Demand and supply
The allocation of resources in the market system is determined by the market forces of demand and supply.
Demand
The demand for a good is the quantity of the good that consumers are willing and able to buy at each price over a period of time, ceteris
paribus. The law of demand states that there is an inverse relationship between price and quantity demanded. When the price of a good
falls, the quantity demanded will rise. Conversely, when the price of a good rises, the quantity demanded will fall.
Effective demand refers to the willingness and ability of consumers to purchase goods at different prices. It shows the amount of goods
that consumers are actually buying – supported by their ability to pay.
Effective demand excludes latent demand – where the willingness to purchase goods may be limited by the inability to afford it – or
lack of knowledge.
Demand schedule
A demand schedule is a list of the quantity demanded at different prices. When constructing a demand schedule, everything else that
might affect demand is held constant. Consider the following demand schedule for pizza:
Quantity
Price
demanded
rs/slice number of slices
5 2
4 5
3 8
2 12
1 17
Demand curve
The demand curve of a good shows the quantity demanded of the good at each price over a period of time, ceteris paribus. The demand
curve is downward sloping due to the law of demand.
As the price increases, the quantity demanded decreases, and, conversely, as the price
decreases, the quantity demanded increases.
Market demand curve
The market demand curve is the summation of all the individual demand curves in a given market. It shows the quantity demanded of
the good by all individuals at varying price points.
For example, suppose that there were just two consumers in the market for good X, Consumer 1 and Consumer 2. These two consumers
have different individual demand curves corresponding to their different preferences for good X. The two individual demand curves are
depicted in Figure below, along with the market demand curve for good X.
The market demand curve for good X is found by
summing together the quantities that both consumers
demand at each price.
For example, at a price of rs1, Consumer 1 demands 2
units while Consumer 2 demands 1 unit; so, the market
demand is 2 + 1 = 3 units of good X. In more general
settings, where there are more than two consumers in
the market for some good, the same principle
continues to apply; the market demand curve would be the horizontal summation of all the market participants' individual demand
curves.
Movement along the demand curve
A change in price causes a movement along the demand curve. It can either be contraction (less demand) or expansion/extension. (more
demand)
Contraction in demand. An increase in price from rs10to rs12 causes a movement
along the demand curve, and quantity demand falls from 55 to 40. We say this is a
contraction in demand
Expansion in demand. A fall in price from rs10 to rs7 leads to an expansion (increase)
in demand from 55 to 75. As price falls, there is a movement along the demand curve
and more is bought.
Change in demand
A change in demand is represented by a shift of the demand curve. As a result of this shift, the quantity demanded at all prices will have
changed.
Factors which can shift the demand curve (Non-price Determinants of Demand)
Tastes and Preferences
A change in tastes and preferences towards a good will lead to an increase in
the demand and vice versa. Tastes and preferences are affected by a number of
factors such as technological advancements and campaigning. For example, the
inventions of smartphones and tablets have led to a change in tastes and
preferences from print publications to digital publications. Healthy living
campaigns have led to a change in tastes and preferences from non-diet soft
drinks to diet soft drinks. These have increased the demand for digital
publications and diet soft drinks and decreased the demand for print
publications and non-diet soft drinks.
Income
Consumer income (Y) is a key determinant of consumer demand (Qd). The relationship between income and demand can be both direct
and inverse.
Normal goods
In the case of normal goods, income and demand are directly related, meaning that an increase in income will cause demand to rise and
a decrease in income causes demand to fall. For example, for most people, consumer durables, technology products and leisure services
are normal goods.
Inferior goods
In the case of inferior goods income and demand are inversely related, which means that an increase in income leads to a decrease in
demand and a decrease in income leads to an increase in demand. For example, necessities like bread and rice are often inferior goods.
It should be noted that ‘normal’ and ‘inferior’ are purely relative concepts. Any good or service could be an inferior one under certain
circumstances. Even luxury goods can become inferior over time. Video players were once luxuries, but as incomes rose consumers
switched to DVDs. Of course, DVD’s have been replaced by digital downloads, on-demand TV, and streaming services like Netflix.
Changes in Price of related goods
Substitutes are goods which are consumed in place of one another such as Coke and Pepsi. A rise in the prices of substitutes for a good
will induce consumers to buy less of the substitutes resulting in an increase in the demand for the good and vice versa. For example, if
the price of Pepsi rises, consumers will buy less Pepsi and more Coke.
Complements are goods which are consumed in conjunction with one another such as car and petrol. A fall in the prices of complements
for a good will induce consumers to buy more of the complements resulting in an increase in the demand for the good and vice versa.
Expectations of future price
When people expect prices to rise in the future, they will stock up now, even though the price hasn't even changed. That shifts the
demand curve to the right. For this reason, the Federal Reserve sets up an expectation of mild inflation. Its target inflation rate is 2%.
Changes in the composition of the population
A society with relatively more children will have a greater demand for goods and services like tricycles and daycare facilities. A society
with relatively more elderly persons has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the
population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the
demand curve.
Other factors include successful advertising, changes in climatic conditions and also government policy (taxes/subsidies/government
spending or interest rate)
Evaluation – Time period
In the real world, a higher price could cause a movement along the demand curve, but in the long-term, it could cause a shift as consumers
respond to the persistently higher prices.
For example, if there is an increase in the price of petrol, there would be a movement along the demand curve, and a smaller quantity
would be bought. However, there is likely to be only a small fall in demand because the demand for petrol tends to be quite price
inelastic.
However, in the long term, the demand curve may shift to left as well because people
respond to the higher price by looking for alternatives, for example, they buy an
electric car and so no longer need petrol.
