Determinants of Market Demand

IGCSE Economics

Key Issues

  How the price mechanism works

  Law of demand

  Determinants (Factors that influence) of demand

  Joint demand, effective demand

  The demand curve and shifts in demand curve

Functions of Prices

  The Price Mechanism • Prices provide the main method through which

scarce resources are allocated between competing uses in virtually all modern economies

  The Signalling Function • Prices signal what is available, conveying

information to producers and consumers alike

• If prices signal wrong or misleading information, then markets may perform inefficiently or break down completely

Functions of Prices

  The Incentive Function • Prices create incentives for agents to behave in

ways consistent with their self-interest. For example, the rising price of a good may: • Result in a firm expanding production of that good

in its pursuit of profit-maximisation • Result in a consumer contracting demand as she

tries to maximise her overall ‘utility’ with her limited income

Demand: Buyers in the Market

  Demand: • The quantity of a product consumers are willing

and able to buy at different prices in a specified time period

• Normally there is an inverse relationship between the price of good X and the quantity demanded of good X

Demand: Buyers in the Market

  Factors that affect demand • Consumer tastes and preferences

• Income available to the consumer

• Prices of other goods and services • Substitute goods • Complementary goods

• Consumer population – Age distribution and size

• Advertising

Demand for New Cars

The Price of New Cars

Interest Rates

Relative prices of second-hand

vehicles

Cost of fuel

Road Charges / Tax

Consumer Confidence

Relative costs of travelling on public

transport

Availability of Credit

Costs of car insurance and servicing etc

Effective Demand

  Effective Demand • When a consumers' desire to buy a product is

backed up by an ability to pay for it

• They must have sufficient real purchasing power

• Consider the market for pay-per-view boxing events – the companies promoting these events must price carefully so that they tap into the largest possible market

Effective demand

Demand is only effective if backed up with an ability to pay for the product

Latent Demand

  Latent Demand • Latent demand exists when there is willingness to

purchase a good, but where the consumer lacks the real purchasing power to be able to afford the product

• Latent demand is affected by persuasive advertising – where the producer is seeking to influence consumer tastes and preferences

Latent demand

Derived Demand (Joint Demand)

  The demand for a product X might be strongly linked to the demand for a related product Y – giving rise to the idea of a derived demand

  For example, the demand for coal is derived in part on the demand for fossil fuels to burn in the process of generating energy

  Demand for steel is strongly linked to the demand for new vehicles and many other manufactured products

Derived demand

The housing market is a good example of the idea of derived demand. When construction of new homes rises, so too does the demand for materials used in new properties as well as demand for labour

Demand for steel

  The construction of a new steel roof

  Global demand for steel is strongly linked to the world economic cycle

Complementary Demand

  As the demand for mobile phone handsets increases, so too does demand for phone calls

  Mobile phone companies often sell handsets at very low prices because they can recoup revenues from the calls made by subscribers to their network

The Demand Curve

Quantity Demanded

Demand

P1

Q1 Q3 Q2

P2

P3

Price

A contraction of demand

Quantity Demanded

Demand

P1

Q1 Q3 Q2

P2

P3

A contraction of demand due to a higher price

Price

An expansion of demand

Quantity Demanded

Demand

P1

Q1 Q3 Q2

P2

P3

An expansion of demand due to a lower price

Price

Falling Prices and Demand

  Many goods and services are cheaper now in both money and real terms than they were a few years ago • Flights/holidays overseas

• Audio-visual equipment – TV’s, DVD Players

• Laptop computers

• New car prices

  When prices are falling, we see a rise in the quantity demanded as consumers respond to the change in price

Price trends for selected items

Downward-sloping demand curve

  For normal goods, more is demanded as price falls   Firstly at lower prices, consumers can afford to

purchase more with their income   Secondly, a fall in price makes one good relatively

cheaper than a substitute   Thirdly, a fall in price means that the consumer derives

more benefit per pound spent on the product than they did before

  The demand curve is normally drawn in textbooks as a straight line suggesting a linear relationship between price and demand, but in reality, the demand curve will be non-linear

Shifts in the demand curve

Changes in the conditions of demand

Shifts in Demand

Quantity Demanded

D1

P1

Q1 Q2 Q3

D2 D3

Increase in Demand Decrease in

Demand Price

An outward shift in demand

  A rise in the real incomes of consumers

  An increase in the price of a substitute good (i.e. a competing product)

  A fall in the price of a complementary good

  A change in consumers’ preferences towards the good

  An increase in the size of the total population

  A fall in interest rates

  A rise in consumer confidence

  Social changes which affect total demand for a product

Substitutes

  Substitutes are goods in competitive demand • They are replacements for another product

• For example, a rise in the price of Esso petrol (other factors held constant) should cause a substitution effect away from Esso towards Shell or other competing brands

Complements

  Complements are said to be in joint demand • Examples include: fish and chips, DVD players

and DVDs, iron ore and steel

• A rise in the price of a complement to Good X should cause a fall in the demand for X

Normal and Inferior Goods

  For normal products, more is demanded as income rises, and less as income falls

  There are exceptions called inferior products

  They are often cheaper poorer quality substitutes for some other good

  With a higher income a consumer can switch from the cheaper substitute to preferred alternative

  As a result, less of the inferior product is demanded at higher levels of income

Income Elasticity of Demand

  For some products there is a strong link between income and demand • New cars

• Expensive furniture

• Overseas holidays

Changes in price of Substitutes

P1

Q1 Q2

Demand

Output (Q)

Price of Texaco petrol

P1

Q1 Q2

D1

Output (Q)

Price of Shell petrol

P2

D2

Changes in tastes and preferences

  Market demand in nearly every market is often affected by changes in consumer preferences

  One person’s preferences can affect those of others

  This is a very powerful force in digital markets e.g. iTunes, demand for DVDs

  But it is also powerful when influencing the demand for meals at restaurants, hotels in holiday destinations et al

  Advertising and marketing are explicitly designed to influence consumer tastes and preferences

What factors are influencing market demand for smoothies?

Exceptions to the law of demand

  Ostentatious consumption

  Some goods are luxurious items where satisfaction comes from knowing both the price of the good and being able to flaunt consumption of it to other people!

  Speculative Demand

  The demand for a product can be affected by speculative demand. Here, potential buyers are interested not just in the satisfaction they may get from consuming the product, but also the potential rise in market price leading to a capital gain or profit