Since scarcity is the basic economic problem, if it does not exist then there is no reason for my economics course. Devoting time to the study of how people use limited resources to fulfill unlimited wants and needs should help us to discover how to best utilize the resources we have at our disposal.
Demand, Supply, and Market Equilibrium
(Part B)
by
Charles Lamson
 |
Demand in Product/Output Markets
In real life, households make many decisions at the same time. To see how the forces of demand and supply work, however, let us focus first on the amount of a single product that an individual household decides to consume within some given period of time, such as a month or a year. A household's decision about what quantity of a particular output, or product, to demand depends on a number of factors including:
Quantity demanded is the amount (number of units) of a product that a household would buy in a given period if it could buy all it wanted at the current market price. Of course, the amount of a product that households finally purchase depends on the amount of product actually available in the market. The phrase if it could buy all it wanted is critical to the definition of quantity demanded because it allows for the possibility that quantity supplied and quantity demanded are unequal. Changes in Quantity Demanded versus Changes in Demand The most important relationship in individual markets is that between market price and quantity demanded. For this reason, we need to begin our discussion by analyzing the likely response of households to changes in price using the device of ceteris paribus, or "all else equal." That is, we will attempt to derive a relationship between the quantity demanded of a good per time period and the price of that good, holding income, wealth, other prices, tastes, and expectations constant.  It is very important to distinguish between price changes, which affect the quantity of a good demanded, and changes in other factors (such as income), which change the entire relationship between price and quantity. For example, if a family begins earning a higher income, it might buy more of a good at every possible price. To be sure that we distinguish between changes in price and other changes that affect demand, I will throughout the rest of this analysis be very precise about terminology. Specifically: Changes in the price of a product affect the quantity demanded per period. Changes in any other factor, such as income or preferences, affect demand. Thus we say that an increase in the price of Coca-Cola is likely to cause a decrease in the quantity of Coca-Cola demanded. However, we say that an increase in income is likely to cause an increase in the demand for most goods. Price and Quantity Demanded: The Law of Demand A demand schedule shows the quantities of a product that a household would be willing to buy at different prices. Table 1 presents a hypothetical demand schedule for Anna, a student who went off to college to study economics while her boyfriend went to art school. If telephone calls were free (a price of zero), Anna would call her boyfriend everyday, or 30 times a month. At a price of $0.50 per call, she makes 25 calls a month. When the price hits $3.50, she cuts back to 7 calls a month. The same information presented graphically is called a demand curve. Anna's demand curve is presented in Figure 2.  You will note in Figure 2 that quantity (q) is measured along the horizontal axis, and price (P) is measured along the vertical axis. This is the convention we will follow throughout this analysis. Demand Curves Slope Downward The data in Table 1 show that at lower prices, Anna calls her boyfriend more frequently; at higher prices, she calls less frequently. There is thus a negative, or inverse, relationship between quantity demanded and price. When price rises, quantity demanded falls, and when price falls, quantity demanded rises. Thus demand curves always slope downward. This negative relationship between price and quantity demanded is often referred to as the law of demand, a term first used by economist Alfred Marshall and his 1890 textbook (Alfred Marshall, Principles of Economics, 8th ed., 1948, p.33).  Some people are put off by the abstraction of demand curves. Of course, we do not actually draw our own demand curves for products. When we want to make a purchase, we usually face only a single price, and how much we would buy at other prices is irrelevant. However, demand curves help analysts understand the kind of behavior that households are likely to exhibit if they are actually faced with a higher or lower price. We know for example that if the price of a good rises enough, the quantity demanded must ultimately drop to zero. The demand curve is a tool that helps us explain economic behavior and predict reactions to possible price changes. Marshall's definition of a social "law" captures the idea: The term "law" means nothing more than a general proposition or statement of tendencies, more or less certain, much more or less definite . . . a social law is a statement of social tendencies; that is, that a certain course of action may be expected from the members of a social group under certain conditions. It seems reasonable to expect that consumers will demand more of a product at a lower price and less of it at a higher price. Households must divide their incomes over a wide range of things goods and services. If I spend $4.50 for a pound of prime beef, I am sacrificing the other things that I might have bought with the $4.50. If the price of prime beef were to jump to $7 per pound, while chicken breasts remained at $1.99 (remember ceteris paribus---we are holding all else constant), I would have to give up more chicken and/or other items to buy that pound of beef. So I would probably eat more chicken and less beef. Anna calls her boyfriend three times when phone calls cost $7 each. A fourth call would mean sacrificing $7 worth of other purchases. At a price of $3.50, however, the opportunity cost of each call is lower, and she calls more frequently. Another explanation for the fact that demand curves slope downward rests on the notion of utility. Economists use the concept of utility to mean happiness and satisfaction. Presumably we consume goods and services because they give us utility. As we consume more of a product within a given period of time, it is likely that each additional unit consumed will yield successively less satisfaction. The utility I gain from a second ice cream cone is likely to be less than the utility I gained from the first; the third is worth even less, and so forth. This law of diminishing marginal utility is an important concept in economics. If each successive unit of a good is worth less to me, I am not going to be willing to pay as much for it. It is thus reasonable to expect a downward slope in the demand curve for the good.  The idea of diminishing marginal utility also helps to explain Anna's behavior. The demand curve is a way of representing what she is willing to pay per phone call. At a price of $7, she calls her boyfriend three times per month. A fourth call, however, is worth less than the third---that is, the fourth call is worth less than $7 to her---so she stops at three. If the price were only $3.50, however, she would keep right on calling. Even at $3.50, she would stop at 7 calls per month. This behavior reveals that the eighth call has less value to Anna then the 7th. Thinking about the ways that people are affected by price changes also helps us see what is behind the law of demand. Consider this example: Luis lives and works in Mexico City. His elderly mother lives in Santiago, Chile. Last year, the airlines servicing South America got into a price war, and the price of flying between Mexico City Santiago dropped from 20,000 pesos to 10,000 pesos. How might Luis's behavior change? First, he is better off. Last year he flew home to Chile three times at a total cost of 60,000 pesos. This year he can fly to Chile the same number of times, buy exactly the same combination of other goods and services that he bought last year, and have 30,000 pesos left over. Because he is better off---his income can buy more---he may fly home more frequently. Second, the opportunity cost of flying home has changed. Before the price war, Lewis had to sacrifice 20,000 pesos worth of other goods and services each time he flew to Chile. After the price war he must sacrifice only 10,000 pesos worth of other goods and services for each trip. The trade-off has changed. Both these effects are likely to lead to a higher quantity demanded in response to the lower price. In sum, it is reasonable to expect quantity demanded to fall when price rises, ceteris paribus, and to expect quantity demanded to rise when price falls, ceteris paribus. Demand curves have a negative slope. Other Properties of Demand Curves Two additional things are notable about Anna's demand curve. First, it intersects the Y-, or price, axis. This means that there is a price above which no calls will be made. In this case Anna simply stops calling when the price reaches $15 per call.  As long as households have limited incomes and wealth, all demand curves will intersect the price axis. For any commodity, there is always a price above which a household will not, or cannot, pay. Even if the good or service is very important, all households are ultimately constrained, or limited, by income and wealth. Second, Anna's demand curve intersects the X-, or quantity, axis. Even at a zero price, there is a limit to the number of phone calls Anna will make. If telephone calls were free, she would call 30 times a month, but not more. That demand curves intersect the quantity axis is a matter of common sense. Demand in a given period of time is limited, if only by time, even at a zero price. To summarize what we know about the shape of demand curves:
 That is all we can say; it is not possible to generalize further. The actual shape of an individual household demand curve whether it is steep or flat, whether it is bowed in or bowed out depends on the unique tastes and preferences of the household and other factors. Some households may be very sensitive to price changes; other households may respond little to a change in price. In some cases, plentiful substitutes are available; in other cases they are not. Thus, to fully understand the shape and position of demand curves, in the next post we turn to the other determinants of household demand. *MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 46-49* end |
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