Market demand for goods and services and Elasticity of Demand


Demand is defined as the quantity of a good or service consumers are willing and able to buy at a given price in a given time period.

EFFECTIVE DEMAND

Only when the consumers' desire to buy something is backed up by a willingness and an ability to pay for it do we speak of demand. To emphasize this point economists use the term effective demand.
There are an unlimited number of human wants and needs - but in the market-place these can only be bought / purchased if there is sufficient purchasing power.

LATENT DEMAND

Latent demand exists when there is a willingness to purchase a good or service, but where the consumer lacks the real purchasing power to be able to afford the product. Latent demand is affected by persuasive advertising - where the producer is seeking to influence consumer tastes and preferences.

THE RATIONAL CONSUMER

Economists assume that in deciding what to buy, consumers will tend to act rationally in their own self-interest. This means that they will choose between different goods and services so as to maximize total satisfaction.
Clearly they will take into consideration

• How much satisfaction they get from buying and consuming an extra unit of a good or service

• The market price that they have to pay to make this purchase

THE LAW OF DEMAND

• If the price of foreign package holidays falls - what would you expect to happen to the demand?

• If the Government raises the tax on each litre of unleaded petrol how would you predict motorists would react?

• If a bus company cuts fares will motorists leave their cars and decide to use public transport?

• If a cinema cuts price for afternoon admissions for retired people, what should be the impact on ticket sales?

The law of demand is that there is an inverse relationship between the price of a good and the demand for a good. As prices fall we see an expansion of demand. If prices rise we expect to see a contraction of demand.

Understanding the demand curve

A demand curve shows the relationship between the price of an item and the quantity of that item demanded over a certain period of time. For normal goods, more will be demanded as the price falls.

CONDITIONS OF DEMAND

Many factors affect the total demand for a product - when these change, the demand curve can shift. A movement along the curve occurs following a change in the price of the good itself, everything else held constant (sometimes called the "ceteris paribus" assumption)

What causes a shift in the demand curve?

We now consider the factors that cause an increase or a decrease in demand for a good or service: These factors are also called the conditions of demand.

A shift in the demand curve means that either more or less will be demanded at each and every ruling price in the market. using the diagram above, the initial demand curve is D1. An outward shift in demand takes the curve to D2. More is being demanded at the price shown by the green line.

Essentially - shifts in demand are caused by changes in the willingness and ability of consumers to buy a particular product at a given price. The factors discussed below are those that most commonly affect the market demand for a given product:

Make sure you understand these conditions of demand really well - they will be tested in the final AS exams!

i) Changing price of a substitute
Substitutes are goods in competitive demand and act as replacements for another product. For example, a rise in the price of Esso petrol should cause a substitution effect away from Esso towards Shell or other competing brands. A fall in the monthly rental charges of cable companies or Mercury phones might cause a decrease in the demand for British Telecom services. Consumers will tend to switch to the cheaper brand or service provider.

ii) Changing price of a complement

A complement tends to be bought together with another good. Two complements are said to be in joint demand. Examples include: fish and chips, DVD players and DVD's, success and hard work, and so on. A rise in the price of a complement to Good X should cause a fall in the demand for X.
For example a decrease in the cost of flights from London Heathrow to New York would cause an increase in the demand for hotel rooms in New York and also an increase in the demand for taxi services both in London and New York.

iii) Change in the income of consumers

Most of the things we buy normal goods, that is, more is bought when income rises. When an individual's income goes up, their ability to purchase goods and services increases, and this causes an outward shift in the demand curve. When incomes fall, there will be a decrease in the demand for most goods.

iv) Change in tastes and preferences

Tastes can often be volatile leading to a change in demand. An example would be demand for British beef during the BSE crisis. Advertising is designed to changes the tastes and preferences of consumers and thereby causes a change in demand.

v) Changes in interest rates

Many goods are bought on credit using borrowed money and therefore the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the Bank of England decides to raise interest rates - the demand for many goods and services may fall. Examples of "interest sensitive" goods include household appliances, electronic goods, new furniture and motor vehicles. The demand for new homes is affected by changes in mortgage interest rates.

Income & Demand - Normal and Inferior Goods

For normal products, more is demanded as income rises, and less as income falls. Most products are like this but there are exceptions called inferior products. They are cheaper poorer quality substitutes for some other good. Examples include black-and-white television sets, white bread and several other basic foods.

With higher income a consumer can switch from the cheaper, but poorer quality substitute to the more expensive, but preferred alternative. As a result, less of the inferior product is demanded at higher levels of income.


Exceptions to the law of demand

Do consumers always buy more of something when the price falls? Some economists claim there are two exceptions:

GIFFEN GOODS: These are highly inferior goods that people on low incomes spend a high proportion of their income on. When price falls, they are able to discard the consumption of these goods (having already satisfied their demand) and move onto better goods. Demand may fall when the price falls. These tend to be very basic foods such as rice and potatoes.

OSTENTATIOUS CONSUMPTION: Some goods are luxurious items where satisfaction comes from knowing the price of the good. A higher price may be a reflection of quality and people on high incomes are prepared to pay this for the "snob value effect". Examples would include perfumes, designer clothes, fast cars.