The Demand Curve
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The Demand Curve
If you ask a taxi driver what he thinks economics is all about, the answer is invariably: "...it's all about supply and demand, guv'." And of course, there is the old joke: "teach a parrot to say supply and demand and you've got an economist!" Obviously there is a lot more to the subject than just supply and demand, but there is an element of truth in the layman's view. Much of what you learn at A' level involves an application of the basic laws of supply and demand that appear in these first few Learn-Its.
Before we look at the basic demand curve, it is important to understand that economists only recognise demand when it is effective demand. This means demand that is backed up with a willingness and ability to pay. I should think that many of you reading this page would demand a Ferrari, but let's face it, it's not really effective demand, is it!
Now we will look at the theory of demand. At higher prices, a lower quantity will be demanded than at lower prices, ceteris paribus. At lower prices, a higher quantity will be demanded than at higher prices, ceteris paribus. Basically, when the price is high demand is low and vice versa. Ceteris paribus means 'all other things being equal'. It is very important that you state this condition when using demand curves. I will explain why under "determinants of demand". First, let's have a look at the normal downward-sloping demand curve:
Note that I've drawn it as a curve, which is probably a little more realistic. Many of you will use straight-line demand curves in the exam. This is perfectly OK, remember that these diagrams are only sketches that you are using to help you analyse a situation. Anyway, as you can see in the diagram above, the demand for CDs is fairly low at the relatively high price of fifteen pounds, but at the bargain price of five pounds demand is much higher.
It is fairly obvious so far that the price of a good is a pretty strong determinant of its demand, but there are many other things that will affect demand too.
- Real income. If one's real income rose (real means 'allowing for inflation'), one should be able to afford more CDs.
- The price of other goods. If the price of CD players rose then one would expect demand for CD players to fall, and so would the demand for CDs. These goods are complements. If the prices of rock concerts rose then one would expect the demand for these concerts to fall. Perhaps those who decided against the concert might buy a CD instead. These goods are substitutes.
- Tastes and preferences. A slightly obscure but very important determinant. As you get older, you may lose interest in the repetitive music currently in the charts and try some original sounds from the 60s, 70s or 80s. Changing preferences will affect your demand for a product regardless of its price.
- Expectations of future prices. If you think that the price for CDs is likely to fall in the near future, perhaps because of reduced production costs or competition from the US, you may delay some purchases which will reduce demand in the current time period. Alternatively, you may feel that CD prices are likely to rise in the near future, perhaps due to the lack of competition in the retail market, so you may increase your demand in the current time period.
- Advertising. Although many of you probably doubt the effectiveness of some of the appalling adverts on the TV, one assumes that these companies would not spend fortunes on these adverts if they did not expect to see a significant rise in demand for the product in question (Virgin and Our Price are always trying to sell you CDs via the TV.)
- Population. Quite obviously, a significant rise in the number of people in a given area or country will affect the demand for a whole host of goods and services. Note that a change in the structure of the population (we have an ageing population) will increase the demand for some goods but reduce the demand for others.
- Interest rates and credit conditions. If interest rates are relatively low then it is cheaper to borrow money that can then be spent. This is not so applicable to CDs, but will certainly affect the demand for 'big ticket' items such as cars and major electrical goods. In boom time (like the late 80s) it is often easier to obtain credit regardless of the rate of interest.
Now that you understand that there are many things that affect the demand for a good other than its price, I hope you can see the importance of the ceteris paribus assumption. The normal downward-sloping demand curve shows the relationship between the price of the good and its demand, all other things being equal. Those 'all other things' are the list above: incomes, prices of other goods, etc. If you do not make this assumption, then you could have a situation when the price of CDs falls, but at the same time one's income falls by such a large amount that one actually demands fewer CDs. In other words, one does not want to confuse shifts in the demand curve and movements along a demand curve.
It is very important that you understand the difference shifts of and movements along demand curves. Examiners often test your understanding of this point in multiple-choice questions.
A movement along a demand curve only occurs when there is a change in the price of the good in question. Some textbooks call these movements extensions and contractions. In the diagram below (note that it is a straight-line sketch), when the price of CDs falls (from P1 to P2) there is a rise in demand (from Q1 to Q2), ceteris paribus. The movement along the curve is from point A to point B. When the price rises (from P1 to P3) there is a fall in demand (from Q1 to Q3), ceteris paribus. The movement along the curve is from point A to point C.
Note that we must say 'ceteris paribus'. If one of the other determinants of demand changes as well, then the curve would shift. Also note - always label all of your diagrams very well. Examiners hate poorly labelled diagrams.
A shift in the demand curve occurs if one of the 'other' (i.e. non-price) determinants of demand change. This means that for a given price level the quantity demanded will change. This is illustrated in the diagram below:
Note that the price has not changed (P1) and yet demand has increased (in the case of the shift to D2) to Q2. This could be due to a rise in real incomes (assuming the good is normal - see the required section in the 'Elasticities' topic), a rise in the price of a substitute good, a fall in the price of a complement, etc. (see 'determinants of demand' above).
In the case of the shift to D3, demand has fallen even though the price has remained constant.
This is quite a difficult idea to understand, so why don't you try the exercise below. Assume the product you are considering is a car. In the left column are a number of factors that may change. Can you click on the way the factor needs to move, in order to make the demand line move to D3?