If you have ever witnessed an auction, then you might have noticed that there are many more low bids for an item than high bids. That is, people are more willing and able to pay a low price for an item than to pay a high price. This willingness and ability to buy something is referred to as demand. The fact that more people are willing to buy at lower prices than at higher prices is called the law of demand.
Reasons for the Law of Demand
Three reasons explain why the law of demand exists: diminishing marginal utility, income effect, and substitution effect. The reason that diminishing marginal utility is an explanation of the law of demand is easy to understand. As you consume more and more of an item, each successive unit provides less utility, or happy points, than the previous unit. As a result, the only way that you will buy more of an item is if the price is lower. You consume until the marginal benefit (utility) equals the marginal cost (price). Assume that your favorite doughnut stand is offering a “buy two and get the third for half-price” deal. On a normal day, you would just buy two doughnuts because a third is not worth it to you due to diminishing marginal utility. But in the case of the deal they are offering, if they lower the price or marginal cost to the point where it is equal or less than the marginal utility or marginal benefit, it makes sense for you to purchase the third doughnut.
Income effect is based on your budget constraint. As the price of a good drops, your purchasing power increases. As the price increases, your purchasing power falls. Income effect explains the logic behind discounts and sale prices. When goods go on sale at a lower price, your limited income is able to purchase more, so that is what you do.
Substitution effect is another explanation for the law of demand. The substitution effect says that you substitute relatively less expensive items for relatively more expensive items. For example, imagine you are at the grocery store to buy food for five days' worth of meals — three chicken dinners and two dinners with beef. If the store happens to have beef on sale, you might substitute one day's chicken with beef. So what happened? The law of demand happened. Beef prices were relatively lower and you bought more beef.
Purchasing power and prices are inverses of each other. As prices rise, purchasing power falls and as prices fall, purchasing power rises. Economists often refer to the concepts of real income and nominal income. Real income is based on your purchasing power while nominal income is the dollar amount earned. When considering your living standard, it is real income that counts.
Elasticity of Demand
Think about all of the things that you buy in a year. You might purchase goods and services as diverse as chewing gum, emergency room visits, and cars. Sometimes you are very sensitive to the price and at other times you are not. For example, you're more likely to shop around for a good price on a car than on an emergency room visit. Economists refer to this sensitivity to price as elasticity of demand. When you can delay the purchase of a good, if it has many close substitutes, or if it takes a large percentage of your income, demand is typically price sensitive or elastic. If, however, the purchase must be made immediately, no close substitutes exist, or the purchase does not take a significant percentage of income, demand is price insensitive or inelastic.
Compare an emergency appendectomy with a facelift. Both are surgeries, but consumer demand for these surgeries is quite different. Acute appendicitis does not wait for you to shop for the best price on surgery. Price is probably the last thing on your mind when experiencing this illness. Your demand for the surgery is inelastic. Facelifts are an entirely different matter. First, the purchase can be delayed. Next, a facelift has available substitutes, like Botox and collagen injection. Finally, because facelifts are optional and not covered by most health insurance plans, they tend to take a large percentage of a person's income. The result of this combination of factors is that, for most, facelift demand is elastic.
Changes in Demand
Several things affect the demand for a good or service, but the one thing that will not affect the demand is the price. As the price of a good increases, you are willing to buy less, and as the price drops, you are willing to buy more. Your demand has not changed in response to changes in price, just the amount or quantity you are willing to buy. Consumer tastes, related prices, income, the number of buyers, and expected prices are factors that will affect the demand for goods and services.
Determining whether goods are substitutes or complements is not a matter of opinion. Economists calculate cross-price elasticity to determine whether goods are complements or substitutes by dividing the percentage change in the quantity demanded of one good by the percentage change in the price of another good. If cross-price elasticity is less than zero, goods are complements, and if cross-price elasticity is greater than zero, goods are substitutes.
Consumer tastes for goods and services are subject to change and when these changes happen, demand shifts. A few years back, there was a recall of fresh leaf spinach because of E. coli contamination. This contamination effectively reduced demand for fresh spinach. Advertising can affect the taste for goods and services as well. The ShamWow is a case in point. The ads for this product were on several channels on TV. After watching that ad for the hundredth time many people decided that they had to have one. The increase in ShamWow sales was not in response to some change in the price of the product but was caused by a change in consumers' tastes due to advertising.
The price of related goods can affect the demand for a good as well. Related goods are classified as either complements or substitutes. Complements are goods used in conjunction with other goods, and substitutes are goods used in lieu of each other. Movie tickets and Junior Mints are complements. As the price of movie tickets rises, people are less willing to buy them and go to the movie. Therefore, there is less demand for Junior Mints. If ticket prices fall, the opposite occurs. Air travel and bus travel are substitutes. As the price of airline tickets falls, demand for bus tickets decreases, and as the price of airline tickets rises, demand for bus tickets increases.
Changes in consumers' income will lead to changes in demand. If income and demand move in the same direction, you are dealing with a normal good. If income and demand move in opposite directions, the good is considered inferior. If organic milk is a normal good and powdered milk is an inferior good, what effect will an increase in consumers' income have on demand for the two? Demand for organic milk increases with increased income, and demand for powdered milk decreases with increased income.
The number of buyers is directly related to the demand for goods and services. As the number of buyers increases, so will demand, and vice versa. This obvious relationship should be considered before investing in the Russian housing market. The population there is shrinking.
How do you know whether a good is normal or inferior?
Economists calculate income elasticity of demand to answer the question. By dividing the percent change in the quantity demanded of a good by the percentage change in income, economists are able to classify goods as either normal or inferior. Income elasticities greater than one indicate normal luxuries, income elasticities between one and zero indicate normal necessities, and income elasticities less than zero indicate inferior goods.
Expected prices can have a direct influence over the demand for goods and services. If investors believe that a stock's price will increase in the future, demand for the stock increases. Likewise, if the price of a stock is expected to fall, the demand for the stock will decrease.