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Microsoft word - theory of demand

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Theory of Demand
Changes in Quantity Demanded (Movement along the Demand Curve) Changes in Demand (Shifts in the entire Demand Curve) 6.1 Determinants of Demand 2010 Adam Smith Economics Tuition Agency All Rights Reserved. Website: //www.economics-tuition.com
The Central Problem of Economics is on how to allocate scarce resources to satisfy
unlimited wants. You have learnt how the Market Economy is an economic system that uses
the price mechanism to handle this problem.
Now, we move on to understand how this price mechanism works, particularly how prices are
determined
. In the market economy, prices are determined by the intersection of demand and
supply. It is these two topics, demand and supply, that we now seek to understand.

1.

DEFINITION OF DEMAND

Demand
is the relationship indicating the quantity of a well-defined good or service that
consumers are **willing and able to buy** at each possible price during a given period of
time, ceteris paribus1.
Demand is different from consumers’ wants. Demand is also not a desire or wish to posses a
good or service. Demand refers to effective demand – a desire that must be backed by
purchasing power**.

2.
THE DEMAND CURVE
A demand schedule refers to a table showing the different total quantities of a good that consumers are willing able to but at various prices over a given period of time. Price of good X
Quantity demanded (units) of good X
A demand curve illustrates a demand schedule in graphical form, with price measured on the vertical axis and quantity demanded on the horizontal axis. 1 Ceteris Paribus in Latin means 'other things being equal'. This assumption has to be made when making deductions from theories. 2010 Adam Smith Economics Tuition Agency All Rights Reserved. Website: //www.economics-tuition.com
THE LAW OF DEMAND

The law of demand states that an inverse relationship exists between the price of a good
and the quantity demanded of the good, ceteris paribus.

Referring to Table 1, it can be seen that the quantity demanded of good X increases as the
price of good X decreases. This is the Law of Demand which is illustrated in Figure 1 as a
downward sloping curve with a negative slope.
4.
INDIVIDUAL DEMAND VS. MARKET DEMAND

Individual demand refers to the demand of an individual consumer.
Market demand refers to the total quantity demanded of all individuals who are willing and able
to purchase the good at various prices. It is derived by the horizontal summation of all the
individual demand curves.

Note: A derived demand is the demand for a factor of production depends on the
demand for the good which uses it. Example: The demand for labour, skilled or
unskilled is a derived demand as it is ultimately the services they are providing that
consumers want i.e. demand for doctors as there is demand for medical services.

2010 Adam Smith Economics Tuition Agency All Rights Reserved. Website: //www.economics-tuition.com
CHANGES IN QUANTITY DEMANDED (MOVEMENT ALONG THE DEMAND CURVE)

The quantity demanded for a particular good refers to a particular point on the demand curve. It
shows the quantity demanded (i.e. 20 units) at one given price (i.e. $1.00).
A demand curve is constructed on the assumption that 'other things remain equal' (ceteris
paribus
). In other words, it is assumed that none of the determinants of demand, other than
price, changes. The effect of a change in price is then simply illustrated by a movement
along the demand curve, e.g. from point A to point B in Figure 3. This is termed as a change
in quantity demanded
.
Figure 3: Change in the quantity demanded (Arising from a change in the PRICE)
CHANGES IN DEMAND (SHIFTS IN THE ENTIRE DEMAND CURVE)

The demand for a particular good refers to the entire relation indicating the quantity demanded
at each price. It is represented by the whole demand schedule or demand curve. When one of
the other determinants does change we see that, at every single price, the quantity demanded
has either increased or decreased. It is illustrated by a shift of the entire demand curve, e.g.
from DD to DD1 or DD2 in Figure 4. This is termed as a change in demand.
Figure 4: Change in demand (Arising
from a change in factors other than
the price of the good itself)
2010 Adam Smith Economics Tuition Agency All Rights Reserved. Website: //www.economics-tuition.com
Determinants of demand (factors that shift the demand curve)

The following are the non-price factors determining the consumers’ willingness and ability to
buy goods and services.
a) Changes in Consumer Income
The ability of consumers to buy goods is directly dependent on their income. Usually, as the
income increases, more of a good will be demanded.
A normal good is a good whose demand is positively related to changes in income. An
increase in income will lead to an increase in demand, illustrated by a rightward shift in the
demand curve as shown by Figure 5(i). At every price, more of the good will be demanded with
the higher income level.
Examples of normal goods will be cars and houses. As people become more affluent, they will
want to own a car. This can be seen in countries like China where people turned away from
bicycles to driving cars as the economy experiences strong growth in recent years.
An inferior good is a good whose demand is inversely related to changes in income. An
increase in income will cause a fall in demand. The demand curve will shift to the left when
income increases, as illustrated by Figure 5(ii).
Examples of inferior good are hawker centre food, bus rides, used furniture and used clothing.
As income increases, consumers tend to switch from consuming these inferior goods to normal
goods such as restaurant food, taxi rides new furniture and new clothing respectively.
Figure 5: Changes in income and the demand curve 2010 Adam Smith Economics Tuition Agency All Rights Reserved. Website: //www.economics-tuition.com
b) Changes in Consumers’ Expectations
Another factor that can shift the demand curve is a change in consumers’ expectations
regarding future income and future price of a good.
A consumer who is expecting a rise in pay is likely to increase his current demand of goods
and services in anticipation of his increase in pay. Demand in this case is based not only on
current income but on expected income.
Demand is also affected by changes in price expectations. For example, if consumers expect
the price of property to increase further, they will probably increase their demand for flats this
year. On the other hand, if prices are expected to fall next year, consumers will tend to
postpone their purchases until next year.
Changes in expectations will have less impact if the good in question is perishable. If an
individual expects the price of fresh milk to go up next month, he will not buy 30 extra boxes
today. However, if the price of fresh milk is to increase tomorrow, the individual may increase
his purchase of fresh milk by a little today.

c) Changes in Tastes and Preferences
Choices in food, clothing, movies, music, reading – indeed, all consumption choices – usually
are influenced by consumers’ tastes and preferences. Since tastes and preferences are merely
consumers’ likes and dislikes, a change in tastes and preferences can change demand.
Consumers usually demand for goods and services that are fashionable and when the craze
is over, the demand will fall. Examples are iPhone, bubble tea, pork floss bun, Rotiboy (coffee
bun) and the most recent will be donuts.
Sometimes, a change in tastes and preferences may be related to some particular events. For
example, the demand for kiwi could increase if the public developed the perception that it is
one of the richest fruit in Vitamin C and can improve people immune system significantly.
Similarly, if health officials warn that kiwi consumption is linked to allergies and advise parents
not to feed kiwi to their children below five years old, the demand will fall.
In recent years, news broadcast on deaths caused by Mad Cow Disease and H5N1 Bird flu2
may also cause the consumers to avoid eating beef and poultry and this will lead to a fall in
demand for beef and poultry.
Consumers' taste and preference are also affected by advertising. Effective and successful
advertising creates wants so that at every single price, the consumer is now willing to
purchase more of the good.

d) Changes in the Price of Related Goods
A change in the price of one good can cause a shift in the demand of another good.
When an increase in the price of one good causes the demand for a related good to increase,
the two goods are substitutes. Goods are substitutes if they are alternatives or perceived
to be alternatives that satisfy the same consumer wants.
For example, an increase in the
price of Adidas shoes will cause the demand for Nike shoes to increase. The demand curve for
2 Refer to Appendix 1 for a report on the rise in demand for Tamiflu tablets. 2010 Adam Smith Economics Tuition Agency All Rights Reserved. Website: //www.economics-tuition.com
Nike shoes will shift to the right, as shown in Figure 6(i). Conversely, a decrease in the price of
one good will lead to a decrease in the demand for its substitutes.
When an increase in the price of one good causes the demand for a related good to decrease,
the two goods are known as complements. Goods, which are complements, are often
jointly demanded as they are used in combination to satisfy the same consumer want.

Examples are computer hardware and software, mobile phones and mobile subscription plans.
Figure 6(ii) shows that when the price of subscription plan decreases, the demand for mobile
phones will shift to the right. Conversely, an increase in the price of the mobile subscription
plan will lead to a decrease in the demand for the mobile phones.
Figure 6: Changes in price of the related goods and the demand curve Note: Goods that are complements are not of an input-output relationship. It is
inaccurate to say sugar and cake are complements as sugar is only one of the
ingredients to bake cake. Rather, goods that are complements are consumed together. A
complement for cake will be a cup of tea.


e) Changes in the Composition of Population
(i) Age Composition
For example, if the number of elderly people increases, the demand for false teeth, spectacles
and old-age homes may increase. Similarly, if the baby population declines, the demand for
baby food and baby diapers will fall.
(ii) Sex Composition
For example, if there is a growing imbalance of females over males, the demand for cosmetics,
clothes for females and beauty salon services will increase.
f) Changes in the Size of Population
Certain markets face huge influences when population size changes relatively quickly. For eg,
hosing and property markets experience turbulence when more foreigners are welcome into
Singapore.
2010 Adam Smith Economics Tuition Agency All Rights Reserved. Website: //www.economics-tuition.com


g) Others
(i) Government Policies and Action
Government actions can change the demand for the good. For example, by informing the
public that smoking causes lung cancer or restricting the advertisement of cigarettes, the
demand for cigarettes would decrease.

(ii) Changes in Seasons and Weather
Certain types of goods may have higher demand in certain time of the year. For example,
demand for flowers and chocolate may be higher when Mother’s Day or Valentine Day is
approaching compared to the rest of the year.

7.

Demand = willingness and ability to purchase Qd = f(price of the good, price of other goods, income, taste, population,….)
Change in quantity demanded
Change in Demand
the good itself other than the price of the good itself 2010 Adam Smith Economics Tuition Agency All Rights Reserved.

Source: http://jacktan.info/aleveleconomics-old/pdf/adam%20smith%202010%20-%20demand%20theory%20notes.pdf

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