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.
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 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.
Elasticity of demand (Ped) = % change in demand of good X / % change in price of good X
• If the PED is greater than one, the good is price elastic. Demand is responsive to a change in price. If for example a 15% fall in price leads to a 30% increase in quantity demanded, the price elasticity = 2.0
• If the PED is less than one, the good is inelastic. Demand is not very responsive to changes in price. If for example a 20% increase in price leads to a 5% fall in quantity demanded, the price elasticity = 0.25
• If the PED is equal to one, the good has unit elasticity. The percentage change in quantity demanded is equal to the percentage change in price. Demand changes proportionately to a price change.
• If the PED is equal to zero, the good is perfectly inelastic. A change in price will have no influence on quantity demanded. The demand curve for such a product will be vertical.
• If the PED is infinity, the good is perfectly elastic. Any change in price will see quantity demanded fall to zero. This demand curve is associated with firms operating in perfectly competitive markets
Factors that determine the value of price elasticity of demand
1. Number of close substitutes within the market - The more (and closer) substitutes available in the market the more elastic demand will be in response to a change in price. In this case, the substitution effect will be quite strong.
2. Luxuries and necessities - Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to be more elastic. For example, the demand for opera tickets is more elastic than the demand for urban rail travel. The demand for vacation air travel is more elastic than the demand for business air travel.
3. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand will be.
4. Habit forming goods - Goods such as cigarettes and drugs tend to be inelastic in demand. Preferences are such that habitual consumers of certain products become de-sensitised to price changes.
5. Time period under consideration - Demand tends to be more elastic in the long run rather than in the short run. For example, after the two world oil price shocks of the 1970s - the "response" to higher oil prices was modest in the immediate period after price increases, but as time passed, people found ways to consume less petroleum and other oil products. This included measures to get better mileage from their cars; higher spending on insulation in homes and car pooling for commuters. The demand for oil became more elastic in the long-run.
Income elasticity of demand measures the relationship between a change in quantity demanded and a change in income. The basic formula for calculating the coefficient of income elasticity is:
Percentage change in quantity demanded of good X divided by the percentage change in real consumers' income
Normal goods have a positive income elasticity of demand so as income rise more is demand at each price level. We make a distinction between normal necessities and normal luxuries (both have a positive coefficient of income elasticity).
Necessities have an income elasticity of demand of between 0 and +1. Demand rises with income, but less than proportionately. Often this is because we have a limited need to consume additional quantities of necessary goods as our real living standards rise. The class examples of this would be the demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive at all to fluctuations in income in this sense total market demand is relatively stable following changes in the wider economic (business) cycle.
Luxuries on the other hand are said to have an income elasticity of demand > +1. (Demand rises more than proportionate to a change in income). Luxuries are items we can (and often do) manage to do without during periods of below average income and falling consumer confidence. When incomes are rising strongly and consumers have the confidence to go ahead with “big-ticket” items of spending, so the demand for luxury goods will grow. Conversely in a recession or economic slowdown, these items of discretionary spending might be the first victims of decisions by consumers to rein in their spending and rebuild savings and household financial balance sheets.
Many luxury goods also deserve the sobriquet of “positional goods”. These are products where the consumer derives satisfaction (and utility) not just from consuming the good or service itself, but also from being seen to be a consumer by others.
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. In a recession the demand for inferior products might actually grow (depending on the severity of any change in income and also the absolute co-efficient of income elasticity of demand). For example if we find that the income elasticity of demand for cigarettes is -0.3, then a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total demand for cigarettes (ceteris paribus).
Within a given market, the income elasticity of demand for various products can vary and of course the perception of a product must differ from consumer to consumer. The hugely important market for overseas holidays is a great example to develop further in this respect.
What to some people is a necessity might be a luxury to others. For many products, the final income elasticity of demand might be close to zero, in other words there is a very weak link at best between fluctuations in income and spending decisions. In this case the “real income effect” arising from a fall in prices is likely to be relatively small. Most of the impact on demand following a change in price will be due to changes in the relative prices of substitute goods and services.
The income elasticity of demand for a product will also change over time – the vast majority of products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or service will be influenced not just by their own experiences of consuming it (and the feedback from other purchasers) but also the appearance of new products onto the market. Consider the income elasticity of demand for flat-screen colour televisions as the market for plasma screens develops and the income elasticity of demand for TV services provided through satellite dishes set against the growing availability and falling cost (in nominal and real terms) and integrated digital televisions.
Cross Price Elasticity of demand measures the responsiveness of demand for a product to a change in the price of other related products. We normally focus on the links between changes in the prices of substitutes and complements.
The formula for cross price elasticity of demand
Cross Price Elasticity of Demand (CPed) = % change in the demand for Good X % change in the price of Good Y
The main use of cross price elasticity concerns changes in the prices of substitutes and complements.
With substitute goods such as brands of cereal or washing powder, an increase in the price of one good will lead to an increase in demand for the rival product. Cross price elasticity will be positive. In recent years, the prices of new cars have been falling. This should increase the demand for new cars and reduce the demand for second hand cars and mass transport services such as bus travel (ceteris paribus)
With goods that are in complementary demand such as the demand for DVD players and DVD videos, when there is a fall in the price of DVD players we expect to see more DVD players bought, leading to an expansion in market demand for DVD videos
When there is no relationship between two products, the cross price elasticity of demand is zero.