02 law of demand

8/8/2019 02 Law of Demand

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Lecture 2Lecture 2

The Law of DemandThe Law of Demand Our objectives:Our objectives:

Explain individual choices among unlimited wants in the faceExplain individual choices among unlimited wants in the faceof limited resourcesof limited resources

Develop a theory that satisfies the universal criteria forDevelop a theory that satisfies the universal criteria fortheoriestheories

Apply the theory to what we observe around usApply the theory to what we observe around us


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The Law of DemandThe Law of Demand

Holding all other relevant factors constant, theHolding all other relevant factors constant, thelower the price of a good, the greater will be thelower the price of a good, the greater will be thequantity demanded.quantity demanded.

Like all scientific propositions, it is aLike all scientific propositions, it is a ceteris paribusceteris paribus (other(otherthings equal) statementthings equal) statement

It is symmetric: a higher price leads to a smaller quantityIt is symmetric: a higher price leads to a smaller quantity

demandeddemanded

NoteNote thethe terminologyterminology::--changes in the price of the good lead to changes in changes in the price of the good lead to changes in quantityquantitydemandeddemanded -------- theythey DO NOTDO NOT lead to changes inlead to changes in demanddemand


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

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

Sprinkler design in arid and wet climatesSprinkler 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 fruit and vegetable pricesThe seasonal pattern of fruit and vegetable prices

Why people sit in inferior seats to watch games or performancesWhy people sit in inferior seats to watch games or performances

The shape of waterfront propertiesThe shape of waterfront properties

Electricity prices and automatic switchesElectricity prices and automatic switches

Etc., etc., etc.Etc., etc., etc.


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FoundationsFoundations

The principle of Diminishing Marginal ValueThe principle of Diminishing Marginal ValueAs the rate of consumption rises, theAs the rate of consumption rises, the marginalmarginal use value ofuse value of

the next unit declinesthe next unit declines

Decision RuleDecision Rule

Chose a rate of consumption so that marginal use value of theChose a rate of consumption so that marginal use value of thelast unit equals price:last unit equals price:

MV=PMV=P

When combined, these yield theWhen combined, these yield the Law of DemandLaw of Demand


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Diminishing MarginalDiminishing Marginal

ValueValue

Rate of ConsumptionRate of Consumption Marginal ValueMarginal Value

11 2.002.00

22 1.751.75

33 1.101.10

44 0.500.5055 0.250.25


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Diminishing MarginalDiminishing Marginal

ValueValue

Units/time period

MV


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Adding the Decision Rule MV=PAdding the Decision Rule MV=P

yields a Demand Curve (Dyields a Demand Curve (D))

Demand

PRICE

UNITS/TIME PERIOD


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The Demand FunctionThe Demand Function

Summarizes the relationship between quantity consumed and theSummarizes the relationship between quantity consumed and thefactors determining that quantityfactors determining that quantity

PricePrice of the good in questionof the good in questiondetermines the locationdetermines the location alongalongthe demand curvethe demand curve

Other factorsOther factors determine thedetermine the placementplacement of the demand curve:of the demand curve: Prices of related goodsPrices of related goods Income of the buyerIncome of the buyer

Tastes (preferences) of the buyerTastes (preferences) of the buyer Expectations held by the buyer, regarding the futureExpectations held by the buyer, regarding the future Other matters, particular to each good, including quality, etc.Other matters, particular to each good, including quality, etc.


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The Role of TastesThe Role of Tastes

De gustibus non est disputandumDe gustibus non est disputandum

They are unmeasurable, and so we ignore themThey are unmeasurable, and so we ignore them

Look to marketing and psychology for guidanceLook to marketing and psychology for guidancehere, for youll not get any from economists!here, for youll not get any from economists!

For us, tastes are the unexplained portion ofFor us, tastes are the unexplained portion ofconsumptionconsumption


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ExpectationsExpectations

Difficult to measure under mostDifficult to measure under mostcircumstancescircumstances

When measurable, include in the analysisWhen measurable, include in the analysis

Like tastes, these can be used to explainLike tastes, these can be used to explainanythinganything

Dont fall into this trapDont fall into this trap


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The Demand FunctionThe Demand Function

The rate of consumption of a good is a function of:The rate of consumption of a good is a function of:

The own price of the goodThe own price of the good

--------------------------------------------------------------------------

TheThe ceteris paribusceteris paribus conditions:conditions:

-- Prices of related goodsPrices of related goods-- IncomeIncome

-- Other, idiosyncratic factors (the XOther, idiosyncratic factors (the X--vector)vector)


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Demand for DVD RentalsDemand for DVD Rentals

Price $Price $ Monthly consumption at different income levelsMonthly consumption at different income levels

$1000/mo$1000/mo $2000/mo$2000/mo $3000/mo$3000/mo

66 11 22 5555 22 4 74 7

33 44 88 1111

22 55 10 1310 13

11 66 1212 1515


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Demand for DVD RentalsDemand for DVD Rentals

PRICE

QUANTITY

Changes in Demand


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Related GoodsRelated Goods

Substitutes:Substitutes: Intuitively, goods used in place of each otherIntuitively, goods used in place of each other Different brands of gasoline;Different brands of gasoline;

theater v. movie rentals;theater v. movie rentals;DVDs v. concert ticketsDVDs v. concert tickets

Complements:Complements: Intuitively, goods used togetherIntuitively, goods used together Computer hardware and software;Computer hardware and software;

tennis balls and rackets;tennis balls and rackets;airplane travel and hotel roomsairplane travel and hotel rooms


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Changes in the Price of Related GoodsChanges in the Price of Related GoodsThese effectsThese effects definedefine the relationship substitutethe relationship substitute

X and Y are substitutes if and only if:X and Y are substitutes if and only 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 Py on Dx is also in same direction


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More on the Prices of Related GoodsMore on the Prices of Related GoodsThese effectsThese effects definedefine the relationship complementthe relationship complement

V and W are complements if:V and W are complements if:

A change inA change in price of Vprice of V changeschanges demand for Wdemand for W ininopposite directionopposite 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 Pw on Dw is also inEffect of Pw on Dw is also in oppositeopposite directiondirection


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Changes in IncomeChanges in Income

Normal Goods:Normal Goods:

Change in income changes demand in same direction

- H

igher income causes increase in demand- Lower income causes decrease in demand

Superior good is a variant: change in demand due to incomechange 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


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Increase in DemandIncrease in Demand

Caused by:Caused by:

--Higher price of substituteHigher price of substitute

--Lower price of complementLower price of complement

--Increase in income if superiorIncrease in income if superior--Decrease in income if inferiorDecrease in income if inferior

Price

D lower

D higher


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Decreases in DemandDecreases in Demand

Caused by:Caused by:

--Lower price of substituteLower price of substitute

--Higher price of complementHigher price of complement

--Decrease in income if superiorDecrease in income if superior--Increase in income if inferiorIncrease in income if inferior

D highD low

PRICE

Quantity


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TerminologyTerminologyThis is important to avoid confusionThis is important to avoid confusion

Changes inChanges in quantity demanded:quantity demanded:

Caused by changes inCaused by changes in own priceown price of goodof good

Refer to movement along a given demand curve

Changes in demand:

Caused by changes in ceteris paribus conditions

- Prices of other goods

- Income

- Other factors

Refer to a shift of the entire demand curve

Be precise and youll be richer. . . .


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

The Demand curve plots the relationship betweenThe Demand curve plots the relationship betweenprice and quantity demandedprice and quantity demanded nothing elsenothing else everything else iseverything else is ceteris paribus.ceteris paribus.

What else would you want to know if you wanted toWhat else would you want to know if you wanted tounderstand that market better?understand that market better?

Name likely relevant factors:Name likely relevant factors:


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Deriving a Real Demand CurveDeriving a Real Demand Curve

Define your market:Define your market:

Boulder, Colorado, over time;Boulder, Colorado, over time;

consumption of water by peopleconsumption of water by people

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

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

consumed by demanders.consumed by demanders.

YearYear PricePrice QuantityQuantity

19681968 $0.28$0.28 292919721972 $0.36$0.36 1919

19771977 $0.50$0.50 1313

19821982 $0.74$0.74 99

Price

Quantity


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Questions on Law of DemandQuestions on Law of Demand

TrueTrue FalseFalse

1.1. Your mother gives you a coat that cost her $100Your mother gives you a coat that cost her $100and that she likes, but you hate. You haveand that she likes, but you hate. You havereceived a gift worth $100.received a gift worth $100.

2.2. In thinking about demand by consumers, weIn thinking about demand by consumers, weusually assume that income varies amongusually assume that income varies amongconsumers but that prices do not.consumers but that prices do not.

3.3. If the price of mailing a letter rises by 10 cents,If the price of mailing a letter rises by 10 cents,from 30 cents to 40 cents; and the price offrom 30 cents to 40 cents; and the price ofsending a letter by special delivery increases 10sending a letter by special delivery increases 10cents, from $3.20 to $3.30, consumers willcents, from $3.20 to $3.30, consumers willpurchase the samepurchase the same proportionsproportions of both kinds ofof both kinds of

delivery services.delivery services.


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Which Goods Are Complements,Which Goods Are Complements,

Which Are Substitutes?Which Are Substitutes?

1.1. Plate glass and bricks.Plate glass and bricks.

2.2. Steel and bricks.Steel and bricks.

3.3. Wine and beer.Wine and beer.

4.4. Domestic shirts and imported shirts.Domestic shirts and imported shirts.

5.5. Oil from Iran and coal from China.Oil from Iran and coal from China.6.6. Paper and pencils.Paper and pencils.


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Needs and WantsNeeds and Wants

When you truly need something, suchWhen you truly need something, suchas a new television, your demandas a new television, your demand

curve is a vertical line. That is, you docurve is a vertical line. That is, you donot care what price you have to paynot care what price you have to paybecause you really need it? Whatbecause you really need it? What

about the need to eat dinner? Theabout the need to eat dinner? Theneed to obtain an MBA? The need toneed to obtain an MBA? The need tohave an operation because you havehave an operation because you havecancer?cancer?


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Demand ApplicationDemand Application

In the past 20 years in the U.S., theIn the past 20 years in the U.S., theprice of attending college has risenprice of attending college has risen

more than the price of most othermore than the price of most othergoods and services. Despite the pricegoods and services. Despite the pricerise, more people are going to collegerise, more people are going to college

than before. Does this contradict thethan before. Does this contradict thelaw of demand?law of demand?


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Demand ApplicationDemand Application The sale of heroin in the U.S. is aThe sale of heroin in the U.S. is a

serious crime. Does that mean that noserious crime. Does that mean that no

heroin is sold?heroin is sold?

Since heroin is illegal, does that meanSince heroin is illegal, does that meanthat the price is higher than it wouldthat the price is higher than it would

be if it were legal?be if it were legal?


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Demand analysisDemand analysis

Which of the following would causeWhich of the following would causean increase in the demand foran increase in the demand for

hairpieces (wigs) or hair replacementhairpieces (wigs) or hair replacementtreatment?treatment?

1.1. A rise in income.A rise in income.

2.2. A rise in the divorce rate.A rise in the divorce rate.

3.3. A rise in the demand by many otherA rise in the demand by many otherpeople.people.

4.4. A fall in the price of wigs.A fall in the price of wigs.


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Clever sales pitchClever sales pitch

A British mobileA British mobile--phone companyphone companypromised new subscribers inpromised new subscribers in

November and December that all callsNovember and December that all callson Christmas Day, December 25,on Christmas Day, December 25,would be free. What would you expectwould be free. What would you expect

happened to the volume of calls thathappened to the volume of calls thatday?day?


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Question onQuestion on

complementary effectscomplementary effects GE research showed that about 1980GE research showed that about 1980

the average size of the Americanthe average size of the American

family was declining and so was thefamily was declining and so was theaverage square footage of houses.average square footage of houses.

How would you think this impactedHow would you think this impacted

the demand for appliances or thethe demand for appliances or thenature of the appliances?nature of the appliances?


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Looking AheadLooking Ahead

Some countries are going toSome countries are going toexperience falling populations andexperience falling populations and

aging populations in the next severalaging populations in the next severaldecades. Japan will be one of thedecades. Japan will be one of thehardest hit, and Italy, Spain, Greecehardest hit, and Italy, Spain, Greece

and Germany.and Germany.All else held equal, what majorAll else held equal, what majorchanges in demand for various goodschanges in demand for various goodsand services are likely to occur?and services are likely to occur?

02 law of demand

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