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Demand Theory

Firms and Households: The Basic

Decision-Making Units
Input Markets and Output Markets: The
Circular Flow
Demand in Product/Output Markets
 Changes in Quantity Demanded versus
Changes in Demand
 Price and Quantity Demanded: The Law of
Demand
 Other Determinants of Household Demand
 Shift of Demand versus Movement Along
the Demand Curve
 From Household Demand to Market
Demand

Firms and Households: The Basic Decision-Making Units

firm An organization that transforms resources (inputs) into products

(outputs). Firms are the primary producing units in a market economy.

entrepreneur A person who organizes, manages, and assumes the

risks of a firm, taking a new idea or a new product and turning it into a
successful business.

households The consuming units in an economy.

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 FIGURE 3.1 The Circular Flow of

Economic Activity
 Diagrams like this one show the
circular flow of economic activity,
hence the name circular flow
diagram.
 Here goods and services flow
clockwise: Labor services
supplied by households flow to
firms, and goods and services
produced by firms flow to
households.
 Payment (usually money) flows in
the opposite (counterclockwise)
direction:
 Payment for goods and services
flows from households to firms,
and payment for labor services
Note: Color Guide—In Figure 3.1 households are depicted in
flows from firms to households. blue and firms are depicted in red. From now on all diagrams
relating to the behavior of households will be blue or shades of
blue and all diagrams relating to the behavior of firms will be red
or shades of red. The green color indicates a monetary flow.

Input Markets and Output Markets: The Circular Flow

product or output markets The markets in which goods and services
are exchanged.

input or factor markets The markets in which the resources used to

produce goods and services are exchanged.
 labor market The input/factor market in which households
supply work for wages to firms that demand labor.
 capital market The input/factor market in which households
supply their savings, for interest or for claims to future profits,
to firms that demand funds to buy capital goods.
 land market The input/factor market in which households
supply land or other real property in exchange for rent.
 Input and output markets are connected through the behavior of both firms and
households.
 Firms determine the quantities and character of outputs produced and the
types and quantities of inputs demanded.
 Households determine the types and quantities of products demanded and the
quantities and types of inputs supplied.

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Q: In the input, or factor markets, which side of the market do firms

and households occupy?
a. Firms are on the supply side and households on the demand
side.
b. Firms are on the demand side and households on the supply
side.
c. Both firms and households are on the demand side.
d. Both firms and households are on the supply side.
e. Neither firms nor households are part of the demand side or
the supply side.

Answer:
b. Firms are on the demand side and households on the
supply side.

Q: Which of the following is supplied by households in factor markets?

a. Labor.
b. Savings.
c. Land.
d. All of the above.
e. None of the above.

Answer:
d. All of the above.

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Markets and Competition

• Market
• A group of buyers and sellers of a particular good
or service
• Can be highly organized
• E.g.: agricultural commodities
• Can be less organized
• E.g.: ice cream, espresso carts, Friday market

Markets and Competition

 Market Types
◦ 1. Perfect Competition
 No individual buyer/seller has a significant influence on
market price
◦ 2. Monopoly
 Single producer of good; chooses output (quantity supplied)
that maximizes profit
◦ 3. Oligopoly
 Small number of suppliers; may “collude” to set price like a
monopolist
◦ 4. Monopolistic Competition
 Compete on both price and quality against several
producers

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Markets and Competition

• Perfectly competitive market
• Each buyer/seller has a negligible impact on market price
• Why? (Key assumptions)
• Goods offered for sale - exactly the same (homogeneous
commodity)
• Buyers and sellers – numerous
• No single buyer or seller has any influence over the market
price
• Must accept the price determined on the market
• Price takers
• At the market price
• Buyers - buy all they want
• Sellers - sell all they want

Demand
• Basic Vocabulary
• The law of demand
• there is a negative, or inverse, relationship between quantity
demanded and price, ceteris paribus .
• Quantity demanded
• Amount of a good purchased at a given price
A point on the demand curve
• Demand
• The entire schedule (curve)
Quantity demanded at various prices
• Difference between a change in quantity demanded and
demand
• Movement along the Demand Curve (change in price) versus
movement of the D Curve

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Demand
• Demand schedule - a table
• Relationship between
Price of a good
Quantity demanded
• Demand curve - a graph
• Relationship between
Price of a good
Quantity demanded
• Individual demand vs Market Demand
• One individual vs all people in buying the good

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The concept of demand

The term ‘demand’ is used to describe the relationship between
the amount of a good or service that consumers are willing and
able to buy at various prices.
Wants and demand
As consumers we all have various ‘wants’ for goods from which we
gain some satisfaction. However, given our limited income we
cannot consume all we would like to and as a result we have to
make choices.
 For example, my willingness to pay for a packet of paracetamol at a
particular moment in time might be that I am prepared to spend $5. If
paracetamol is currently selling at $7 then despite the fact that I have a
demand for paracetamol, no transaction will take place.
 If however paracetamol is available at $5 (or less) then a transaction will
take place.
 Therefore the quantity demanded is the amount that households are
willing and able to buy and this is not necessarily the same as how much
they do buy.

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Determinants of demand
A household’s decision about what quantity of a particular output, or
product, to demand (Qdx) depends on a number of factors, including:
1. The price of the product in question (Px): For most goods, the
higher the price, the less of that good people will want to buy; the lower
the price, the more quantity is demanded (paracetamol and its price).
2. The income available to the household (I): The higher your
income, the more likely it is that more of a good will be demanded at any
given price. Therefore if your income falls, you might consume less
paracetamol per year.
 Normal good – buy/want more as income increases
 Inferior good - buy less as income increases
3. The prices of other products (substitutes (Ps) or complements
(Pc)) available to the household.

Substitute goods are goods which you can use instead of your good
(e.g. if you are buying paracetamol for a headache then a substitute
might be aspirin).

Determinants of demand
 The relationship between demand for paracetamol and the price
of substitute, say aspirin, is positive.
 If the price of a substitute good (say aspirin) increases, demand for your
good (paracetamol ) may increase.

Complementary goods are those bought in conjunction with

your product (e.g. a syringe and a needle).

 If the price of a complementary good rises then demand for

your good may fall.

4. The household’s tastes and preferences (T):

If your tastes change (you experience an allergic reaction to
paracetamol) then your demand for it will change and you will be
prepared to pay less (or possibly nothing at all) for paracetamol

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Determinants of demand
5. The household’s expectations about future income and prices
(EX) (Optimistic and pessimistic expectations).

6. Number of buyers (N):

the increase in the number of consumers resulting from
population growth or migration lead to an increase in
demand for various goods and services (drugs, tests…etc).

Q xd  f (Px , I , N ,T , PC , PS , EX )

Determinants of demand
A household’s decision about what quantity of a particular output, or
product, to demand (Qdx) depends on a number of factors, including:
1. The price of the product in question (Px).
2. The income available to the household (I).
 Normal good – buy/want more as income increases
 Inferior good - buy less as income increases
3. The prices of other products (substitutes (Ps) or complements (Pc))
available to the household.
4. The household’s expectations about future income and prices (EX)
(Optimistic and pessimistic expectations)
5. The household’s tastes and preferences (T).
6. Number of buyers (N)

Q xd  f (Px , I , N ,T , PC , PS , EX )

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Demand in Product/Output Markets

Price and Quantity Demanded: The Law of Demand

law of demand The negative relationship

between price and quantity demanded: As price
rises, quantity demanded decreases; as price
falls, quantity demanded increases.

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.

TABLE 3.1 Relationship between price

and quantity demanded
Figure 3.1 Demand curve for paracetamol
Price Quantity Demanded
(per pack) (pack per Week)
$ 8.00 0
7.00 2
6.00 3
5.00 5
4.00 7
3.00 10
2.00 14
Price of paracetamol $

1.00 20
0.00 26

The relationship between price (P)

and quantity demanded (q) presented
£

graphically.
• negative slope, lower prices cause
quantity demanded to increase.

Quantity demanded per week

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Slope of the demand curve

The demand curve usually slopes downwards – but why?
Two reasons for that:
1) The substitution-effect: If the price of paracetamol rises,
consumption of paracetamol falls and the consumption of other
drugs like aspirin tends to rise.
2) The income effect: When the price of a good rises (such as
paracetamol), if you continue to buy the same amount as before,
you will have less income available to buy other goods (drugs). So
the rise in the price of a good is similar to a fall in real income.
This income effect means that you will buy less of a good when its
price rises in order to have enough income available to buy other
goods.

Together, the income effect (a limited budget means you can only
purchase lower quantities of the good) and the substitution effect (you
swap with alternative goods that are cheaper) give a downward sloping
demand curve.

Fill in the blanks. It is reasonable to expect that quantity demanded will

__________ when price rises, ceteris paribus, and that demand curves
have a __________ slope.
a. rise; positive
b. rise; negative
c. fall; positive
d. fall; negative
Answer:
d. fall; negative

Q:That demand curves intersect both the price and the quantity axes is a
matter of common sense. Which of the following explains that they
intersect the price axis?
a. Time limitations and diminishing marginal utility.
b. Limited incomes and wealth.
c. The law of demand.
d. All of the above.

Answer:
b. Limited incomes and wealth.

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Demand
• Shifts in demand
• Increase in demand
• Any change that increases the quantity demanded at every
price
• Demand curve shifts right
• Decrease in demand
• Any change that decreases the quantity demanded at every
price
• Demand curve shifts left

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 Shifts versus Movement Along a Demand Curve – Change in Price of

Related Goods

1. Along the demand curve:

• price of hamburger rises, the quantity of hamburger demanded declines
2. Movement of the demand curve: (change in price of substitute or complement)
• same price rise for hamburger shifts the demand for chicken (a substitute
for hamburger) to the right and the demand for ketchup (a complement to
hamburger) to the left.

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Changes in Quantity Demanded versus Changes in

Demand

The most important relationship in individual markets is that between

market price and quantity demanded.

 Changes in the price of a product affect the quantity demanded

per period (Change in Quantity Demanded).
 Changes in any other factor, such as income or preferences,
affect demand (Change in 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.

Q: Refer to the figure below. Which move illustrates the impact of a decrease in
market price on market demand, all else the same?
a. The move from A to B.
b. The move from A to C.
c. Both moves show the same result on demand.
d. None of the above.

Answer:
a. The move from A to B.

Q: Refer to the figure below. Assume that TVs and VCRs are two complements and
that the diagram below represents the demand for VCRs. Which move would best
describe the impact of a decrease in the price of TVs on this diagram?
a. The move from A to B.
b. The move from A to C.
c. Both a and b above.
d. None of the above.

b. The move from A to C.

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 Shift of a Demand Curve following a Rise in Income

Shift of Demand versus Movement Along a Demand Curve
TABLE 3.2 Shift of Demand Schedule Due to Increase
in Income
Schedule D0 Schedule D1
Quantity Demanded Quantity Demanded
Price (Paracetamol per Week (paracetamol per
(per pack) at an Income of $500 per Week at an Income of
Week) $700 per Week)
$ 8.00 0 3
7.00 2 5
6.00 3 7
5.00 5 10

Price of paracetamol $
4.00 7 12
3.00 10 15
2.00 14 19
1.00 20 24
0.00 26 30

Increase in income changes the relationship

between price and quantity; there is a shift of
the demand curve, in this case from D0 to D1.
paracetamol is a normal good.

Quantity demanded per week

Normal goods: Goods for which demand goes up when income is higher and
for which demand goes down when income is lower.

Inferior goods: Goods for which demand tends to fall when income rises.

 FIGURE 3.4 Shifts versus Movement Along a Demand Curve

a. When income increases, the demand for inferior goods shifts to the left
and the demand for normal goods shifts to the right.

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Demand
• Variables that can shift the demand curve
1) Prices of related goods (substitutes or complements)
2) Income
3) Number of buyers(market vs individual demand)
4) Expectations
5) Individual Tastes and Preferences

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Individual vs. Market Demand

• Market demand
• Sum of all individual demands for a good or service
• Market demand curve
• Sum - individual demand curves horizontally
• Total quantity demanded of a good varies
• As the price of the good varies
• All other factors that affect how much consumers want to
buy are hold constant

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2
Market demand is the sum of individual demands (demand
schedule)
Price of paracetamol Catherine Nicholas Market

$0.00 12 + 7 = 19
0.50 10 6 16
1.00 8 5 13
1.50 6 4 10
2.00 4 3 7
2.50 2 2 4
3.00 0 1 1
 The quantity demanded in a market is the sum of the quantities demanded by all
the buyers at each price.
 Thus, the market demand curve is found by adding horizontally the individual
demand curves.
 At a price of $2.00, Catherine demands 4 paracetamol, and Nicholas demands 3
paracetamol packs. The quantity demanded in the market at this price is 7 packs.

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2
Market demand as the sum of individual demands
Catherine’s Nicholas’s Market
demand
+ demand
= demand
Price of Price of Price of
paracetamol paracetamol paracetamol

$3.00 DCatherine $3.00 $3.00

DNicholas
2.50 2.50 2.50

2.00 2.00 2.00

1.50 1.50 1.50

DMarket
1.00 1.00 1.00

0.50 0.50 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 14 16 18
Quantity of paracetamol Quantity of Quantity of paracetamol
paracetamol
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 FIGURE 3.5 Deriving Market Demand

from Individual Demand Curves

Total demand in the marketplace is simply

the sum of the demands of all the
households shopping in a particular
market. It is the sum of all the individual
demand curves—that is, the sum of all
the individual quantities demanded at
each price.

Expectations

What you decide to buy today certainly depends on today’s prices and
your current income and wealth.

There are many examples of the ways expectations affect demand.

Increasingly, economic theory has come to recognize the importance of

expectations.

It is important to understand that demand depends on more than just

current incomes, prices, and tastes.

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Table 4: Factors That Shift the Demand Curve

Demand function ‫دالة الطلب‬

Q xd  a  bPx

Q xd Quantity demanded

a Quantity when price = 0

Q xd
b Slope  b 
Px
Px Price of commodity x

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Activity 1
1. Suppose that the price charged for a dental check-up falls, from P1
to P2. Mark the effect on Figure below.
2. If people’s income falls, what would be the effect on demand for
dental check-ups? Again mark the change on Figure below.

The demand for dental health checks

Feedback
1. This fall in price can be represented by a movement along the
demand curve. As the demand curve slopes downwards, quantity
demanded increases (from q1 to q2 in Figure).
2. If a dental check-up is a normal good (and you have no reason to
believe it is not) then the fall in income will result in a decrease in
quantity demanded at all prices. Hence the demand curve shifts to
the left (from D1 to D2 in Figure).

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Demand for health care

 Some aspects of health care may fit the simple demand
model better than others.
 For example, our earlier example of the market for paracetamol
– a person with a headache knows with a relatively high degree
of certainty the effects of consuming this medicine.
 They can buy paracetamol according to their preferences and
without going through a third party.

 However, the demand for health care is different from the

demand for other goods.
 Here are some ways in which the demand for health care is
more complicated than the simple model of demand presented
in this lecture.
1) The demand for health care is often for a single one-off
intervention rather than multiple or repeated requests as often
occurs with the consumption of DVDs or coffee.

Demand for health care

 Here are some ways in which the demand for health care
is more complicated than the simple model of demand
presented in this lecture.
2) It is generally assumed in economics that consumers are
able to make informed decisions about their consumption
patterns. However, in the case of health care, consumers
often delegate this decision-making power to health
professionals who are much better informed.
3) Patients’ perceptions of their need and of their capacity to
benefit, both of which shape their demand, may be
strongly influenced by their doctor – the supplier of health
care.

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Demand for health care

 Here are some ways in which the demand for health care is
more complicated than the simple model of demand
presented in this lecture.
3) Another complication relates to the fact that health care is
extremely heterogeneous. Every patient has a slightly
different combination of ailments and symptoms, and
therefore every patient needs to buy a slightly different
package of care. Furthermore, individuals will vary in how they
respond to treatments.
4) A major difference is that payment for many health services
comes, partly or wholly, from a third party (either an insurance
company or a government) which means individual users of
services may not be sensitive to the price of these services.

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