw down (Dw shifts to left)
- Pv down implies Dw (Dw shifts to right)
► Effect of a change in Pw on Dv is also in
opposite direction
Changes in Income
■ Normal Goods:
► Change in income changes demand in same direction
- Higher income causes increase in demand
- Lower income causes decrease in demand
► ”Superior” good is a variant: change in demand due to
income change is quite large
■ Inferior goods:
► Change in income changes demand in opposite direction
- Higher income causes decrease in demand
- Lower income causes increase in demand
Terminology:
Used to avoid confusion
■ Changes in quantity demanded:
► Caused by changes in own price of good
means movement along a given demand curve
■ Changes in demand:
► Caused by changes in other factors:
- Prices of other goods
- Income
- Expectations, etc.
► Means a shift of the entire demand curve
Summarizing the Demand Curve
The demand curve is a simple way of
expressing a complex market.
Strip it to the essentials to think about it.
The curve represents the individual values of
many different existing and potential
demanders.
All that information is imagined to be
captured in that little curve to help us focus
our thinking about the basics.
Change in Price

A change in the price of a good means
a movement along a demand curve.
Price
Pa
Pb
Demand
Qa
Qb
Quantity/time
Change in Demand
A change in a factor that determines demand, besides the
price of the good itself, causes the Demand curve to shift.
Example: Increase in price of substitute or increase in income
causes an increase in demand.

Price
Da
Pa
Db
Qa
Qb
Quantity/time
Deriving a Real Demand Curve
Define your market:
Price
Boulder, Colorado, over time;
consumption of water by people
.74
served by city water; price per
1,000 gallons; billions gallons/yr.
.50
consumed by demanders.
Demand
.36
Year
1968
1972
1977
1982
Price
$0.28
$0.36
$0.50
$0.74
Quantity
29
19
13
9
.28
0
9
13
19
29
Quantity
What else would you want to know?
The Demand curve plots the relationship between
price and quantity demanded – nothing else –
everything else is held constant
But in the real world, other things are not constant, so
what else would you want to know if you wanted to
understand that market better?
Name likely relevant factors:
Demand analysis

1.
2.
3.
How would demand for hair
replacement treatment be likely to
change if the following occurs?
A fall in the price of treatment.
A rise in income.
A rise in the divorce rate.
Clever sales pitch

A British cellphone company promised
new subscribers in November and
December that all calls on Christmas
Day, December 25, would be free.
What would you expect happened to
the volume of calls that day?
Question on changing demand

Trying to predict future demand, GE
research showed that the average size
of the American family was declining
and so was the average square
footage of houses.
How would you think this impacted
the demand for the design of, say,
refrigerators?
Key Point from Peter Drucker
Most important question sellers must ask:
“What is value to the customer?”
Sellers often think they know, but do not. The
customers do not buy a product; they buy value.
Demanders are buying a product to satisfy a want.
Do not guess what customers want—carefully
evaluate what they want.
Evaluate products from customers’ viewpoint, not
how the producer knows it works.