Lecture 3 The Law of Demand

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Lecture 3
The Law of Demand

• Our objectives
• ? Explain individual choices among unlimited
  wants in a world of limited resources
• ? Develop a theory that helps us better
  understand and predict human actions
• ?What do people (our customers) want?

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A Very Difficult Issue

• What we measure in demand is a reflection of
  individual desires.
• Daniel Bernoulli, a mathematical genius who lived
  in Basel, noted, in 1738, that people seek
  goodness or pleasure (utility).
• That is, we do not seek cellphones because they
  are cellphones but because they are useful and
  give us pleasure. Use and pleasure cannot be
  measured, only approximated.
• This is behind the law of demand.

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A Note on Value, Scarcity, and Price as Related
to Demand

• Why do people want what they want?
• The diamond-water paradox.
• Scarcity need not mean highly valued think of
  snake meat.
• Markets reflect what people value in relationship
  to current availability.
• Demand is our best understanding of what people
  valuegiven current conditions.

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The Law of Demand

• Holding all other relevant factors constant,
  the lower (higher) the price of a good, the
  greater (lower) will be the quantity demanded.
• ? Like all scientific propositions, it is a
  ceteris paribus (other things equal or other
  things constant) statement
• ? Note the terminology
• - Price means opportunity cost
• - Good means anything people value

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Why focus on the Law of Demand?

• This is the most powerful proposition in
  economics.
• ? Irrigation design in arid and wet climates
• ? Building heights in cities compared to small
  towns
• ? The seasonal pattern of vegetable prices
• ? Why many stand in crowded trains to go visit
  family
• ? The shape of waterfront properties
• ? Electricity prices and automatic switches
• ? Etc., etc., etc.

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The Demand Function Some Definitions

• The relationship between quantity consumed and
  the factors determining that D f (P, PS, PC,
  I, E, T, etc.)
• Price of the good in questiondetermines the
  location along a demand curve
• Other variables (relevant factors) determine
  the placement of a demand curve
• ? Prices of related goods (substitutes and
  complements)
• ? Income of buyers
• ? Tastes (preferences) of buyers
• ? Expectations held by buyers, regarding the
  future
• ? Other matters particular to a certain good

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The Role of Tastes

• They are very hard to measure, so we generally
  ignore them, but we know they exist.
• Look to marketing and psychology for guidance
  here, not economists!
• For economists, tastes are often the
  unexplained portion of consumption

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Expectations

• Also difficult to measure but important
• When measurable, include in the analysis. But
  experience showsmeasures are very poor
  predictors of actions.
• Like tastes, these can be used to explain
  anything
• ? Dont fall into this trap

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This or that?

• Substitutes
• Essentially, goods used in place of each
  othersame geographic market similar performance
  characteristics. What is a substitute in one
  market may not be seen by consumers as such in
  another marketorange juice and orange soda.
• ? Different brands of gasoline robots in Renault
  factory in France v. workers in Renault factory
  in Russia (former Lada) paid 200 a month movie
  theater v. movie rentals corn or sugar in
  ethanol.

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Related Goods

• Complements
• Essentially, goods used together
• ? Computer hardware and software
• tennis balls and rackets airplane travel
  and hotel rooms Google maps and discount
  coupons growing corn for ethanol and Deere
  tractors

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Changes in the Price of Related Goods

• Goods X and Y are substitutes if
• ? A change in price of X changes demand for Y in
  same direction
• - Px up implies Dy up (Dy shifts to the right)
• - Px down implies Dy down (Dy shifts to the
  left)
• ? Effect of change in Py on Dx is also in same
  direction

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More on the Prices of Related Goods

• Goods V and W are complements if
• ? A change in price of V changes demand for W in
  opposite direction
• - Pv up implies Dw down (Dw shifts to left)
• - Pv down implies Dw (Dw shifts to right)
• ? Effect of a change in Pw on Dv is also in
  opposite direction

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Changes in Income

• Normal Goods
• ? Change in income changes demand in same
  direction
• - Higher income causes increase in demand
• - Lower income causes decrease in demand
• ? Superior good is a variant change in demand
  due to income change is quite large
• Inferior goods
• ? Change in income changes demand in opposite
  direction
• - Higher income causes decrease in demand
• - Lower income causes increase in demand

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TerminologyUsed to avoid confusion

• Changes in quantity demanded
• ? Caused by changes in own price of good means
  movement along a given demand curve
• Changes in demand
• ? Caused by changes in other factors
• - Prices of other goods
• - Income
• - Expectations, etc.
• ? Means a shift of the entire demand curve

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Change in Price

• A change in the price of a good means a movement
  along a demand curve.

Price
Pa
Pb
Demand
Quantity/time
Qa Qb
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Change in Demand

• A change in a factor that determines demand,
  besides the price of the good itself, causes the
  Demand curve to shift.
• Example Increase in price of substitute or
  increase in income causes an increase in demand.

Price
Da
Pa
Db
Quantity/time
Qa
Qb
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Deriving a Real Demand Curve

• Define your market
• Boulder, Colorado, over time
• consumption of water by people
• served by city water price per
• 1,000 gallons billions gallons/yr.
• consumed by demanders.
• Year Price Quantity
• 1968 0.28 29
• 1972 0.36 19
• 1977 0.50 13
• 1982 0.74 9

Price
.74
Demand
.50
.36
.28
0
9 13 19 29
Quantity
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What else would you want to know?

• The Demand curve plots the relationship between
  price and quantity demanded nothing else
  everything else is held constant
• But in the real world, other things are not
  constant, so what else would you want to know if
  you wanted to understand that market better?
• Name likely relevant factors

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Hard Test Which Goods Are Complements, Which
Are Substitutes?

• Wine and beer.
• Domestic shirts and imported shirts.
• Oil from Iran and coal from China.
• Paper and pencils.
• Plate glass and brick/concrete

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Demand analysis

• How would demand for hair replacement be likely
  to change if the following occurs?
• A fall in the price of hairpieces.
• A rise in income.
• A rise in the divorce rate.

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Clever sales pitch

• A British cellphone company promised new
  subscribers in November and December that all
  calls on Christmas Day, December 25, would be
  free. What would you expect happened to the
  volume of calls that day?

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Question on changing demand

• Trying to predict future demand, GE research
  showed that the average size of the American
  family was declining and so was the average
  square footage of houses.
• How would you think this impacted the demand for
  the design of, say, refrigerators?

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Key Point from Peter Drucker

• Most important question sellers must ask
• What is value to the customer?
• Sellers often think they know, but do not. The
  customers do not buy a product they buy value.
• Demanders are buying a product to satisfy a want.
  Do not guess what customers wantalways carefully
  evaluate what they want.