AS Micro: Determinants of Demand

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Determinants of Market
Demand
AS Economics

Key Issues
 Functions of the price mechanism
 Law of demand
 Determinants of demand
 Joint demand, effective demand
 The demand curve and shifts in demand curve

Functions of Prices
 The Price Mechanism
• Prices provide the main method through which
scarce resources are allocated between
competing uses in virtually all modern economies

Functions of Prices
 The Signalling Function
• Prices signal what is available, conveying
information to producers and consumers alike
• If prices signal wrong or misleading information,
then markets may perform inefficiently or break
down completely

Functions of Prices
 The Incentive Function
• Prices create incentives for agents to behave in
ways consistent with their self-interest. For
example, the rising price of a good may:
• Result in a firm expanding production of that good
in its pursuit of profit-maximisation
• Result in a consumer contracting demand as she
tries to maximise her overall ‘utility’ with her limited
income

Demand: Buyers in the Market
 Demand:
• The quantity of a product consumers are willing
and able to buy at different prices in a specified
time period
• Normally there is an inverse relationship between
the price of good X and the quantity demanded of
good X

Demand: Buyers in the Market
 Factors that affect demand
• Consumer tastes and preferences
• Income available to the consumer
• Prices of other goods and services
• Substitute goods
• Complementary goods
• Interest rates
• Consumer population

Demand for New Cars
The Price of New
Cars
Interest Rates
Relative prices of
second-hand
vehicles
Cost of fuel
Road Charges /
Tax
Consumer
Confidence
Relative costs of
travelling on
public transport
Availability of
Credit
Costs of car
insurance and
servicing etc

Effective Demand
 Effective Demand
• When a consumers' desire to buy a product is
backed up by an ability to pay for it
• They must have sufficient real purchasing power
• Consider the market for pay-per-view boxing
events – the companies promoting these events
must price carefully so that they tap into the
largest possible market

Effective demand
Demand is only effective if
backed up with an ability to
pay for the product

Latent Demand
 Latent Demand
• Latent demand exists when there is willingness to
purchase a good, 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

Latent demand

Derived Demand (Joint Demand)
 The demand for a product X might be strongly
linked to the demand for a related product Y –
giving rise to the idea of a derived demand
 For example, the demand for coal is derived in
part on the demand for fossil fuels to burn in
the process of generating energy
 Demand for steel is strongly linked to the
demand for new vehicles and many other
manufactured products

Derived demand
The housing market is a good example of the idea of
derived demand. When construction of new homes
rises, so too does the demand for materials used in
new properties as well as demand for labour

Demand for steel
 The
construction
of a new
steel roof
 Global
demand for
steel is
strongly
linked to the
world
economic
cycle

Complementary Demand
 As the demand for
mobile phone handsets
increases, so too does
demand for phone calls
 Mobile phone
companies often sell
handsets at very low
prices because they
can recoup revenues
from the calls made by
subscribers to their
network

The Demand Curve
Quantity
Demanded
Demand
P1
Q1 Q3Q2
P2
P3
Price

A contraction of demand
Quantity
Demanded
Demand
P1
Q1 Q3Q2
P2
P3
A contraction of demand
due to a higher price
Price

An expansion of demand
Quantity
Demanded
Demand
P1
Q1 Q3Q2
P2
P3
An expansion of demand
due to a lower price
Price

Falling Prices and Demand
 Many goods and services are cheaper now in
both money and real terms than they were a
few years ago
• Short-break holidays overseas
• Prices of new audio-visual equipment
• Personal computers
• New car prices
 When prices are falling, we see a rise in the
quantity demanded as consumers respond to
the change in price

Downward-sloping demand curve
 For normal goods, more is demanded as price falls
 Firstly at lower prices, consumers can afford to
purchase more with their income
 Secondly, a fall in price makes one good relatively
cheaper than a substitute
 Thirdly, a fall in price means that the consumer derives
more benefit per pound spent on the product than they
did before
 The demand curve is normally drawn in textbooks as a
straight line suggesting a linear relationship between
price and demand, but in reality, the demand curve will
be non-linear

Shifts in the demand curve
Changes in the conditions of
demand

Shifts in Demand
Quantity
Demanded
D1
P1
Q1 Q2Q3
D2
D3
Increase in
Demand
Decrease in
DemandPrice

An outward shift in demand
 A rise in the real incomes of consumers
 An increase in the price of a substitute good (i.e. a
competing product)
 A fall in the price of a complementary good
 A change in consumers’ preferences towards the good
 An increase in the size of the total population
 A fall in interest rates
 A rise in consumer confidence
 Social changes which affect total demand for a product

Substitutes
 Substitutes are goods in competitive demand
• They are replacements for another product
• For example, a rise in the price of Esso petrol
(other factors held constant) should cause a
substitution effect away from Esso towards Shell
or other competing brands

Complements
 Complements are said to be in joint demand
• Examples include: fish and chips, DVD players
and DVDs, iron ore and steel
• A rise in the price of a complement to Good X
should cause a fall in the demand for X

Normal and Inferior Goods
 For normal products, more is demanded as
income rises, and less as income falls
 There are exceptions called inferior products
 They are often cheaper poorer quality
substitutes for some other good
 With a higher income a consumer can switch
from the cheaper substitute to preferred
alternative
 As a result, less of the inferior product is
demanded at higher levels of income

Income Elasticity of Demand
 For some products
there is a strong link
between income and
demand
• New cars
• Expensive furniture
• Cruise tours
 What of the demand
for package holidays?

Changes in price of Substitutes
P1
Q1Q2
Demand
Output (Q)
Price of
Texaco
petrol
P1
Q1 Q2
D1
Output (Q)
Price of
Shell
petrol
P2
D2

Changes in tastes and preferences
 Market demand in nearly every market is often affected
by changes in consumer preferences
 One person’s preferences can affect those of others
 This is a very powerful force in digital markets e.g.
iTunes, demand for DVDs
 But it is also powerful when influencing the demand for
meals at restaurants, hotels in holiday destinations et
al
 Advertising and marketing are explicitly designed to
influence consumer tastes and preferences

What affects demand for smoothies?

Exceptions to the law of demand
 Ostentatious consumption
 Some goods are luxurious items where
satisfaction comes from knowing both the
price of the good and being able to flaunt
consumption of it to other people!

Exceptions to the law of demand
 Speculative Demand
 The demand for a product can be affected by
speculative demand. Here, potential buyers
are interested not just in the satisfaction they
may get from consuming the product, but
also the potential rise in market price leading
to a capital gain or profit

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AS Micro: Determinants of Demand

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