 The determinants of the demand for goods and services

How the price mechanism works in a free market system is now understood well by economists, but this wasn't always so. In the past, and even now, some people think the price of something is calculated by adding the cost of all the things that went into making it, (the land, labour, capital) and then adding some profit. Today, economists believe that it is the forces of demand and supply that determines prices. In this section we look at demand.

Demand
It is important to note that demand is an expression of what people are ‘willing and able to buy’, not merely what they want. Sometimes we refer to this as 'effective demand'. Let us begin with some casual observations from the real world. In the temperate zones of the world such as northern Europe and the UK, mangoes are expensive and few are demanded. But in tropical areas mangoes are relatively cheap and a great many more are demanded. Casual observation like this leads us to infer that when prices are low, many are demanded. When prices are high, few are demanded. We also know that when shops want to get rid of stock they drop the price, not increase it!

The relationship between price and quantity demanded can be shown in a number of ways: in a table called a demand schedule, as a line on a graph that we call a demand curve (even though they aren't always curved) or as an equation which is sometimes called a demand function.. Plotting the demand schedule results in a demand curve; When the price is 0 the quantity demanded is 8000, and we can see from the graph we are dealing with a straight line and that when the price goes up by 20p quantity demanded falls by 1000. 1000 divided by 20 = 50. So when price goes up by 1p, quantity demanded falls by 50. Therefore:

Qd = 8000 - 50p

Don’t panic! AQA examiners are not going to ask you to do equations like this but you will see demand schedules and demand curves.

Students and even some economists sometimes fail to distinguish between demand and quantity demanded. It is important to understand the difference. 'Quantity demanded' is a point on the demand curve; 'demand' refers to the whole curve. When you are writing try to be precise as this makes your writing easier to understand. Furthermore, try to recognize when textbooks and examiners are not using the terms correctly.

In the diagram below I want to show what the quantity demanded is 4,000 when the price is 80p. Notice how the points are labelled (P1,Q1) and that I am showing quantity demanded - a point on the curve. From repeated observations in the real world we observe that demand curves slope downwards from left to right. We know that the quantity demanded of a good or service is a function of its price and this allows us to write a rule or law. The law of demand states; as the price of a good or service falls the quantity demanded rises, and vice-versa. Another way of stating this is to say that; quantity demanded and price are inversely related.

As in any subject, conventions arise. Learning about these conventions is not vital to understanding economic principles but it does make reading, writing notes and communicating to others easier. When we abbreviate quantity demanded we use Qd an when we label the demand curve we use the letter D. Against the conventions of other subjects, the non-dependent variable, price, is placed on the y-axis.  This dates back to the 19th century and we just have to live with it.

A very important point to note is that in the small hypothetical economic model we have constructed, there are some unwritten assumptions.  It would be tedious to write out these assumptions in full every time we constructed similar models, so as economists we also assume that other economists understand them:

1. That all the mangoes are the same i.e. they are homogeneous.

2. That there are only two variables involved in the model; the price and the quantity demanded.

3. Nothing else can interfere in the model – or as economists like to say in English, 'other things being equal', and in Latin 'ceteris paribus'.

The reality of these assumptions is questionable, but economics is sometimes about simplifying the real world to make it more understandable. Using these assumptions makes the problem of analyzing the market easier. As long as we do not forget the underlying assumptions this is a reasonable approach, but remember this is a model of the real world not reality itself.

Movements along the curve
If at the current moment the price of mangoes is 80 pence and this then falls to 60 pence, quantity demanded will increase from 4,000 to 5,000, this is described as an extension of demand. This movement is shown on the graph below. The price, P1 falls to P2 on the price axis and the quantity demanded rises from Q1 to Q2 on the quantity demanded axis. If the opposite occurs then this is a contraction of demand.  We use the words contraction and extension to denote a movement along the curve, which distinguishes it from a movement of the whole curve.

Why do demand curves slope downwards?

Our demand schedule and curve above illustrate the law of demand; at higher prices people demand few mangoes and at lower prices more. However, this is just an observation and proves nothing much other than about mangoes in one particular instance. The demand curve is merely describing a relationship, not explaining it. Why is it that at lower prices people demand more? The first reason is a simple deductive proof.

The income effect
Imagine you earn £100 a week. If mangoes were priced at £1 each you could buy 100 mangoes, but if the price of mangoes was 50p you could buy 200 mangoes. It’s mathematics and as simple as that!

Notice that in my example, nominal income does not change. It is the price that changes from, £1 to 50p. When students write about the income effect they frequently make a mistake and say income changes - it does not. However, it would be true to say that real incomes rise. That is to say your nominal income (what you earn in pounds) stays the same, but when prices fall you can buy more with the same amount of money. Although you still have the same amount of cash in your pocket you are better of in real terms.

The substitution effect
The other reason demand curves slope downward is because when the price of a good falls, other things being equal, people stop buying the substitute products. Two close substitutes are Coke and Pepsi. If Coke decreases their price some Pepsi customers would purchase Coke instead. Although the price of Pepsi has not changed, if Coke reduces in price, Pepsi becomes relatively more expensive.

The law of diminishing marginal utility
Present day economists have few problems with the income and substitution effects as an explanation for downward sloping demand curves. More contentious is the following argument.

One explanation for the negative gradient is the idea of diminishing marginal utility. Marginal has a special meaning in economics. It means ‘one extra unit’. The marginal unit may be the last unit or the next unit depending how the writer phrases it. For example, the marginal unit of production would usually describe the last car to come off the production line. Marginal consumption would mean the last glass of water drunk.

Utility means usefulness. The philosophy of Jeremy Bentham and John Stuart Mill’s in the 19th century suggested that economic and political decisions should be made on the basis of bringing the ‘greatest happiness to the greatest number’. Their way of deciding the ‘what to produce’ question meant making what made the most people happy, and their way of measuring this was to look at its utility or usefulness.

It is argued that as more units of a good or service are consumed the utility of each successive unit diminishes. For example a man in a desert would value the first glass of water highly and be prepared to pay a lot for it. But after the fifth glass his thirst would have dissipated and he would want no more, or if he did, he would not be prepared pay much for it.

The concept of diminishing marginal utility is difficult because it is hard to measure as there is no convenient unit such as centimetres or inches. Utils, which some economists proposed, has no precise meaning. One util to me may mean something entirely different to you.

Furthermore some exceptions to the concept of diminishing marginal utility might be thought of, for example I might enjoy the third glass of vodka more than the first! Therefore modern explanations for the law of demand tend to concentrate on the income and substitution effects. These yield to mathematical proofs much more easily. However, if you are asked a question about why demand curves slope downwards it is worth discussing diminishing marginal utility, and even better to discuss the weakness in the theory.

Key Terms

Effective demand - demand in economics means effective demand, which is ‘the willingness and ability to pay for a good, service or factor of production’.

Latent demand is the willingness but not the ability to pay for a good, service or factor of production, or the ability to pay but not the willingness.

Composite demand is demand for a good that has two or more uses; an increase in demand for one good will lead to a decrease in supply of the other good, e.g. wheat can be used to make bread or biofuel.

Joint demand occurs when two or more complementary goods are demanded to satisfy the same want; for example road travel requires cars and petrol, the demand for cakes requires flour, eggs and sugar. When the demand to fulfil the want increases demand for the goods in joint demand increases too.

This page has covered the shape of the demand curve and movements along the demand curve. In the next section we relax the ceteris paribus assumption and see what happens when we change variables other than price. Changes in variables other than price make the whole demand curve move.

Movement of the demand curve and the determinants of demand