Theory of Demand
Topic Four

Previous - Economic Systems

The Law of Demand - Movement along a Demand Curve

Demand is the willingness and ability of consumers to pay for their wants and needs. For example, you may want a cellphone but you must be able to pay for it in order for demand to exist. While demand is the willingness and ability of consumers to pay for their wants and needs, quantity demanded is that demand that relates to a particular price.

There is an inverse relationship between price and quantity demanded. As price increases, caeteris paribus, quantity demanded for a product will fall; likewise, when the price decreases, quantity demanded for the product will rise. This is what is referred to as the law of demand. Ceteris paribus is a Latin phrase which means that all other things being equal or held constant. Quantity demanded in influenced by the price and the price only and it is reflected as a movement along the demand curve only; not a shift of the entire demand curve. For example, as shown in the following graph, if the price of pens decreases from $4.00 to $2.00, quantity demanded will increase from 4 pens to 6 pens and this will be depicted as a movement along the demand curve from point o to point p.

Graph 1

As stated earlier, demand is the willingness and ability of consumers to pay for their wants and needs. In response to this increase in quantity demanded, supply will now have to increase in order to facilitate the increase in quantity demanded. Supply curve now shifts from S1 to S2 as in the following graph.

Graph 2

The Law of Demand - Shift of the Demand Curve

The above illustrates the case of quantity demanded. On the other hand, demand is the overall demand picture and is depicted as a shift of the entire demand curve (not a movement along the curve). This shift in the entire demand curve is as a result of changes in market forces which are called factors or determinants of demand such as follows:

Income – when income of persons increases, caeteris paribus, their ability to purchase a particular good will increase and the demand for that good will increase. Therefore, its demand curve will shift to the right from D1 to D2 as in Graph 1. As a result, price increases from $4.00 to $8.00 and demand increases from 4 units to 12 units.

Graph 3

On the other hand, if income falls, demand will fall and the demand curve will shift from D0 down to D1. As a result, price will fall from $4.00 to $2.00 and demand will decrease from 4 units to 2 units as can be seen in Graph 2.

Graph 4

Price of Substitutes – ceteris paribus, when the price of a substitute good increases relative to the price of the good in consideration, the demand for the good in consideration will increase. For example, if the price of butter increases relative to cheese, the demand for cheese will rise and the demand curve for cheese will shift from D1 to D2. As a result, price increases from $4.00 to $8.00 and demand for cheese will increase from 4 units to 12 units as shown in Graph 1. On the other hand, if the price of the substitute good falls relative to the good in consideration, the demand for the good in consideration will fall and the demand curve will shift from D0 down to D1. As a result, price will fall from $4.00 to $2.00 while demand will fall from 4 units to 2 units as shown in Graph 2.

Price of Complement goods – when the price of complement good increases, ceteris paribus,the demand for the good in consideration will fall because both goods go together. The demand curve for the good in consideration will shift to the left from D0 to D1 resulting in demand falling from 4 units to 2 units and price falling from $4.00 to $2.00 as shown in Graph 2. On the other hand, when the price of a complement good falls, the demand for its complement will rise and the demand curve will shift to the right from D1 to D2 with price increasing from $4.00 to $8.00 and demand from 4 units to 12 units as shown in Graph 1.

Advertising – when a company starts a huge advertising campaign to publicize a good or product or when taste shifts towards a particular product, one can expect to see an increase in the demand for that particular good. The demand curve will therefore shift to the right from D1 to D2 as in Graph 1. On the other hand, if advertising falls and taste shifts away from a product, the demand curve will shift leftward from D0 to D1 as in Graph 2.

Exceptions to the Law of Demand

There are exceptions to the normal rules regarding the relationship between price and current demand or the law of demand. These and Giffen and Veblen Goods.

Giffen Goods - Giffen goods are those which are consumed in greater quantities when their price rises. Basically, a Giffen good is a staple food, such as bread or rice, which forms a large percentage of the diet of the poorest persons in society, and for which there are no close substitutes. A rise in the price of such a staple food will not result in a fall in such goods as with the case of typical goods. This is so because such goods are needed by the poor.

Veblen goods - Veblen goods are a second possible exception to the general law of demand. These goods are named after the American sociologist, Thorsten Veblen, who, in the early 20th century, identified a certain high-spending leisure class. According to Veblen, a rise in the price of high status luxury goods might lead members of this leisure class to increase their consumption, rather than reduce it.

The demand curve for both Giffen and Veblen goods is upward sloping indicating that when price rises, quantity demanded for such goods will rise as can be seen in the following graph.

Graph 5

Individual and the Aggregate or Market Demand Curve

The market demand curve shows the relationship between the total quantity of goods and services that are demanded by all consumers and the price that they are willing to pay for these goods and services. This market demand curve is derived by summing the horizontal demand curves for all of the individuals in the market. For example, for simplicity, if we assume that there are only two consumers for the demand for flash drives, Joe and Jack, the market demand curve for flash drives will be as in the following graph. When the price is $12 a flash drive, the quantity demanded of flash drives by Joe is 4 and the quantity demanded by Jack is 6 resulting in market demand of 10 flash drives. Now if the price for each flash drive falls to $10, according to the law of demand, quantity demanded will rise. In this example, quantity demanded for the flash drives will increase to 6 for Joe and 8 for Jack resulting in a new market demand for flash drives of 14 flash drives.

Graph 6

Next - Theory of Consumer Choice