Economics Fundamentals: The Law Of Demand

People make economic decisions every day. As a consumer you have to decide how to spend your limited money income on goods and services in order to derive as much utility or satisfaction as possible. Besides, you have also to decide whether you will spend all of your income on goods and services or save some of it to finance future consumption. As an entrepreneur you have to decide how many people to hire, how much you are going to produce, what price to charge, or how much to invest in new plant or equipment.

Suppose you are a beef manufacturer and you look for information about the impact of your pricing decisions on the demand for your beef products in a small foreign market. To determine the quantity demanded that consumers would purchase each year at alternative prices, you perform a market research, which reveals the following: the quantity demanded of beef that consumers are willing and able to buy decreases as the price of beef increases.

One of the fundamental principles in Economics is known as the law of demand. Demand refers to the relationship between the price of a good or a service and the quantity demanded that consumers are willing and able to buy at a certain price. According to the law of demand, price and quantity demanded are inversely related and if all other factors that affect consumer demand are held constant, as the price of a good increases (decreases) the quantity demanded for that particular good decreases (increases). Besides, the law of demand is one of the most important managerial tools because it assists managers in forecasting changes in product and input prices.

Variables other than the price of a good that can influence demand are known as demand shifters. In the above example, the quantity demanded of beef that consumers are willing and able to buy may also depend on consumer income, the prices of related goods and advertising. Each variable has a different impact on demand and when a variable changes, it leads to a change in demand. This change is depicted on the demand curve, which is a straight line that interpolates the quantities that consumers are willing and able to buy at certain prices. A rightward shift in the demand curve implies an increase in demand as more quantity is demanded at each price. A leftward shift in the demand curve implies a decrease in demand as less quantity is demanded at each price.

a)      Consumer Income

Because income affects the ability of consumers to purchase a good, changes in income affect the quantity that consumers will buy at each price. However, economists suggest that an increase in consumer income may increase or decrease demand for a particular good depending on the type of good and distinguish between normal and inferior goods.

Normal goods are those for which an increase (decrease) in income leads to an increase (decrease) in the demand for that good. Inferior goods are those for which an increase (decrease) in income leads to a decrease (increase) in the demand for that good.

b)      Prices of related goods

In the above example, if the price of beef increases, most consumers will begin to substitute chicken because the relative price of beef is higher than before. As more and more consumers substitute chicken for beef, the quantity demanded for chicken will increase at each price as a result of the increase in the price of beef. Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in the demand of the other good are known as substitutes. In contrast, goods for which an increase (decrease) in the price of one good leads to a decrease (increase) in the demand of the other good are known as complements. The most common example of complement goods in Economics is beer and pretzels. When the price of beer increases, consumers decrease the consumption of pretzels.

c)      Advertising

The impact of advertising on consumers can be interpreted in two ways. From the one hand, advertising provides consumers with information about the existence or quality of a product, which in turn induces more consumers to buy the product. This is known as informative advertising. On the other hand, advertising can influence demand by altering the underlying tastes of consumers, for example, by promoting the latest fad in clothing. This is known as persuasive advertising. Depending on the type of advertising, consumers may be willing to buy more quantity of a good even for a higher price, which will lead to a relevant change in demand and a relevant shift of the demand curve.

Other factors that may affect the demand are consumer expectations and population. For instance, if consumers expect that the price of cars will be significantly higher next year, the demand for cars this year will increase. In other words, consumers will substitute current purchases for future purchases if they expect future prices to rise. This type of consumer behavior is referred to as stockpiling and it generally occurs for durable products.

Finally, the market demand is influenced by changes in the size and composition of the population. In general, as the population increases, more people are willing to buy a product. Also, changes in the composition of the population affect the demand for a product. For instance, middle-aged consumers demonstrate increased demand for real estate or medical services.