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?

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.

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.

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

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.

The Demand Function:

Some Definitions
The relationship between quantity consumed and the
factors determining that: D = f (P, P S, 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

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

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

This or that?
Substitutes:

Essentially, goods used in place of each other

same 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.

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

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

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

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

Terminology:

Used 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

Change in Price

A change in the price of a good

means a movement along a
demand
curve.
Price
Pa
Pb

Demand

Qa

Qb

Quantity/time

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

Qa

Qb

Quantity/time

Deriving a Real Demand

Curve
Define your market:

Boulder, Colorado, over time; Price

consumption of water by people
.74
served by city water; price per
1,000 gallons; billions gallons/yr.
.50
consumed by demanders.

Demand

.36
Year
1968
1972
1977
1982

Price
$0.28
$0.36
$0.50
$0.74

Quantity
29
19
13
9

.28
0

13

19

2
Quantit

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:

Hard Test:
Which Goods Are Complements,
Which Are Substitutes?
1.
2.

3.
4.
5.

Wine and beer.

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

Demand analysis

1.
2.
3.

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.

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?

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?

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.