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Demand theory


Consumer demand and price

The relationship between price and quantity demanded is the starting point for building a model of consumer behaviour. Measuring the relationship between price and quantity demanded provides information which is used to create a demand schedule, from which a demand curve can be derived. Once a demand curve has been created, other determinants can be added to the model.

The determinants of demand

Demand schedules

A demand schedule shows the relationship between price and demand over a hypothetical range of prices. For example, the schedule opposite is based on a survey of college students who indicated how many cans of cola they would buy in a week, at various prices.   

PRICE (£) QUANTITY DEMANDED
1.10 0
1.00 100
90 200
80 300
70 400
60 500
50 600
40 700
30 800

Video

Demand curves

At higher prices, the quantity demanded is less than at lower prices. This relationship is easiest to see when a graph is plotted, as shown.

Demand curves generally have a negative slope. There are at least three accepted explanations of why demand curves slope downwards:

  1. The law of diminishing marginal utility

  2. The income effect

  3. The substitution effect

Diminishing marginal utility

One of the earliest explanations of the inverse relationship between price and quantity demanded is the law of diminishing marginal utility. This law suggests that as more of a product is consumed the marginal (additional) benefit to the consumer falls, hence consumers are prepared to pay less. This can be explained as follows:

Most benefit is generated by the first unit of a good consumed because it satisfies all or a large part of the immediate need or desire.

A second unit consumed would generate less utility - perhaps even zero, given that the consumer now has less need or less desire.

With less benefit derived, the rational consumer is prepared to pay rather less for the second, and subsequent, units, because the marginal utility falls.

Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the less the marginal utility and the less value derived - hence the rational consumer would be prepared to pay less for that unit.

Utility

While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the lower the marginal utility and the less the rational consumer would be prepared to pay.

BARS TOTAL UTILITY MARGINAL UTILITY
1 100  
2 190 90
3 270 80
4 340 70
5 400 60
6 450 50
7 490 40
8 520 30
8 540 20

The income effect

The income and substitution effect can also be used to explain why the demand curve slopes downwards. If we assume that money income is fixed, the income effect suggests that, as the price of a good falls, real income - that is, what consumers can buy with their money income - rises and consumers increase their demand.

Therefore, at a lower price, consumers can buy more from the same money income, and, ceteris paribus, demand will rise. Conversely, a rise in price will reduce real income and force consumers to cut back on their demand.

The substitution effect

In addition, as the price of one good falls, it becomes relatively less expensive. Therefore, assuming other alternative products stay at the same price, at lower prices the good appears cheaper, and consumers will switch from the expensive alternative to the relatively cheaper one.

It is important to remember that whenever the price of any resource changes it will trigger both an income and a substitution effect.

Exceptions

It is possible to identify some exceptions to the normal rules regarding the relationship between price and current demand.

Giffen Goods

Giffen goods are those which are consumed in greater quantities when their price rises. These goods are named after the Scottish economist Sir Robert Giffen, who is credited with identifying them by Alfred Marshall in his highly influential Principles of Economics (1895).

In essence, a Giffen good is a staple food, such as bread or rice, which forms are large percentage of the diet of the poorest sections of a society, and for which there are no close substitutes. From time to time the poor may supplement their diet with higher quality foods, and they may even consume the odd luxury, although their income will be such that they will not be able to save. A rise in the price of such a staple food will not result in a typical substitution effect, given there are no close substitutes. If the real incomes of the poor increase they would tend to reallocate some of this income to luxuries, and if real incomes decrease they would buy more of the staple good, meaning it is an inferior good. Assuming that the money incomes of the poor are constant in the short run, a rise in price of the staple food will reduce real income and lead to an inverse income effect. However, most inferior goods will have substitutes, hence despite the inverse income effect, a rise in price will trigger a substituion effect, and demand will fall. In the case of a Giffen good, this typical response does not happen as there are no substitutes, and the price rise causes demand to increase.

Example

For example, a family living on the equivalent of just $150 a month, may purchase some bread (say 50 loaves at $2 each, which is the minimum they need to survive), and a luxury item at $50. If the price of bread rises by 25% to $2.50 per loaf, continuing to purchase 50 loaves would cost the individual $125, making the luxury unaffordable. They cannot reduce their consumption of bread, given that their current consumption is the minimum they require, and they cannot find a suitable substitute for their stable food. Not being able to afford the luxury would leave the family with an extra $25 to spend, and, given no alternatives to bread, they would purchase 10 more loaves each month. Hence the 25% price increase has resulted in a 20% increase in the demand for bread - from 50 to 60 loaves.

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 'new' 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 in their consumption, rather than reduce it.  The purchase of such higher priced goods would confer status on the purchaser - a process which Veblen called conspicuous consumption.

See: shifts in demand