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3.2 Demand
[3.3 Price Elasticity] [3.4 Supply] [3.5 Production]
[3.6 Costs]

How can you increase the demand for your company's product? How will
your competitor's production and pricing decisions affect the demand for
your product? How will raising the price of your product by $20 affect your
sales? What determines the prices of the inputs you need to produce your
products? Should you expect these input prices to rise or fall in the near
future?

To answer important questions like these, you need to understand the
economic meaning of the demand for a good. Organisations that understand
demand and the factors that influence demand can respond optimally to
changes in the demand for their products or the products they rely on as
inputs.

Law of Demand

The demand for a good refers to the relation between the price of a good
and the quantity of the good that consumers will be willing and able to
purchase at various prices, holding all other factors that affect purchase
decisions constant.
The law of demand states that other things being equal, as the price of a
good increases, the quantity demanded of that good decreases.
This is true both for the individual consumer's demand and the market
demand for a good, because the market consists of many individual
consumers.
For example, suppose that through a combination of market research and
data from pricing experiments, a manager at Ekina Sports estimates that at
a price of $100 per pair, consumers would purchase, or "demand", 10,000
pairs of Ekina running shoes each week. The manager further estimates that
consumers would demand 15,000 pairs per week if the price were decreased
to $80, and 20,000 pairs per week if the price were further decreased to
$60.
If you assume that the relation between price (P) and quantity demanded
(Q
d
) continues in a similar fashion for even higher or lower prices, you can
illustrate the demand for Ekina shoes on a graph.
Start by constructing a demand schedule that lists various prices and the
quantity of shoes consumers would demand at each price. For example,
assume Ekina further estimates that at a price of $140, consumers would
not demand any shoes; at a price of $120, consumers would demand five
thousand pairs; at a price of $100, consumers would demand ten thousand
pairs, and so on.
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Then draw x- and y-axes and show price (P) on the y-axis and the quantity
of shoes demanded (Q) on the x-axis.
You can plot the price-quantity pairs (from the demand schedule) on the
graph and connect them in a linear fashion to produce the demand line, or
"market demand curve" as it is more generally known.

As you look at the graph, notice how the line slopes downwards, indicating
that as the price of shoes decreases, the quantity demanded increases.
Consumers are willing and able to purchase more shoes at the lower prices
than they were willing and able to purchase at the higher prices.

The following link provides a brief look at how the law of demand works for
energy.
Observing the Law of Demand

The law of demand is not necessarily something that applies only for explicit
dollar prices. Click on the link below for another possibility.
The Law of Demand in Different Environments

Demand Function

It is often convenient to express this relation between price and quantity
demanded as a mathematical function. You can write the function in two
equivalent ways. One way expresses price as a function of quantity
demanded:

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The second way expresses quantity demanded as a function of price:
You read the function above: "quantity demanded is a function of price,"
not, "quantity demanded equals f times P." Quantity demanded depends on
price; it is the dependent variable. P is the independent variable.
What does the demand function tell you?

The following linear function summarises the relation between price and
quantity demanded represented by the Demand Schedule and Market Demand
Curve above:
For a reminder of what linear functions and their properties are, click on the
link below.
Analytical Methods: Linear Functions

Notice how this function reflects the information in the graph below. For
example, substituting a quantity of ten thousand pairs of shoes for Q
d
results
in a price of $100, which indicates that consumers would demand ten
thousand pairs of shoes at a price of $100 per pair.

You can express the same relation between price and quantity demanded with
quantity demanded on the left side of the function. Rearranging the same
equation to isolate quantity demanded yields:
Q = 35 - P/4
Notice how the conversion maintains the underlying relation between price
and quantity demanded. Substituting $100 for price results in Q
d
= 10
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(thousand) as before.
The function
Q
d
= 35 - P/4
is formally called a demand function because it expresses quantity demanded
as a function of price.
The function
is called the inverse demand function because it represents the same demand
relationship, just inverted. Because both equations represent the same
demand relationship, many economists refer to either as just the demand
function.
You will often use the demand function with price on the left side because it
is consistent with the way economist s represent demand graphically. That is,
it reflects the placement of price on the y-axis and quantity demanded on the
x-axis. This subject will adhere to this practice throughout.
Generally, you can express the demand function for any linear demand as
a = the y-intercept
-b = the slope of the function

Notice that a corresponds to the price at which quantity demanded becomes
zero, and b indicates the change in price that will generate a one-unit change
in quantity demanded. In practice, you will often estimate these parameters
using the statistical technique regression analysis. Regression analysis
involves collecting real observations on two variables, such as P and Q, and
then using these observations to estimate a mathematical relation between
the two variables.

If you want to review the mathematics of constants, variables and
coefficients, click on the link below.

Analytical Methods: Constants, Variables and Coefficients

The information contained in a simple demand equation should not be
underestimated. You will find later in the subject that you can derive a wealth
of additional information from a simple demand equation.

Example: Demand for coffee
Assume a bakery finds the daily demand function for its coffee to be
P = price per cup of coffee
Q
d
= the number of cups that consumers would be willing to buy per
day at each price
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To plot this demand function on a graph, you first want to solve the demand
function for P. Expressing demand in terms of price is consistent with placing
price on the y-axis and quantity demanded on the x-axis.
The demand function above has a slope of -0.02, and a y-intercept of 4. By
substituting values for Q
d
, such as 50 and 100, you can find two additional
quantity-price pairs (50, $3; 100, $2). You can now plot the pairs, or points,
on a graph, with price on the y-axis and quantity demanded on the x-axis.

Click on the following link for another example of how to draw a linear demand
curve.

Example of a Linear Demand Curve

Sometimes it is better to represent a demand function in a nonlinear form.
Before doing this, you might like to review the mathematics of non-linear
functions in the following link.

Analytical Methods: Nonlinear Functions

You can take a look at the advanced material in the following link to explore
nonlinear demand functions.

(Advanced) Nonlinear Demand Functions


Other Factors That Influence Demand
Recall that the law of demand states that other things being equal, as the
price of a good increases, the quantity demanded of that good decreases. But
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what if one of the "other things" changes? For example, how would an
economic recession affect the demand for Ekina shoes? How would an
increased marketing campaign by Ekina affect the demand for its shoes? What
would happen in July if Ekina announced that it would be raising all of its shoe
prices in September in response to increased costs of rubber and other
materials? The demand relationship in each of these cases would change.
When an important factor other than the price of a good itself changes, a
change in demand for that good may occur. In the Ekina shoes example, an
increase in demand means that consumers are now willing to purchase more
shoes at each price. Graphically, an increase in demand appears as a
rightward (or "upward") shift of the demand curve.
Similarly, a decrease in demand for Ekina shoes means that consumers are
willing to purchase fewer shoes at each price than previously. Graphically, a
decrease in demand appears as a leftward (or "downward") shift of the
demand curve.
Mathematically, an increase or a decrease in demand appears as an increase
or a decrease in the y-intercept a, respectively:
Change in quantity demanded vs. change in demand
A change in quantity demanded occurs when the price of the good alone
changes. A change in demand results from a change in one of the factors
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other than price. When price alone changes, no "shift" occurs in the underlying
relationship, you simply move to a higher or lower price-quantity pair along the
same demand curve.
The primary factors that can cause a change in demand (or a shift in the
demand curve) are
consumer income
prices of related goods
advertising and consumer preferences
population
seasonal factors
expectations
Understanding these factors will allow you to predict the market response to
real economic events.
Test your knowledge now with an example of a bakery. Click here to begin.

Consumer income
An increase in consumer income means consumers can afford to purchase more
of all goods. In general, you can expect the demand for most goods to increase
when consumer income increases. The demand for certain items, however,
such as public transportation, may actually decrease as income increases
because consumers can afford more desirable alternatives. A good for which
demand decreases when income increases is an inferior good; a good for which
demand increases when income increases is a normal good.
Prices of related goods
Changes in the prices of related goods (substitutes and complements) lead to
changes in demand. A decrease in the price of a substitute good can cause
demand to decrease. For example, assume that ice cream is a substitute good
for frozen yoghurt. A decrease in the price of ice cream can cause demand for
yoghurt to decrease. A decrease in the price of a complement good can cause
demand to increase. For example, if Ekina put its athletic apparel on sale
(sports shoes and athletic wear are complement goods), the demand for its
shoes may increase.
Advertising and consumer preferences
If consumer preferences change so that consumers get more fulfilment from
consuming a good, whether the result of a firm's advertising or outside forces,
demand for the good will increase. Demand for Ekina's running shoes might
increase if Ekina ran commercials in which Olympic track stars endorsed its
shoes, or if a medical report announced some new health benefits from jogging.

Click here for more information on the importance of brand recognition.

The link here discusses how changes in consumer preferences impacted upon
the demand for energy.

Population
An increase in the population of consumers will increase demand. For example,
as the baby boomer generation ages and the population of elderly Americans
grows, the demand for health care and related services in the United States will
increase.
Seasonal factors
Seasonal factors can also affect the demand for a product. Buyers purchase
certain products heavily during certain times of the year. For instance, the
demand for children's toys will be higher during the Christmas season (often the
fourth quarter) than during other times of the year.
Expectations
Finally, if consumers' expectations about the price of a good changes, demand
for the good will change. For instance, if consumers expect prices to rise in the
near future, they may demand more of a good today. The opposite is true if
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consumers expect prices to fall in the future. Homebuyers may delay home
purchases if they expect the housing market to be more attractive in a year.
The interactive exercise here allows you to see how each of these factors
affects the demand curve for another market - sports drinks.

Topic Summary

In this topic, you have learnt how to

explain the law of demand and why demand curves slope downwards
express demand functions mathematically and graphically
identify how changes in consumer income, prices of related good,
advertising and consumer preferences, population, seasonal factors and
expectations can cause changes in demand

Now go on to topic 3.3, Price Elasticity.