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
A Very Difficult Issue
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What we measure in demand is a reflection of
individual desires.
Daniel Bernoulli, a mathematical genius who
lived in Basel, noted, in 1738, that people seek
goodness or pleasure (utility).
That is, we do not seek cellphones because
they are cellphones 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
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The diamond-water paradox.
Scarcity need not mean highly valued;
such as snake meat in U.S.
Markets reflect what people value in
relationship to current availability.
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 the terminology:
- 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
► Why many people sit in bad seats on a train to go visit family
► The shape of waterfront properties
► Electricity prices and automatic switches
► Etc., etc., etc.
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
■ Also difficult to measure — but important
■ When measurable, include in the analysis.
But experience shows—measures are very
poor predictors of actions.
■ Like tastes, these can be used to “explain”
anything
► Don’t fall into this trap
Related Goods
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Substitutes:
Essentially, goods used in place of each other—
similar occasions for use; 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;
movie theater v. movie rentals;
DVDs v. concert tickets
Related Goods
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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
Change in Price
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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.
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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:
Hard Test:
Which Goods Are Complements,
Which Are Substitutes?
1.
2.
3.
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5.
Wine and beer.
Domestic shirts and imported shirts.
Oil from Iran and coal from China.
Paper and pencils.
Plate glass and brick/concrete
Question: Thinking of Changes
in Demand
In the past 20 years in the U.S., the
price of attending college has risen
more than most prices. Despite the
price rise, more people are going to
college than before.
Does this contradict the law of demand?
What factors may explain this?
Demand analysis
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2.
3.
How would demand for hair
replacement be likely to change if
the following occurs?
A fall in the price of hairpieces.
A rise in income.
A rise in the divorce rate.
Clever sales pitch
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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
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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?
Before we move on…
We know that Total Revenue (TR) is PxQ.
But firms also want to know what will happen to
revenue from a change P
in Q. Marginal revenue
(MR) is the change in
Demand
TR from a change in Q.
Raise Q, you must cut
P. When is that a good
Q
idea?
MR