Understanding Demand Lecture Notes
I. Introduction to Understanding Demand: In a market system, the interaction of
buyers and sellers determines the prices of most goods as well as what quantity of a
good will be produced. Buyers demand goods, sellers supply those goods, and the
interactions between the two groups lead to an agreement on the price and the quantity
traded.
A. Definition of demand: The desire to own something and the ability to pay for it.
B. Law of demand: The law of demand says that when a good’s price is lower,
consumers will buy more of it. When the price is higher, consumers will buy less
of it. Demand is not wanting to buy something you can’t afford, like a sports car
or a trip to Hawaii, but wanting to buy something within your means, such as a
new CD. Simply stated, the price of any item affects the quantity demanded of
that item. The law of demand is the result of two patterns of behavior that are
known as the substitution effect and the income effect. (picture)
a. Substitution effect: when consumers react to an increase in a good’s
price by consuming less of that good and more of other goods
Pizza example: If the cost to make a pizza rises, the price of pizza is going to rise and
will be more expensive compared to other foods such as tacos and burgers.
Consumers are more likely to purchase tacos and burgers as substitutions, therefore
causing a drop in demand. The substitutions effect takes place when a consumer
reacts to the price change by consuming less pizza and more tacos or burgers. This
can also go the other way around. If the price of pizza drops, consumers might begin
replacing their consumption of tacos and burgers with pizza.
b. Income effect: the change in consumptions resulting from a change in
real income.
Pizza Example: Rising prices can cause the income effect. When you see a rise in
price for pizza, you feel as though you have less money, and therefore buy less pizza.
Economists measure consumption buy the amount of goods bought, not money spent,
so if you spend more on pizza, but consume less, your consumption goes down. In this
case, when the price goes up, the quantity demanded goes down. This can also be
seen oppositely. When the price of pizza is lowered, you feel as though you have more
money, and therefore might buy more pizza.
C. Demand Schedule: a table that lists the quantity of a good a person will buy at
each different price. (purchase decisions based on one consumer)
D. Market Demand Schedule: a table that lists the quantity of a good all
consumers in a market will buy at each different price. (purchase decisions
based on all potential consumers in the market)
 The difference between the two is that the market demand schedule
lists larger quantities demanded.
E. Demand Curve: a representation of a demand schedule on a graph.
 Demonstrate on the board how to plot a demand curve using prices and
quantities demanded as the vertical and horizontal axis. Show how to
read a demand curve.
II. Shifts of the Demand Curve
A. Changes in Demand
a. ceteris paribus: a Latin phrase that means “all other things held
constant.” This means that the demand curve is only accurate as long as
there are no changes other than price that could affect the consumer’s
decision. When the price changes, we move along the curve to a different
quantity demanded.
b. When the ceteris paribus rule is dropped and other factors are allowed
to change, we no longer move along the demand curve. Instead, the
entire demand curve shifts. A shift in the demand curve means that at
every price, consumers buy a different quantity than before. Economists
refer to this as a change in demand.
B. What causes a shift?
a. Income: When a person’s income increases, he or she demands more
normal goods and less inferior goods. An increase in income would cause
a shift to the right, called an increase in demand. A fall in income would
cause the demand curve to shift to the left, called a decrease in demand.
b. Consumer Expectations: Our expectations for the future can affect our
demand for certain goods today.
c. Population: Changes in the size of population will also affect the
demand for most products. Growing populations need to be housed and
fed, therefore, a rise in population will increase demand for housing and
food, as well as many other goods and services.
d. Consumer Tastes and Advertising: Changes in tastes and advertising
can be the result of clever advertising campaigns, social trends, the
influence of television shows, or some combination of these factors.
C. Prices of Related Goods: The demand curve for one good can be affected by
a change in the demand for another good.
a. Complements: two goods that are bought and used together. (You buy
skis, you will buy ski boots too)
b. Substitutes: goods used in place of one another. (When the price of
skis go up, you might decide to buy a snowboard instead)
III. Elasticity of Demand: A measure of how consumers react to a change in price.
(There are some goods that consumers always find the money to buy, despite the price
change. There are some goods that even the slightest rise in price could stop
consumers from buying)
Inelastic: describes demand that is not very sensitive to a change in price.
Elastic: describes demand that is very sensitive to a change in price.
A. Calculating Elasticity
Percent change in quantity demanded
Elasticity = -----------------------------------------------------------Percentage change in price
Original number – New number
Percentage change = ------------------------------------------------------- x100
Original number
a. If the elasticity of demand for a good at a certain price is less than 1, it
is inelastic. If the elasticity is greater than 1, demand is elastic.
b. If elasticity is exactly equal to 1, it is described as unitary elastic.
B. Factors Affecting Elasticity
a. Availability of Substitutes: Lack of substitutes can make demand
inelastic. Wide choice of substitute goods can make demand elastic.
b. Relative Importance: Will it fit in your budget? How important is it?
c. Necessities vs. Luxuries: Demand for necessities is inelastic, demand
for luxuries is elastic.
d. Change over Time: Consumers do not always react quickly to price
increase because it takes time to find substitutes.
C. Elasticity and Revenue: The elasticity of demand determines how a change in
prices will affect a firm’s total revenue or income.