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Key Issues
Functions of the price mechanism
Law of demand
Determinants of demand
Joint demand, effective demand
The demand curve and shifts in demand curve
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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
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Functions of Prices
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
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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
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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
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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
• Interest rates
• Consumer population
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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
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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
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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
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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
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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
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Demand for steel
The
construction
of a new
steel roof
Global
demand for
steel is
strongly
linked to the
world
economic
cycle
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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
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A contraction of demand
Quantity
Demanded
Demand
P1
Q1 Q3Q2
P2
P3
A contraction of demand
due to a higher price
Price
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An expansion of demand
Quantity
Demanded
Demand
P1
Q1 Q3Q2
P2
P3
An expansion of demand
due to a lower price
Price
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Falling Prices and Demand
Many goods and services are cheaper now in
both money and real terms than they were a
few years ago
• Short-break holidays overseas
• Prices of new audio-visual equipment
• Personal computers
• New car prices
When prices are falling, we see a rise in the
quantity demanded as consumers respond to
the change in price
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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
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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
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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
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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
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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
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Income Elasticity of Demand
For some products
there is a strong link
between income and
demand
• New cars
• Expensive furniture
• Cruise tours
What of the demand
for package holidays?
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Changes in price of Substitutes
P1
Q1Q2
Demand
Output (Q)
Price of
Texaco
petrol
P1
Q1 Q2
D1
Output (Q)
Price of
Shell
petrol
P2
D2
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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
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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!
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Exceptions to the law of demand
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
Demand is defined as the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. Each of us has an individual demand for particular goods and services. Demand at each market price reflects the degree of value consumers place on item and their expected satisfaction gained from purchase and consumption.
Market demand is simply the sum of the individual demand for a product from each consumer in the market. If more people enter the market, then demand at each price level will rise.
Demand in economics must be effective. Only when a consumers' desire to buy a product is backed up by an ability to pay for it do we speak of demand. For example, many people would be willing to buy a luxury sports car, but their demand would not be effective if they did not have the financial means to do so. They must have sufficient 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.
A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. For normal goods, more of a product will be demanded as the market price falls.
At higher prices, consumers generally willing to purchase less than at lower prices
At lower prices there is a financial incentive to demand more of a good or service
Changes in any of the factors other than price causes the demand curve to shift
Changes in the price of the good itself cause a movement along the demand curve
Substitutes are goods in competitive demand and act as replacements for another product.
For example, a fall in the monthly rental charges of cable companies or Vodafone mobile phones might cause a decrease in the demand for British Telecom services. Consumers will tend over time to switch to the cheaper brand or service provider. When it is easy and cheap to switch, then consumer demand will be sensitive to price changes