No Such Thing as a Free Lunch: Principles of Economics (Part 11)

We shouldn't measure everything in terms of GDP figures or economics. There is something called quality of life.

Nigel Farage

Demand, Supply, and Market Equilibrium

(Part C)

by 

Charles Lamson

Other Determinants of Household Demand

Of the many factors likely to influence a household's demand for a specific product, we have considered only the price of the product itself. Other determining factors include household income and wealth, the prices of other goods and services, tastes and preferences, and expectations.

Income and Wealth Before we proceed, we need to define two terms that are often confused, income and wealth. A household's income is the sum of all wages, salaries, profits, interest payments, rents, and other forms of earnings received by the household in a given period of time. Income is thus a flow measure: We must specify a time period for it---income per month or per year. You can spend or consume more or less than your income in any given period. If you consume less than your income, you save. To consume more than your income in a period, you must either borrow or draw on savings accumulated from previous periods.

Wealth is the total value of what a household owns less what it owes. Another word for wealth is net worth---the amount a household would have left if it sold off all its possessions and paid off all its debts. Wealth is a stock measure: It is measured at any given point in time. If in a given period, you spend less than your income, you save; the amount that you save is added to your wealth. Saving is the flow that affects the stock of wealth. When you spend more than your income, you dissave---you reduce your wealth.

Households with higher incomes and higher accumulated savings or inherited wealth can afford to buy more things. In general, we would expect higher demand at higher levels of income/wealth and lower demand at lower levels of income/wealth. Goods for which demand goes up when income is higher and for which demand goes down when income is lower are called normal goods. Movie tickets, restaurant meals, telephone calls, and shirts are all normal goods.

However, generalization in economics can be hazardous. Sometimes demand for a good falls when household income rises. Consider, for example, the various qualities of meat available. When a household's income rises, it is likely to buy higher quality meats---its demand for filet mignon is likely to rise---but it's demand for lower quality meats---chuck steak, for example---is likely to fall. Transportation is another example. At higher incomes people can afford to fly. People who can afford to fly are less likely to take the bus long distances. Thus higher income may reduce the number of times someone takes a bus. Goods for which demand tends to fall when income rises are called inferior goods.

Prices of Other Goods and Services No consumer decides in isolation on the amount of any one commodity to buy. Instead, each decision is part of a larger set of decisions that are made simultaneously. Households must apportion their incomes over many different goods and services. As a result, the price of any one good can and does affect the demand for other goods.

When an increase in the price of one good causes demand for another good to increase (a positive relationship), we say that the goods are substitutes. A fall in the price of a good causes a decline in demand for its substitutes. Substitutes are goods that can serve as replacements for one another.

To be substitutes, two products do not need to be identical. Identical products are called perfect substitutes. Japanese cars are not identical to American cars. Nevertheless, all have four wheels, are capable of carrying people, and run on gasoline. Thus, significant changes in the price of one country's cars can be expected to influence demand for other country's cars. Restaurant meals are substitutes for meals eaten at home, and flying from New York to Washington as a substitute for taking the train.

Often, two products "go together"---that is, they complement each other. Bacon and eggs are complementary goods, as are cars and gasoline, and cameras and film. When two goods are complements, a decrease in the price of one results in an increase in demand for the other, and vice versa.

Because any one good may have many potential substitutes and complements at the same time, a single price change may affect a household's demand for many goods simultaneously; the demand for some of these products may rise while the demand for others may fall.

Tastes and Preferences Income, wealth, and prices of goods available are the three factors that determine the combinations of things that a household is able to buy. You know that you cannot afford to rent an apartment at $1,200 per month if your monthly income is only $400, but within these constraints, you are more or less free to choose what to buy. Your final choice depends on your individual tastes and preferences.

Expectations What you decide to buy today certainly depends on today's prices and your current income and wealth. You also have expectations about what your position will be in the future. You may have expectations about future changes in prices, too, and these may affect your decisions today.

There are many examples of the ways expectations affect demand. When people buy a house or a car, they often must borrow part of the purchase price and repay it over a number of years. In deciding what kind of house or car to buy, they presumably must think about their income today, as well as what their income is likely to be in the future.

Increasingly, economic theory has come to recognize the importance of expectations. We will devote a good deal of time to discussing how expectations affect more than just demand. For the time being, however, it is important to understand that demand depends on more than just current incomes, prices, and taste. 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 49-51*

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