Lecture 3 Lecture 3

The Law of DemandThe Law of Demand

■ ■ Our objectives:Our objectives:

► ► Explain individual choices among Explain individual choices among unlimited wants in a world of limited unlimited wants in a world of limited resourcesresources

► ► Develop a theory that helps us better Develop a theory that helps us better understand and predict human actions understand and predict human actions

►►What do people (our customers) want?What do people (our customers) want?

A Very Difficult IssueA Very Difficult Issue

What we measure in demand is a What we measure in demand is a reflectionreflection of individual desires. of individual desires.

Daniel Bernoulli, a mathematical genius Daniel Bernoulli, a mathematical genius who lived in Basel, noted, in 1738, that who lived in Basel, noted, in 1738, that people seek goodness or pleasure people seek goodness or pleasure (utility).(utility).

That is, we do not seek cellphones That is, we do not seek cellphones because they are cellphones but because because they are cellphones but because they are useful and give us pleasure. Use they are useful and give us pleasure. Use and pleasure cannot be measured, only and pleasure cannot be measured, only approximated.approximated.

This is behind the law of demand.This is behind the law of demand.

A Note on Value, Scarcity, A Note on Value, Scarcity, and Price as Related to and Price as Related to DemandDemandWhy do people want what they want?Why do people want what they want? The diamond-water paradox.The diamond-water paradox. Scarcity need not mean highly valued; Scarcity need not mean highly valued;

think of snake meat.think of snake meat. Markets reflect what people value in Markets reflect what people value in

relationship to current availability.relationship to current availability. Demand is our best understanding of Demand is our best understanding of

what people value—given current what people value—given current conditions.conditions.

The Law of DemandThe Law of Demand

■■ Holding all other relevant factors Holding all other relevant factors constant, the lower (higher) the price of a constant, the lower (higher) the price of a good, the greater (lower) will be the good, the greater (lower) will be the quantity demanded.quantity demanded.

► ► Like all scientific propositions, it is a Like all scientific propositions, it is a ceteris paribus ceteris paribus (“other things equal” or (“other things equal” or “other things constant”) statement“other things constant”) statement

► ► NoteNote thethe terminologyterminology::- Price means opportunity cost- Price means opportunity cost- Good means anything people value- Good means anything people value

Why focus on the Law of Why focus on the Law of Demand?Demand?

This is the most powerful proposition in economics.This is the most powerful proposition in economics.

► ► Irrigation design in arid and wet climatesIrrigation design in arid and wet climates

► ► Building heights in cities compared to small townsBuilding heights in cities compared to small towns

► ► The seasonal pattern of vegetable pricesThe seasonal pattern of vegetable prices

► ► Why many stand in crowded trains to go visit familyWhy many stand in crowded trains to go visit family

► ► The shape of waterfront propertiesThe shape of waterfront properties

► ► Electricity prices and automatic switchesElectricity prices and automatic switches

► ► Etc., etc., etc.Etc., etc., etc.

The Demand Function:The Demand Function:Some DefinitionsSome Definitions

The relationship between quantity consumed and the The relationship between quantity consumed and the factors determining that: D = f (P, Pfactors determining that: D = f (P, PSS, P, PCC, I, E, T, , I, E, T, etc.)etc.)

■ ■ PricePrice of the good in question—determines the of the good in question—determines the location location alongalong a demand curve a demand curve

■ ■ Other variables (relevant factors) determine the Other variables (relevant factors) determine the placementplacement of a demand curve: of a demand curve:

► ► Prices of related goods (substitutes and Prices of related goods (substitutes and complements)complements)

► ► Income of buyersIncome of buyers► ► Tastes (preferences) of buyersTastes (preferences) of buyers► ► Expectations held by buyers, regarding the futureExpectations held by buyers, regarding the future► ► Other matters particular to a certain goodOther matters particular to a certain good

The Role of TastesThe Role of Tastes

■ ■ They are very hard to measure, so we They are very hard to measure, so we generally ignore them, but we know generally ignore them, but we know they exist.they exist.

■ ■ Look to marketing and psychology for Look to marketing and psychology for guidance here, not economists!guidance here, not economists!

■ ■ For economists, tastes are often the For economists, tastes are often the unexplained portion of consumptionunexplained portion of consumption

ExpectationsExpectations

■ ■ Also difficult to measure — but importantAlso difficult to measure — but important

■ ■ When measurable, include in the When measurable, include in the analysis. But experience shows—analysis. But experience shows—measures are very poor predictors of measures are very poor predictors of actions.actions.

■ ■ Like tastes, these can be used to Like tastes, these can be used to “explain” anything “explain” anything ► ► Don’t fall into this trapDon’t fall into this trap

This or that?This or that?

■ ■ Substitutes:Substitutes:Essentially, goods used in place of each other—Essentially, goods used in place of each other—

same geographic market; similar same geographic market; similar performance characteristics. What is a performance characteristics. What is a substitute in one market may not be seen by substitute in one market may not be seen by consumers as such in another market—consumers as such in another market—orange juice and orange soda.orange juice and orange soda.

► ► Different brands of gasoline; robots in Different brands of gasoline; robots in Renault factory in France v. workers in Renault factory in France v. workers in Renault factory in Russia (former Lada) paid Renault factory in Russia (former Lada) paid $200 a month; movie theater v. movie $200 a month; movie theater v. movie rentals; corn or sugar in ethanol.rentals; corn or sugar in ethanol.

Related GoodsRelated Goods

■ ■ Complements:Complements:Essentially, goods used togetherEssentially, goods used together

► ► Computer hardware and software; Computer hardware and software;

tennis balls and rackets; airplane tennis balls and rackets; airplane travel and hotel rooms; Google travel and hotel rooms; Google maps and discount coupons; maps and discount coupons; growing corn for ethanol and Deere growing corn for ethanol and Deere tractorstractors

Changes in the Price of Related Changes in the Price of Related GoodsGoods

■ ■ Goods X and Y are Goods X and Y are substitutessubstitutes if: if:

► A change in price of X changes demand for Y in same direction

- Px up implies Dy up (Dy shifts to the right)

- Px down implies Dy down (Dy shifts to the left)

► Effect of change in Py on Dx is also in same direction

More on the Prices of Related More on the Prices of Related GoodsGoods

■ ■ Goods V and W are Goods V and W are complementscomplements if: if:

► ► A change in A change in price of Vprice of V changes changes demand demand for Wfor W in opposite direction: in opposite direction:- Pv up implies Dw down (Dw shifts to left)- Pv up implies Dw down (Dw shifts to left)

- Pv down implies Dw (Dw shifts to right)- Pv down implies Dw (Dw shifts to right)

► ► Effect of a change in Pw on Dv is also in Effect of a change in Pw on Dv is also in oppositeopposite direction direction

Changes in IncomeChanges in Income

■ ■ Normal Goods:Normal Goods:► Change in income changes demand in same

direction- Higher income causes increase in demand- Lower income causes decrease in demand

► ”Superior” good is a variant: change in demand due to income change is quite large

■ Inferior goods:► Change in income changes demand in opposite

direction- Higher income causes decrease in demand- Lower income causes increase in demand

Terminology:Terminology:Used to avoid confusionUsed to avoid confusion

■ ■ Changes in Changes in quantity demanded:quantity demanded:► Caused by changes in Caused by changes in own priceown price of good of good

means means movement along a given demand curve

■ Changes in demand:► Caused by changes in other factors:

- Prices of other goods- Income- Expectations, etc.

► Means a shift of the entire demand curve

Change in PriceChange in Price

A change in the price of a good A change in the price of a good means a movement along a means a movement along a demand curve.demand curve.

Quantity/timeQa Qb

Demand

Price

Pa

Pb

Change in DemandChange in Demand

A change in a factor that determines demand, A change in a factor that determines demand, besides the price of the good itself, causes the besides the price of the good itself, causes the Demand curve to shift.Demand curve to shift.

Example: Increase in price of substitute or increase in Example: Increase in price of substitute or increase in income causes an increase in demand. income causes an increase in demand.

Price

Quantity/time

Pa

Da

Db

Qa Qb

Deriving a Real Demand Deriving a Real Demand CurveCurve

Define your market:Define your market:Boulder, Colorado, over time; Boulder, Colorado, over time;

consumption of water by people consumption of water by people

served by city water; price per served by city water; price per

1,000 gallons; billions gallons/yr.1,000 gallons; billions gallons/yr.

consumed by demanders.consumed by demanders.

YearYear Price Price QuantityQuantity

19681968 $0.28 $0.28 29 29

19721972 $0.36 $0.36 19 19

19771977 $0.50 $0.50 13 13

19821982 $0.74 $0.74 9 9

Price

Quantity

Demand

9 13 19 29

.74

.50

.36

.28

0

What else would you want to know?What else would you want to know?

The Demand curve plots the relationship The Demand curve plots the relationship between price and quantity demanded – between price and quantity demanded – nothing else – everything else is held constantnothing else – everything else is held constant

But in the real world, other things are not But in the real world, other things are not constant, so what else would you want to constant, so what else would you want to know if you wanted to understand that know if you wanted to understand that market better?market better?

Name likely relevant factors:Name likely relevant factors:

Hard Test: Hard Test: Which Goods Are Complements, Which Goods Are Complements, Which Are Substitutes?Which Are Substitutes?

1.1. Wine and beer.Wine and beer.

2.2. Domestic shirts and imported Domestic shirts and imported shirts.shirts.

3.3. Oil from Iran and coal from China.Oil from Iran and coal from China.

4.4. Paper and pencils.Paper and pencils.

5.5. Plate glass and brick/concretePlate glass and brick/concrete

Demand analysisDemand analysis

How would demand for hair How would demand for hair replacement be likely to change replacement be likely to change if the following occurs?if the following occurs?

1.1. A fall in the price of hairpieces.A fall in the price of hairpieces.

2.2. A rise in income. A rise in income.

3.3. A rise in the divorce rate.A rise in the divorce rate.

Clever sales pitchClever sales pitch

A British cellphone company A British cellphone company promised new subscribers in promised new subscribers in November and December that all November and December that all calls on Christmas Day, calls on Christmas Day, December 25, would be free. December 25, would be free. What would you expect happened What would you expect happened to the volume of calls that day?to the volume of calls that day?

Question on changing Question on changing demanddemand

Trying to predict future demand, GE Trying to predict future demand, GE research showed that the average research showed that the average size of the American family was size of the American family was declining and so was the average declining and so was the average square footage of houses.square footage of houses.

How would you think this impacted How would you think this impacted the demand for the design of, say, the demand for the design of, say, refrigerators?refrigerators?

Key Point from Peter Key Point from Peter DruckerDrucker

Most important question sellers must ask:Most important question sellers must ask:

““What is value to the customer?”What is value to the customer?”

Sellers often think they know, but do not. Sellers often think they know, but do not. The customers do not buy a product; The customers do not buy a product; they buy they buy value.value.

Demanders are buying a product to Demanders are buying a product to satisfy a want. Do not satisfy a want. Do not guessguess what what customers want—always carefully customers want—always carefully evaluate what evaluate what theythey want. want.