Demand

In every market, there are both buyers and sellers. The buyers' willingness to buy a particular good (at various prices) is referred to as the buyers' demand for that good. The sellers' willingness to supply a particular good (at various prices) is referred to as the sellers' supply of that good.

The buyers' demand is represented by a demand schedule, which lists the quantities of a good that buyers are willing to purchase at different prices. An example of a demand schedule for a certain good X is given in Table . Note that as the price of good X increases, the quantity demanded of good X decreases.

This kind of behavior on the part of buyers is in accordance with the law of demand. According to the law of demand, an inverse relationship exists between the price of a good and the quantity demanded of that good. As the price of a good goes up, buyers demand less of that good. This inverse relationship is more readily seen using the graphical device known as the demand curve, which is nothing more than a graph of the demand schedule. A demand curve for the demand schedule given in Table is presented in Figure .

The vertical axis in Figure depicts the price per unit of good X measured in dollars, while the horizontal axis depicts the quantity demanded of good X measured in units of good X. In addition to the demand schedule and the demand curve, the buyers' demand for a good can also be expressed a third way—algebraically, using a demand equation. The demand equation relates the price of the good, denoted by P, to the quantity of the good demanded, denoted by Q. For example, the demand equation for good X corresponding to the demand schedule in Table and the demand curve in Figure is

From the demand equation, you can determine the intercept value where the quantity demanded is zero, as well as the slope of the demand curve. In the example above, the intercept value is 10 and the slope of the demand curve is −2. In order to satisfy the law of demand, the slope of the demand equation must be negative so that there is an inverse relationship between the price and quantity demanded.

Change in the quantity demanded. A change in the quantity demanded is a movement along the demand curve due to a change in the price of the good being demanded. As an example, suppose that in Figure the current market price charged for good X is $4 so that the current quantity demanded of good X is 3 units. If the price of good X increases to $6, the quantity demanded of good X moves along the demand curve to the left, resulting in new quantity demanded of 2 units of good X. The change in the quantity demanded due to the $2 increase in the price of good X is 1 less unit of good X. Similarly, a decrease in the price of good X from $4 to $2 would induce a movement along the demand curve to the right, and the change in the quantity demanded would be 1 more unit of good X.

Change in demand. A change in demand is represented by a shift of the demand curve. As a result of this shift, the quantity demanded at all prices will have changed. Figures (a) and (b) present just two of the many possible ways in which the demand curve for good X might shift. In both figures, the original demand curve is the same as in Figure and is denoted by D _A . In Figure (a), demand curve D _A has shifted to the left to the new demand curve D _B . The leftward shift means that at all possible prices, the demand for good X will be less than before. For example, before the shift, a price of $4 corresponded to a quantity demanded of 3 units of good X. After the shift left, at the same price of $4, the quantity demanded is less, at 1 unit of good X. In Figure (b), demand curve D _A has shifted to the right to the new demand curve D _C . The rightward shift means that at all possible prices, the demand for good X will be greater than before. For example, before the shift, a price of $6 implied a quantity demanded of 2 units of good X. After the shift, at the same price of $6, the quantity demanded is greater, at 4 units of good X.

Reasons for a change in demand. It is important to keep straight the difference between a change in quantity demanded, or a movement along the demand curve, and a change in demand, or shift in the demand curve. There is only one reason for a change in the quantity demanded of good X: a change in the price of good X; however, there are several reasons for a change in demand for good X, including:

1. Changes in the price of related goods: The demand for good X may be changed by increases or decreases in the prices of other, related goods. These related goods are usually divided into two categories called substitutes and complements. A substitute for good X is any good Y that satisfies most of the same needs as good X. For example, if good X is butter, a substitute good Y might be margarine. When two goods X and Y are substitutes, then as the price of the substitute good Y rises, the demand for good X increases and the demand curve for good X shifts to the right, as in Figure (b). Conversely, as the price of the substitute good Y falls, the demand for good X decreases and the demand curve for good X shifts to the left, as in Figure (a). A complement to good X is any good that is consumed in some proportion to good X. For example, if good X is a pair of shoelaces, then a complement good Y might be a pair of shoes. When two goods X and Y are complements, then as the price of the complementary good Y rises, the demand for good X decreases and the demand curve for good X shifts to the left, as in Figure (a). Conversely, as the price of the complementary good Y falls, the demand for good X increases and the demand curve for good X shifts to the right, as in Figure (b).
2. Changes in income: The demand for good X may also be affected by changes in the incomes of buyers. Typically, as incomes rise, the demand for a good will usually increase at all prices and the demand curve will shift to the right, as in Figure (b). Similarly, when incomes fall, the demand for a good will decrease at all prices and the demand curve will shift to the left, as in Figure (a). Goods for which changes in demand vary directly with changes in income are called normal goods. There are some goods, however, for which an increase in income leads to a decrease in demand and a decrease in income leads to an increase in demand. Goods for which changes in demand vary inversely with changes in income are called inferior goods. For example, consider the two goods meat and potatoes. As incomes increase, people demand relatively more meat and relatively fewer potatoes, implying that meat may be regarded as a normal good, and potatoes may be considered an inferior good.

  3.  Changes in preferences: As peoples' preferences for goods and services change over time, the demand curve for these goods and services will also shift. For example, as the price of gasoline has risen, automobile buyers have demanded more fuel‐efficient, “economy” cars and fewer gas‐guzzling,“luxury” cars. This change in preferences could be illustrated by a shift to the right in the demand curve for economy cars and a shift to the left in the demand curve for luxury cars.

  4.  Changes in expectations: Demand curves may also be shifted by changes in expectations. For example, if buyers expect that they will have a job for many years to come, they will be more willing to purchase goods such as cars and homes that require payments over a long period of time, and therefore, the demand curves for these goods will shift to the right. If buyers fear losing their jobs, perhaps because of a recessionary economic climate, they will demand fewer goods requiring long‐ term payments and will therefore cause the demand curves for these goods to shift to the left.

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Elasticity

In addition to understanding how equilibrium prices and quantities change as demand and supply change, economists are also interested in understanding how demand and supply change in response to changes in prices and incomes. The responsiveness of demand or supply to changes in prices or incomes is measured by the elasticity of demand or supply.

Price elasticity of demand and supply. The price elasticity of demand is given by the formula: The price elasticity of supply is given by a similar formula:

The price elasticity of supply is given by a similar formula: 

If the percentage change in quantity demanded is greater than the percentage change in price, demand is said to be price elastic, or very responsive to price changes. If the percentage change in quantity demanded is less than the percentage change in price, demand is said to be price inelastic, or not very responsive to price changes. Similarly, supply is price elastic when the percentage change in quantity supplied is greater than the percentage change in price, and supply is price inelastic when the percentage change in quantity supplied is less than the percentage change in price.

The price elasticity of demand or supply will differ among goods. For example, consider a 50 percent increase in the price of two goods—candy bars and prescription medicines. While the demand for both candy bars and prescription medicines should decline in response to the price increases, the percentage change in the quantity demanded of candy bars is likely to be much greater than the percentage change in the quantity demanded of prescription medicines because candy bars are less of a necessity than prescription medicines. You could summarize this finding by stating that the demand for candy bars is more price elastic than the demand for prescription medicines. Alternatively, you might state that the demand for prescription medicines is more price inelastic than the demand for candy bars.

Two extreme cases. There are two cases where the price elasticity of demand or supply can take on extreme values. One is the case of perfectly price elastic demand or supply. Demand is perfectly price elastic if for any percentage decrease in price, no matter how small, the percentage change in quantity demanded is infinitely large—demanders demand all that they can. Supply is perfectly price elastic if for any percentage increase in price, no matter how small, the percentage change in quantity supplied is also infinitely large—suppliers supply all that they can.

The other extreme case occurs when the percentage change in quantity demanded or supplied is always equal to 0, regardless of the percentage change in price. In this case, demand or supply is said to be perfectly price inelastic, or completely nonresponsive to change in prices.

The two extreme cases are illustrated in Figure . The demand curve D ₁ in Figure (a) illustrates the case of perfectly price elastic demand, while the supply curve S ₁ in Figure (b) illustrates the case of perfectly price elastic supply. The demand curve D ₂ in Figure (a) illustrates the case of perfectly price inelastic demand, and the supply curve S ₂ in Figure (b) illustrates the case of perfectly price inelastic supply.

Income elasticity of demand. The income elasticity of demand is given by the formula:

  If the percentage change in the quantity demanded is greater than the percentage change in income, then demand is said to be income elastic, or very responsive to changes in demanders' incomes. If the percentage change in the quantity demanded is less than the percentage change in income, then demand is said to be income inelastic, or not very responsive to changes in demanders' incomes. Notice from the definition of income elasticity that if the income elasticity of demand is positive, the good must be a normal good, and if the income elasticity of demand is negative, the good must be an inferior good.

Cross‐price elasticity of demand. The cross‐price elasticity of demand is the ratio of the percentage change in the quantity demanded of some good X to a percentage change in the price of some other good Y. The cross‐price elasticity of demand is given by the formula:

If the percentage change in the quantity demanded of good X is greater than the percentage change in the price of good Y, the demand for good X is cross‐price elastic with respect to good Y, or very responsive to changes in the price of good Y. If the percentage change in the quantity demanded of good X is less than the percentage change in the price of good Y, the demand for good X, is cross‐price inelastic with respect to good Y, or not very responsive to changes in the price of good Y. From the definition of cross‐price elasticity, one may also conclude that if the cross‐price elasticity of demand is positive, the goods X and Y must be substitutes, and if the cross‐price elasticity of demand is negative, the goods X and Y must be complements.

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Demand, Supply, and Elasticity

 Equilibrium Analysis

In the market for any particular good X, the decisions of buyers interact simultaneously with the decisions of sellers. When the demand for good X equals the supply of good X, the market for good X is said to be in equilibrium. Associated with any market equilibrium will be an equilibrium quantity and an equilibrium price. The equilibrium quantity of good X is that quantity for which the quantity demanded of good X exactly equals the quantity supplied of good X. The equilibrium price for good X is that price per unit of good X that allows the market to “clear”; that is, the price for which the quantity demanded of good X exactly equals the quantity supplied of good X. The determination of equilibrium quantity and price, known as equilibrium analysis, can be achieved in two different ways: by simultaneously solving the algebraic equations for demand and supply or by combining the demand and supply curves in a single graph and determining the equilibrium price and quantity graphically.

The algebraic approach to equilibrium. The algebraic approach to equilibrium analysis is to solve, simultaneously, the algebraic equations for demand and supply. In the example given above, the demand equation for good X was 

and the supply equation for good X was 

To solve simultaneously, one first rewrites either the demand or the supply equation as a function of price. In the example above, the supply curve may be rewritten as follows:

Substituting this expression into the demand equation, one can solve for the equilibrium price:

The equilibrium price of good X is found to be $2. Substituting the equilibrium price of 2 into the rewritten supply equation for good X, one has: 

The equilibrium quantity is found to be 4 units of good X.

A graphical depiction of equilibrium. The graphical approach to equilibrium analysis is illustrated in Figure . The equilibrium price and quantity are determined by the intersection of the two curves. The equilibrium quantity is 4 units of good X, and the equilibrium price is $2 per unit of good X. This result is the same as the one obtained by simultaneously solving the algebraic equations for demand and supply.

A price of $2 and a quantity of 4 units of X are the equilibrium price and quantity only when the demand and supply for good X are exactly as depicted in Figure . If either the demand curve or the supply curve shifts, the equilibrium price and quantity change. Examples of shifts in the demand and supply curves and the resultant changes in equilibrium are illustrated in Figures (a) and (b). In Figure (a), a shift to left of the demand curve, from D _A to D _B, leads to a decrease in both the equilibrium price and quantity of good X, while a shift to the right of the demand curve, from D _A to D _C, leads to an increase in both the equilibrium price and quantity of good X, assuming supply is held constant‐the ceteris paribus assumption. In Figure (b), a shift to the left of the supply curve, from S _A to S _B, leads to an increase in the equilibrium price of good X but a decrease in the equilibrium quantity of good X, assuming demand is held constant. A shift to the right of the supply curve, from S _A to S _C, leads to a decrease in the equilibrium price of good X but an increase in the equilibrium quantity of good X, again assuming that demand is held constant.

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