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DEMAND

A central feature of a market economy is the efficient operation of free markets. A market occurs whenever two or more parties freely exchange something of value. Recall from the circular flow model that there are two primary types of markets, a product market where households buy products from businesses and a factor market where businesses buy resources from households. There are countless exchanges that take place in the U.S. product market and factor market every day. But how are the prices for goods, services, and resources determined? In a market economy, the impersonal forces of demand and supply establish most prices and, in doing so, bring order to the seeming chaos of the marketplace.

Demand

Demand is the amount of a good, service, or resource that people are willing and able to buy at a series of prices at a moment in time. The demand for a product or resource is illustrated in tabular form by a demand schedule, or with a demand curve, as shown in Figure 2.4. The demand curve slopes downward, reflecting the most famous of all economic laws, the law of demand. According to the law of demand, there is an inverse relationship between price and quantity demanded. That is, if the price of a good increases, the quantity demanded will decrease. Conversely, if the price of a good decreases, the quantity demanded will increase.

To construct an initial demand curve for a product, economists employ the ceteris paribus assumption. Under the ceteris paribus assumption, all external factors that might affect the demand for the product, except price, are temporarily held constant. In the product market, the demand curve typically represents the viewpoint of the consumer, who buys final goods or services from businesses. In the factor market, the demand curve typically represents the viewpoint of the producer, who buys resources from households.

The demand curve shown in Figure 2.4 represents the demand for product X at a moment in time. Hence, a change in the price of product X causes a change in the quantity demanded, not a change in the overall demand for the product. Speaking precisely, economists say that a change in price causes a movement along an existing demand curve. In Figure 2.4, for example, if the price of product X decreases from $6 to $4, there is a downward movement along the existing demand curve. In this case, the $2 decrease in price caused the quantity demanded to increase from 6,000 items to 8,000 items but had no impact on the overall demand for product X. Note that a change in price does not cause the demand curve to shift to the right or to the left.

Changes in Demand

How does a change in the overall demand for a good occur? To change the demand for a good, the ceteris paribus assumption is lifted, allowing other factors, called determinants of demand, to enter the picture. A change in one or more of the determinants of demand causes buyers to want more or less of a good at each and every price. There are six main determinants of demand: people's tastes and preferences, income level, market size, price of substitute goods, price of complementary goods, and expectations.

Suppose, for example, that a successful television commercial favorably affects people's tastes and preferences for product X. The likely result is that buyers would purchase more of product X at each and every price. Perhaps at a price of $10, buyers would now be

Illustrating the Demand for Product X

Figure 2.4 Illustrating the Demand for Product X

willing to purchase 4,000 items; at $8 they would buy 6,000 items; at $6 they would buy 8,000 items; at $4 they would buy 10,000 items; and at $2 they would buy 12,000 items. Hence, a change in tastes and preferences, a determinant of demand, causes the entire demand curve to shift to the right (a positive shift). The new demand curve represents the new reality of the marketplace, so the original demand curve disappears. Of course, people's tastes and preferences can also work against a product or service, as is often the case with fads or products that have become obsolete such as typewriters or horse-drawn wagons. A decline in people's tastes and preferences causes a shift of the entire demand curve to the left to show that people are willing to buy less of the product at each and every price. In addition to tastes and preferences, the other determinants of demand include:

Income level. An increase in people's incomes causes the demand for most goods to increase; a decrease in income causes a decrease in demand for most products.

Market size. An increase in market size (a larger number of potential buyers) causes the demand for most goods to increase; a decrease in market size causes a decrease in demand for most products.

Price of a substitute good. An increase in the price of a substitute good causes an increase in the demand for the related product; a decrease in the price of a substitute good causes a decrease in the demand for the related product. (A substitute good is a product that can be used in place of a similar good.)

Price of a complementary good. A decrease in the price of a complementary good causes an increase in demand for the related good; an increase in the price of a complementary good causes a decrease in the demand for the related good. (A complementary good is a product that is used in conjunction with another product.)

Expectations. An optimistic view about personal or national prosperity causes an increase in the demand for most goods; a pessimistic view has the opposite effect.

Price Elasticity of Demand

The law of demand shows an inverse relationship between the price of a product and the quantity demanded—as the price increases, the quantity demanded decreases, and when the price decreases, the quantity demanded increases. What still needs to be determined is the degree to which a change in price affects the quantity demanded. This question, to the economist, concerns the price elasticity of demand.

The price elasticity of demand measures the impact of price changes on the quantity demanded of a good. The demand for a good is said to be elastic when even a relatively small change in the price of a good causes a larger change in the quantity demanded. In other words, people's demand for some goods is very flexible, or responsive to a change in the good's price. Conversely, the demand for a good is considered inelastic when even a relatively large change in a good's price causes a smaller change in the quantity demanded. That is, people's demand for the other good is inflexible, and people will be less willing to change their buying habits even when the price changes. Three main determinants explain the price elasticity of demand of a certain good or service: the availability of close substitutes, whether the good is a necessity or a luxury, and time, as shown in Table 2.1.

The demand for a good tends to be price elastic, or flexible, when there are close substitute goods available for purchase, when this good is viewed as a luxury, and when there is more time to make a buying decision. Consider the demand for a particular automobile. While an auto is a necessity for many people, the demand for a particular auto is elastic because there are many substitutes available in the automobile market—many different makes and models of autos from which to choose. In most cases, people who want to buy an auto also have sufficient time to visit a number of auto dealerships so that a rational buying decision can be made. The consumer may even decide to postpone the purchase of the auto for another year if the right deal cannot be reached.

Table 2.1 Determinants of Price Elasticity of Demand

Offshore oil platforms supplement onshore production of petroleum, one of the world's most important energy resources.

The demand for a good tends to be price inelastic, or inflexible, when there are no close substitutes available for purchase, when this good is viewed as a necessity, and when time constraints prevent a convenient switch to another product. Consider the demand for the gasoline that is used in the automobile. The demand for gasoline is price inelastic because there are few if any substitutes for this fuel, it is essential to the operation of the auto, and when the tank moves toward empty, more gasoline must be purchased. In recent years gasoline prices have been on a roller coaster, with rapid and significant price increases and decreases. Despite these price changes, gasoline consumption in the United States, by and large, has changed little.

 
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