What effect is the effect that a change in the price of a good service or resource has on the purchasing power of income?

DemandA schedule showing the amounts of a good or service that buyers (or a buyer) wish to purchase at various prices during some time period. is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time.1 Demand shows the quantities of a product that will be purchased at various possible prices, other things equal. Demand can easily be shown in table form. The table in Figure 3.1 is a hypothetical demand schedule(See demand.) for a single consumer purchasing bushels of corn.

FIGURE 3.1	An individual buyer's demand for corn.
(K) Because price and quantity demanded are inversely related, an individual's demand schedule graphs as a downsloping curve such as D. Other things equal, consumers will buy more of a product as its price declines and less of the product as its price rises. (Here and in later figures, P stands for price and Q stands for quantity demanded or supplied.)

The table reveals the relationship between the various prices of corn and the quantity of corn a particular consumer would be willing and able to purchase at each of these prices. We say “willing and able” because willingness alone is not effective in the market. You may be willing to buy a plasma television set, but if that willingness is not backed by the necessary dollars, it will not be effective and, therefore, will not be reflected in the market. In the table in Figure 3.1, if the price of corn were $5 per bushel, our consumer would be willing and able to buy 10 bushels per week; if it were $4, the consumer would be willing and able to buy 20 bushels per week; and so forth.

The table does not tell us which of the five possible prices will actually exist in the corn market. That depends on the interaction between demand and supply. Demand is simply a statement of a buyer's plans, or intentions, with respect to the purchase of a product.

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To be meaningful, the quantities demanded at each price must relate to a specific period—a day, a week, a month. Saying “A consumer will buy 10 bushels of corn at $5 per bushel” is meaningless. Saying “A consumer will buy 10 bushels of corn per week at $5 per bushel” is meaningful. Unless a specific time period is stated, we do not know whether the demand for a product is large or small.

Law of Demand

A fundamental characteristic of demand is this: Other things equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls. In short, there is a negative or inverse relationship between price and quantity demanded. Economists call this inverse relationship the law of demandThe principle that, other things equal, an increase in a product's price will reduce the quantity of it demanded, and conversely for a decrease in price..

The other-things-equal assumption is critical here. Many factors other than the price of the product being considered affect the amount purchased. For example, the quantity of Nikes purchased will depend not only on the price of Nikes but also on the prices of such substitutes as Reeboks, Adidas, and New Balances. The law of demand in this case says that fewer Nikes will be purchased if the price of Nikes rises and if the prices of Reeboks, Adidas, and New Balances all remain constant. In short, if the relative price of Nikes rises, fewer Nikes will be bought. However, if the price of Nikes and the prices of all other competing shoes increase by some amount—say, $5—consumers might buy more, fewer, or the same number of Nikes.

Why the inverse relationship between price and quantity demanded? Let's look at three explanations, beginning with the simplest one:

• The law of demand is consistent with common sense. People ordinarily do buy more of a product at a low price than at a high price. Price is an obstacle that deters consumers from buying. The higher that obstacle, the less of a product they will buy; the lower the price obstacle, the more they will buy. The fact that businesses have “sales” to clear out unsold items is evidence of their belief in the law of demand.

  ORIGIN OF THE IDEA

  O 3.3 Diminishing marginal utility

  
  

• In any specific time period, each buyer of a product will derive less satisfaction (or benefit, or utility) from each successive unit of the product consumed. The second Big Mac will yield less satisfaction to the consumer than the first, and the third still less than the second. That is, consumption is subject to diminishing marginal utility(See law of diminishing marginal utility.). And because successive units of a particular product yield less and less marginal utility, consumers will buy additional units only if the price of those units is progressively reduced.

• We can also explain the law of demand in terms of income and substitution effects. The income effectA change in the quantity demanded of a product that results from the change in real income (purchasing power) caused by a change in the product's price. indicates that a lower price increases the purchasing power of a buyer's money income, enabling the buyer to purchase more of the product than before. A higher price has the opposite effect. The substitution effect(1) A change in the quantity demanded of a consumer good that results from a change in its relative expensiveness caused by a change in the product's price; (2) the effect of a change in the price of a resource on the quantity of the resource employed by a firm, assuming no change in its output. suggests that at a lower price buyers have the incentive to substitute what is now a less expensive product for other products that are now relatively more expensive. The product whose price has fallen is now “a better deal” relative to the other products.

For example, a decline in the price of chicken will increase the purchasing power of consumer incomes, enabling people to buy more chicken (the income effect). At a lower price, chicken is relatively more attractive and consumers tend to substitute it for pork, lamb, beef, and fish (the substitution effect). The income and substitution effects combine to make consumers able and willing to buy more of a product at a low price than at a high price.

The Demand Curve

The inverse relationship between price and quantity demanded for any product can be represented on a simple graph, in which, by convention, we measure quantity demanded on the horizontal axis and price on the vertical axis. In the graph in Figure 3.1 we have plotted the five price-quantity data points listed in the accompanying table and connected the points with a smooth curve, labeled D. Such a curve is called a demand curveA curve illustrating demand.. Its downward slope reflects the law of demand—people buy more of a product, service, or resource as its price falls. The relationship between price and quantity demanded is inverse (or negative).

The table and graph in Figure 3.1 contain exactly the same data and reflect the same relationship between price and quantity demanded. But the graph shows that relationship much more simply and clearly than a table or a description in words.

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Market Demand

So far, we have concentrated on just one consumer. But competition requires that more than one buyer be present in each market. By adding the quantities demanded by all consumers at each of the various possible prices, we can get from individual demand to market demand. If there are just three buyers in the market, as represented in the table in Figure 3.2, it is relatively easy to determine the total quantity demanded at each price. Figure 3.2 shows the graphical summing procedure: At each price we sum horizontally the quantities demanded by Joe, Jen, and Jay to obtain the total quantity demanded at that price; we then plot the price and the total quantity demanded as one point on the market demand curve.

FIGURE 3.2	Market demand for corn, three buyers.
(K) The market demand curve D is the horizontal summation of the individual demand curves (D1, D2, and D3) of all the consumers in the market. At the price of $3, for example, the three individual curves yield a total quantity demanded of 100 bushels (= 35 + 39 + 26).

Competition, of course, ordinarily entails many more than three buyers of a product. To avoid hundreds or thousands or millions of additions, we suppose that all the buyers in a market are willing and able to buy the same amounts at each of the possible prices. Then we just multiply those amounts by the number of buyers to obtain the market demand. That is how we arrived at the demand schedule and demand curve D1 in Figure 3.3 for a market of 200 corn buyers, each with a demand as shown in the table in Figure 3.1.

FIGURE 3.3

Changes in the demand for corn.

(K) A change in one or more of the determinants of demand causes a change in demand. An increase in demand is shown as a shift of the demand curve to the right, as from D1 to D2. A decrease in demand is shown as a shift of the demand curve to the left, as from D1 to D3. These changes in demand are to be distinguished from a change in quantity demanded, which is caused by a change in the price of the product, as shown by a movement from, say, point a to point b on fixed demand curve D1.

In constructing a demand curve such as D1 in Figure 3.3, economists assume that price is the most important influence on the amount of any product purchased. But economists know that other factors can and do affect purchases. These factors, called determinants of demandFactors other than price that determine the quantities demanded of a good or service., are assumed to be constant when a demand curve like D1 is drawn. They are the “other things equal” in the relationship between price and quantity demanded. When any of these determinants changes, the demand curve will shift to the right or left. For this reason, determinants of demand are sometimes referred to as demand shifters.

The basic determinants of demand are (1) consumers' tastes (preferences), (2) the number of buyers in the market, (3) consumers' incomes, (4) the prices of related goods, and (5) consumer expectations.

Changes in Demand

A change in one or more of the determinants of demand will change the demand data (the demand schedule) in the table accompanying Figure 3.3 and therefore the location of the demand curve there. A change in the demand schedule or, graphically, a shift in the demand curve is called a change in demand.

If consumers desire to buy more corn at each possible price than is reflected in column 2 in the table in Figure 3.3, that increase in demand is shown as a shift of the demand curve to the right, say, from D1 to D2. Conversely, a decrease in demand occurs when consumers buy less corn at each possible price than is indicated in column 2. The leftward shift of the demand curve from D1 to D3 in Figure 3.3 shows that situation.

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Now let's see how changes in each determinant affect demand.

Tastes  A favorable change in consumer tastes (preferences) for a product—a change that makes the product more desirable—means that more of it will be demanded at each price. Demand will increase; the demand curve will shift rightward. An unfavorable change in consumer preferences will decrease demand, shifting the demand curve to the left.

New products may affect consumer tastes; for example, the introduction of digital cameras greatly decreased the demand for film cameras. Consumers' concern over the health hazards of cholesterol and obesity have increased the demand for broccoli, low-calorie beverages, and fresh fruit while decreasing the demand for beef, veal, eggs, and whole milk. Over the past several years, the demand for coffee drinks and table wine has greatly increased, driven by a change in tastes. So, too, has the demand for touch-screen mobile phones and fuel-efficient hybrid vehicles.

Number of Buyers  An increase in the number of buyers in a market is likely to increase demand; a decrease in the number of buyers will probably decrease demand. For example, the rising number of older persons in the United States in recent years has increased the demand for motor homes, medical care, and retirement communities. Large-scale immigration from Mexico has greatly increased the demand for a range of goods and services in the Southwest, including Mexican food products in local grocery stores. Improvements in communications have given financial markets international range and have thus increased the demand for stocks and bonds. International trade agreements have reduced foreign trade barriers to American farm commodities, increasing the number of buyers and therefore the demand for those products.

In contrast, emigration (out-migration) from many small rural communities has reduced the population and thus the demand for housing, home appliances, and auto repair in those towns.

Income  How changes in income affect demand is a more complex matter. For most products, a rise in income causes an increase in demand. Consumers typically buy more steaks, furniture, and electronic equipment as their incomes increase. Conversely, the demand for such products declines as their incomes fall. Products whose demand varies directly with money income are called superior goods, or normal goodsA good or service whose consumption increases when income increases and falls when income decreases, price remaining constant..

Although most products are normal goods, there are some exceptions. As incomes increase beyond some point, the demand for used clothing, retread tires, and third-hand automobiles may decrease, because the higher incomes enable consumers to buy new versions of those products. Rising incomes may also decrease the demand for soy-enhanced hamburger. Similarly, rising incomes may cause the demand for charcoal grills to decline as wealthier consumers switch to gas grills. Goods whose demand varies inversely with money income are called inferior goodsA good or service whose consumption declines as income rises, prices held constant..

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Prices of Related Good  A change in the price of a related good may either increase or decrease the demand for a product, depending on whether the related good is a substitute or a complement:

• A substitute goodProducts or services that can be used in place of each other. When the price of one falls, the demand for the other product falls; conversely, when the price of one product rises, the demand for the other product rises. is one that can be used in place of another good.

• A complementary goodProducts and services that are used together. When the price of one falls, the demand for the other increases (and conversely). is one that is used together with another good.

Substitutes  Häagen-Dazs ice cream and Ben & Jerry's ice cream are substitute goods or, simply, substitutes. When two products are substitutes, an increase in the price of one will increase the demand for the other. Conversely, a decrease in the price of one will decrease the demand for the other. For example, when the price of Häagen-Dazs ice cream rises, consumers will buy less of it and increase their demand for Ben & Jerry's ice cream. When the price of Colgate toothpaste declines, the demand for Crest decreases. So it is with other product pairs such as Nikes and Reeboks, Budweiser and Miller beer, or Chevrolets and Fords. They are substitutes in consumption.

Complements  Because complementary goods (or, simply, complements) are used together, they are typically demanded jointly. Examples include computers and software, cell phones and cellular service, and snowboards and lift tickets. If the price of a complement (for example, lettuce) goes up, the demand for the related good (salad dressing) will decline. Conversely, if the price of a complement (for example, tuition) falls, the demand for a related good (textbooks) will increase.

Unrelated Goods  The vast majority of goods are not related to one another and are called independent goods. Examples are butter and golf balls, potatoes and automobiles, and bananas and wristwatches. A change in the price of one has little or no effect on the demand for the other.

Consumer Expectations  Changes in consumer expectations may shift demand. A newly formed expectation of higher future prices may cause consumers to buy now in order to “beat” the anticipated price rises, thus increasing current demand. That is often what happens in so-called hot real estate markets. Buyers rush in because they think the price of new homes will continue to escalate rapidly. Some buyers fear being “priced out of the market” and therefore not obtaining the home they desire. Other buyers—speculators—believe they will be able to sell the houses later at a higher price. Whichever their motivation, these buyers increase the current demand for houses.

Similarly, a change in expectations concerning future income may prompt consumers to change their current spending. For example, first-round NFL draft choices may splurge on new luxury cars in anticipation of lucrative professional football contracts. Or workers who become fearful of losing their jobs may reduce their demand for, say, vacation travel.

In summary, an increase in demand—the decision by consumers to buy larger quantities of a product at each possible price—may be caused by:

• A favorable change in consumer tastes.

• An increase in the number of buyers.

• Rising incomes if the product is a normal good.

• Falling incomes if the product is an inferior good.

• An increase in the price of a substitute good.

• A decrease in the price of a complementary good.

• A new consumer expectation that either prices or income will be higher in the future.

You should “reverse” these generalizations to explain a decrease in demand. Table 3.1 provides additional illustrations of the determinants of demand.

TABLE 3.1	Determinants of Demand: Factors That Shift the Demand Curve
(K)

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Changes in Quantity Demanded

A change in demand must not be confused with a change in quantity demanded. A change in demandA movement of an entire demand curve or schedule such that the quantity demanded changes at every particular price; caused by a change in one or more of the determinants of demand. is a shift of the demand curve to the right (an increase in demand) or to the left (a decrease in demand). It occurs because the consumer's state of mind about purchasing the product has been altered in response to a change in one or more of the determinants of demand. Recall that “demand” is a schedule or a curve; therefore, a “change in demand” means a change in the schedule and a shift of the curve.

In contrast, a change in quantity demandedA change in the quantity demanded along a fixed demand curve (or within a fixed demand schedule) as a result of a change in the price of the product. is a movement from one point to another point—from one price-quantity combination to another—on a fixed demand curve. The cause of such a change is an increase or decrease in the price of the product under consideration. In the table in Figure 3.3, for example, a decline in the price of corn from $5 to $4 will increase the quantity demanded of corn from 2000 to 4000 bushels.

In Figure 3.3 the shift of the demand curve D1 to either D2 or D3 is a change in demand. But the movement from point a to point b on curve D1 represents a change in quantity demanded: Demand has not changed; it is the entire curve, and it remains fixed in place.

1This definition obviously is worded to apply to product markets. To adjust it to apply to resource markets, substitute the word “resource” for “product” and the word “businesses” for “consumers.”

What effect does change in price have on the quantity of a good or service demanded and what is the economic term for this phenomenon?

What happens when there is a change in the price of a good?

What is income effect and price effect?

When the price of a good service or resource increases?