2.1 Demand Theory

demand

willingness and ability of a consumer to pay a certain amount for a good or service at a specified price and a prticular point in time

law of demand

as the price of a good or service rises, the quantity demanded falls, and as the price of a good falls, the quantity demanded rises (ceteris paribus)

negative relationship between quantity demanded and price

what are the three assumptions underlying the law of demand?

1. real income effect

2. substitution effect

3. law of diminishing marginal utility

real income effect

when a change in the price of a good affects consumers’ purchasing power

e.g. a lower price increases a consumer’s purchasing power since with the same amount of money they can afford to buy more of that good

substitution effect

change in the quantity demanded of a good when its price changes, making it more or less expensive relative to other goods

-consumers will substitute away from more expensive goods in favour of cheaper alternatives

-as the price of a good falls, the quantity demanded increases partly because the good offers greater satisfaction to the consumer per unit of money spent compared to its substitutes

law of diminishing marginal utility

as more of a good is consumed, the additional satisfaction (marginal utility) gained from each extra unit consumed decreases, and so consumers will only buy more of the good if its price falls

utility

satisfaction that a consumer derives from consuming a good or a service

individual demand

quantity of a good or service that a single consumer is willing and able to purchase at various prices over a given period of time, specific to that consumer’s tastes and preferences

market demand

total quantity of a good or service that all consumers in a market are willing and able to purchase at various prices over a given period of time

how to figure out market demand given individual demand curves

5 non-price determinants of demand

1. income

2. tastes and preferences

3. future price expectations

4. price of related goods (substitutes and complements)

5. number of consumers

normal goods

positive relationship between consumer income and demand

e.g. fresh food, new cars

inferior goods

negative relationship between consumer income and demand

e.g. instant noodles, public transport

necessity goods

as household incomes rise, the demand for necessity goods will rise but at a less than proportionate rate relative to the rise in income

type of normal good

e.g. bread, housing, electricity

luxury goods

as household income rise the demand for the luxury goods will rise but at a greater than proportionate rate relative to the rise in income

strong positive correlation between income and demand

e.g. holidays, branded clothing

what causes a movement along the demand curve

change in the price of a good or a service itself

what causes a shift in the demand curve

a change in any of the non-price determinants altering the quantity demanded at every point