Session 2: Analysis of Demand

In a free market individuals are free to make their own economic decisions. Consumers are free to decide what to buy with their incomes: free to make demand decisions. Firms are free to choose what to sell and what production methods to use: free to make supply decisions. The price mechanism is a process where the market forces of demand and supply interact to fix the price of a good or service. Definition of Demand Demand is the quantity of a good or service that consumers are willing and are able to buy at a given price within a specified period of time when all other demand factors (such as consumer income, tastes and preferences, prices of related goods, consumer population, expectations, etc.) are held unchanged. Hence demand could simply be defined as a set of prices for a good or service with a corresponding set of quantities. In economics, demand goes beyond the expression of mere desire, wish or want. That is, economists mean effective demand when they mention demand which is the desire, wish or want, backed by the ability to pay for what you desire, wish or want. The Law of Demand The way consumers react to a change in the price of a good or service is so typical that economists state it as a law. The law of demand states that if the price of a good or service rises quantity demanded will decline, and if the price falls quantity demanded will increase when all other factors of demand remain unchanged. Stating the law in another way, we say that the quantity demanded of a good is inversely (or oppositely) related to its price, when we hold constant other factors that influence consumers consumption of a commodity. Representation of Demand The demand for a commodity may be represented in three ways: as a schedule, a curve or a function (equation). The Demand Schedule The demand schedule is a table or a list of various prices of a good or service and the corresponding quantities that would be purchased at a particular time period, when all other demand factors are held fixed. Table 1.1 is an example of a demand schedule for a good. Table 1.1: The Demand Schedule for a Good Price of Jeans Quantity of Jeans Sold (GH) (units) 0 5 10 15 20 25 30 35 40 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0

It shows the quantity of a good that will be demanded at a given price, holding all other demand factors fixed. When the price is GH0, quantity demanded is 80,000 units. When the price increases to GH5, quantity demanded decreases to 70,000 units. As the price of the good increases from GH0 through to GH40, quantity demanded decreases from 80,000 units through to 0 units depicting the law of demand. The Demand Function/Equation We have defined demand as the quantity of a good or service that consumers are willing and are able to buy at a given price within a specified period of time when all other demand factors remain fixed. The other factors that influence demand but are expected to remain unchanged include consumer income (Y), prices of related goods and services (PR), and other variables affecting demand. The demand function or equation is a mathematical expression that relates the quantity demanded of a good or service to the own price of the good or service and the other demand factors. Mathematically, a general demand function (for say Good X) may be stated as follows:

Qxd = f(Px , PY , M, H,)

Qxd = quantity demand of good X. Px = price of good X. PY = price of a related good Y. Substitute good. Complement good. M = income. Normal good. Inferior good. H = any other variable affecting demand (advertising, consumer population, etc). Illustrations Problem 1 An economic consultant for X Corp. recently provided the firms marketing manager with this estimate of the demand function for the firms product:

Q xd ! 12 ,000  3 Px  4 Py  1M  2 Ax
Where Q xd represents the amount consumed of good X, Px is the price of good X, Py is the price of good Y, M is income , and Ax represents the amount of advertising spent on good X. Suppose good X sells for GH200 per unit, good Y sells for GH15 per unit, the company utilizes 2,000 units of advertising, and consumer income is GH10,000. a) How much of good X do consumers purchase?

b) Are goods X and Y substitutes or complements? c) Is good X a normal or an inferior good? Solution (a) (b)
d Q x ! 12 ,000  3( 200 )  4 (15 )  1(10 ,000 )  2( 2,000 ) ! 5, 460 units

Since the coefficient of Py in the demand equation is 4>0 (positive), we know that GH1 increase in the price of good Y will increase the consumption of good X by 4 units. Thus Goods X and Y are substitutes. Since the coefficient of M in the demand equation is -1<0, we know that GH1 increase in income will decrease the consumption of good X by 1 unit. Thus Good X is an inferior good.

(c)

Problem 2 A firms demand function for its product is given as: Qd = 1000 0.07P, where P is the own price and Qd, the quantity demanded of the product. (a) (b) Calculate the quantity that will be consumed when price is: (i) 2,000 (ii) 1,500 What should the firm charge to sell exactly300 units of the product?

Solution (a) From the demand function: Qd = 1000 0.07P (i) If price is 2,000, the quantity consumed will be: Qd = 1000 0.07(2,000) = 1000 140 = 860. i.e. consumers will buy 860 units of the product if the price is 2,000. (ii) If price is 1,500, the quantity consumed will be: Qd = 1000 0.07(1,500) = 1000 105 = 895 units. i. e. consumers will buy 895 units if the firm charges 1,500. (b) The price to charge when the firm wants to sell 300 units: 300 = 1000 0.07P 0.07P = 1000 300 0.07P = 700 P = 700 / 0.07 = 10,000 To sell 300 units, the firm should charge 10,000.

The Demand Curve/Graph When the set of quantities demanded in the demand schedule is plotted against the set of prices, we obtain a demand curve or graph. Hence, the demand curve is a graph (or a locus of points) showing the various quantities that will be bought at given prices of a commodity for a given time period, when all other demand factors remain fixed or constant. Usually price is plotted on the vertical axis with quantity demanded is on the horizontal axis. A typical demand curve has a negative slope. That is, it slopes downward from left to right depicting the law of demand.

Figure 1.1: The Demand Curve Price (GH)

P1

D 0 Q1 Q2 Quantity demanded (in units)

In Figure 1.1, D is a typical demand curve. At price OP1 quantity demanded is OQ1. A fall in price from OP1 to OP2 brings about an increase in quantity demanded from OQ1 to OQ2.

Determinants (Shifters) of Demand Economists mean shifters of the demand curve when they refer to the determinants of demand. Whereas the quantity demanded of a commodity is determined by the own price of the commodity, the demand for a commodity on the other hand is determined by factors other than the own price of the commodity. For most commodities, when the price falls, more of it is purchased whiles when the price rises, lesser quantity than before is purchased when all other demand factors remain unchanged. Under the determinants of demand, we usually focus on those factors that collectively determine the position of the demand curve in price-quantity demanded space. The demand for a commodity is determined by several factors including prices of related (substitutable or complementary) commodities, consumer income, consumer taste and preference, consumer expectation in both income and price, and population of consumers, etc. Consumer Income A change in consumer income, given that all other demand factors remain unchanged, may bring about a change in the demand for a commodity. However, the direction of change in demand will depend on the type of commodity in question. For a normal good, demand might increase when

consumer income increases and demand might fall when consumer income falls, given that all other demand factors remain unchanged. In the case of an inferior good, demand might decline when consumer income increases whiles demand might increase as consumer income increases, also given that all other demand factors remain unchanged. Hence, for inferior goods we consume more when we are worse off financially but consume less when we are better off. For instance who would want to buy second hand or home used goods (such as clothing, shoes, vehicles, etc.) when he or she is rich? For a necessity, a change in consumer income may not affect demand. Prices of Related Commodities Commodities when related may either be complements or substitutes. Commodities are described as complementary when they have joint demand. That is, they are jointly needed before a want can be satisfied. Examples of complementary commodities are camera and film. One can satisfy a want to take a photograph only when he or she has both commodities. With complementary commodities, a steep rise in the price of one will lead not only to a fall in its consumption but a fall in the consumption (decrease in demand) of the other commodity too. A fall in the price of one commodity would lead to an increase in the demand for the other. Substitutable commodities are those that only one is needed to satisfy a want/need (not both). For substitutable commodities, a fall in the price of one leads to a decrease in demand for the other and an increase in the price of one leads to an increase in the demand for the other, all other factors remaining unchanged. Tea and coffee, or butter and margarine could be considered as examples of substitutable commodities. Only one of each pair is needed. Only butter or margarine (but not both) is needed to add to say bread. A sharp increase in the price of margarine will let people consume more butter (increase in demand for butter) if the price of butter does not increase too. Consumer Taste, Habit and Custom A change in taste, habit or custom will change demand for certain commodities. Increased taste for a particular commodity will increase demand whilst a declining taste will decrease the demand, other factors remaining unchanged. Taste or preference for goods and services is in turn influenced by marketing strategies such as advertisement, publicity, sales promotions (e. g. raffles) and fashion. If one forms a habit of consuming a particular commodity, the demand for such a commodity will increase. On the other hand, if custom forbids the consumption of a particular commodity, its demand will decline. Consumer Expectations The decision to buy a commodity today is influenced by the expected future price of the commodity and expected change in consumer income. If a consumer anticipates the price of a commodity to increase in future, todays demand for the commodity will increase but if the consumer anticipates a fall in future price, then todays demand for the commodity will fall. Similarly, an expected increase in consumer income in the near future may cause current demand for a normal commodity to increase and that of an inferior commodity to decline. Population of Consumers Increase in population or changes in the structure of population may affect the demand for a certain commodities. If the population of a country increases, the demand for certain commodities will also increase. For example, if the population of Ghana increases the demand for certain goods and services will increase, and if there is a decline in the population of Ghana the demand for certain

commodities will decline. A change in the structure or composition of population may change the demand of certain goods and services. If the structure of the population of Ghana changes such that the population of aged (people above 60 years) increases the demand for commodities demanded by the aged, such as hats, walking sticks, etc., may increase.

Natural Factors Variations in seasons may affect the demand for a commodity at certain times of the year. For example, during the raining season, demand for commodities such as jackets, raincoats and umbrellas will increase while during the dry season, demand for the commodities mentioned above will decrease but the demand for commodities such as fans and air conditioners will rise. Availability of credit The availability of credit facilities in the form of credit purchases, hire purchases and the use of credit cards and cheques, may increase the demand for certain commodities such as consumer durables (TV sets, fridges, sound systems, cars, etc.). Granting credit facilities, therefore, increases demand for goods covered by these facilities, all things being equal. Cost of borrowing (Interest rate) In a country lower interest rates mean cost of borrowing is low. This encourages people to borrow much from financial institutions to consume more of normal goods and services. If credit facilities are available (i. e. financial institutions are will to lend to the consuming public) but cost of borrowing is high people will be unwilling to go in for the credits and so cannot consume more goods and services.

Types of Demand Under this section, we look at the different types of demand that we have. Demand may be complementary, derived, or composite. Joint/Complementary Demand Goods are in joint/complementary demand when they produce more consumer satisfaction when they are consumed together than when they are consumed separately. Examples include bread and margarine, camera and film, automobile and gasoline, and cassette player and cassette. One gets some satisfaction from the consumption of bread but will be satisfied better when it is consumed together with margarine. Competitive Demand Goods are said to be in competitive demand when they all compete for the same consumers income. Competitive goods are mostly substitutes - i.e. goods that are alternatives to one another in consumption. Examples are peak milk and ideal milk; pork, beef and chicken. When one is taking say, tea, it is unusual for the person to use peak milk and ideal milk at the same time. Derived Demand The demand for final products leads to the demand for other products which are used to produce the final products - i.e. if the demand for a product is not for its own sake, but for the making of another

product which is in demand. For example, the demand for furniture derives the demand for wood while the demand for petrol derives the demand for crude oil. Composite Demand A commodity is said to have a composite demand when it is demanded for alternative uses. For example, wood has composite demand because it is demanded for several alternative uses such as the making of tables, chairs, windows, doors, body of vehicles, etc.

Change in Quantity Demanded A change in quantity demanded occurs when the consumption of a commodity changes (increases or decreases) as a result a change (an increase or a decrease) in the price of the commodity, when all other demand factors remain unchanged. This will result in a movement along a demand curve. There are two types of changes in quantity demanded: an increase in quantity demanded and a decrease in quantity demanded. The only cause of a change in quantity demanded is a change in price of the commodity. Increase in Quantity Demanded When consumption of a commodity increases as a result of a fall in the own price of a commodity it is referred to as increase in quantity demanded. It produces a downward movement along the same demand curve. In our milk example, buying more milk as a result of a fall in its price with GH20 is an example of an increase in quantity demanded. Figure 1.2: An Increase in Quantity Demanded Price (GH)

A
P1

D 0 Q1 Q2 Quantity demanded (in units)

From Figure 1.2 when the price of the commodity was OP1, quantity demanded was OQ1 and when price decreased to OP2, consumption increased to OQ2. This produces a movement AB along then same demand curve, D.

Decrease in Quantity Demanded When consumption of a commodity declines as a result of a rise in the price of the commodity, it is referred as a decrease in quantity demanded. This is shown as an upward movement along a demand curve. In Figure 1.3 when the price of the commodity was OP1, quantity demanded was OQ1 and when price increased to OP3, consumption decreased to OQ3. This produces a movement from point A to point C along the demand curve, D. Figure 1.3: A Decrease in Quantity Demanded Price (GH)

P3

C A

D 0 Q3 Q1 Quantity demanded (in units)

Change in Demand The consumption of a commodity may change (either increase or decrease) when the price has not changed. Economists refer to such a situation as change in demand for the commodity in question. A change in demand is normally brought about by a change in any of the other demand factors (referred to as demand shifters). It causes a complete shift in the demand curve either to the right or to the left. a) Increase in Demand A situation where the price of a commodity remains unchanged but consumption of the commodity increases is referred to as an increase in demand. In the milk example, the second instance showed that milk was still being sold at GH4, but demand increased when my monthly income increased. This situation could be described as increase in the demand for milk. An increase in demand causes a complete shift in the demand curve of the commodity to the right. Figure 1.4: An Increase in Demand Price (GH)

A
P1

D2 D1 0 Q1 Q2 Quantity demanded (in units)

The initial demand curve is D1 in Figure 1.4 and as a result of the increase in demand D1 has shifted completely to D2. At the same price of the commodity of OP1, consumption has increased from OQ1 to OQ2 units. b) Decrease in Demand A decrease in demand for a commodity occurs when the consumption of a commodity decreases when the commoditys price has not changed. A decrease in demand causes a complete shift in the demand curve of the commodity to the left as shown in Figure 1.5. The initial demand curve is given as D1 and as a result of a decrease in demand D1 has shifted completely to D3. At the same price of the commodity of OP1, consumption has increased from OQ1 to OQ3 units. Figure 1.5: A Decrease in Demand Price (GH)

B
P1

D1 D3 0 Q3 Q1 Quantity demanded (in units)

c) Factors that cause a Change in Demand A change in demand is caused by a change in any of the demand shifters namely: y y y y y y y y prices of related goods (substitutes and complements), consumers income (inferior and normal goods), consumer tastes, habit and custom, consumer expectations (in prices and income), population of consumers, natural factors availability of credits cost of borrowing (interest rate)

The explanations of how a change in any of the above factors causes a change in demand are given in the same ways as we did under determinants of demand for a commodity. But note that a change in the own price of a commodity does not cause a change in demand. It causes only a change in quantity demanded.

Individual Demand and Market Demand The demand for a commodity normally refers to the market demand for that commodity but individuals consume the commodity therefore we may talk of individual demand too. The individual demand for a commodity is the quantities that would be purchased by an individual consumer of that commodity at a given set of prices of the commodity, when all other factors remain unchanged. For a given set of prices for the commodity individuals make their purchases therefore the set of prices and the corresponding quantities purchased by each individual consumer represents his/her individual demand. The market demand for a commodity on the other hand is the total quantities that would be purchased by all individual consumers of a commodity at the same given set of prices, when all other factors remain unchanged. Market demand reflects the total demand of all individuals consuming the commodity. Hence, market demand is a horizontal summation of all individual demands for a commodity. Illustration: Let us assume that there are only three consumers, John, Ama and Bob for a good with demand schedules as follows: Table 1.2: Individual and Market Demands Johns Amas Bobs Price Quantity Quantity Quantity (GH) Demanded Demanded Demanded (QJ) (QA) (QB) 1 200 180 150 2 190 170 140 3 150 150 120 4 130 120 110 5 110 100 90 6 100 80 70 7 80 60 40

Market Quantity Demanded Q = (QJ + QA + QB) 530 500 420 360 300 250 180

From Table 1.2, the set of prices (Gh1 to Gh7) the quantities John will consume ranging from 200 to 80 units, holding all other things constant constitute Johns individual demand for the commodity. Similarly, the same set of prices and the corresponding set of purchases (ranging from 180 to 60 units) by Ama constitute her individual demand for the commodity. Again, the same set of prices and the corresponding set of purchases (ranging from 150 to 40 units) by Bob constitute his individual demand for the commodity. The market demand for the commodity is obtained by summing horizontally, all the individuals purchases at each given price (as depicted by the last column of Table 1.2). The market demand schedule will be the set of prices and market quantities demanded.

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Self Assessment Questions 1. (a) (b) What do economists mean by the demand for a commodity? Explain each of the three (3) ways of representing demand.

2.

The demand equation for a product is given as: Q D ! 4000  0.8 P Where QD = the quantity demanded of the product in units, P = the price of the product. (a) Compute the quantity demanded when the price of the product is: (i) GH100 (ii) GH105 (iii) GH120 (b) What price should be charged when quantity demanded is: (i) 1000 units (ii) 2000 (iii) 1600 units List and explain five (5) shifters of the demand curve.

3.

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