Lecture 3 The Law of Demand

1. Lecture 3 The Law of Demand ■ Our objectives: ► Explain individual choices among unlimited wants in a world of limited resources ► Develop a theory that helps us better understand and predict human actions ►What do people (our customers) want?

2. A Very Difficult Issue • What we measure in demand is a reflection of individual desires. • Daniel Bernoulli, a mathematical genius who lived in Basel, noted, in 1738, that people seek goodness or pleasure (utility). • That is, we do not seek cellphones because they are cellphones but because they are useful and give us pleasure. Use and pleasure cannot be measured, only approximated. • This is behind the law of demand.

3. A Note on Value, Scarcity, and Price as Related to Demand Why do people want what they want? • The diamond-water paradox. • Scarcity need not mean highly valued; think of snake meat. • Markets reflect what people value in relationship to current availability. • Demand is our best understanding of what people value—given current conditions.

4. The Law of Demand ■Holding all other relevant factors constant, the lower (higher) the price of a good, the greater (lower) will be the quantity demanded. ► Like all scientific propositions, it is a ceteris paribus (“other things equal” or “other things constant”) statement ► Notetheterminology: - Price means opportunity cost - Good means anything people value

5. Why focus on the Law of Demand? This is the most powerful proposition in economics. ► Irrigation design in arid and wet climates ► Building heights in cities compared to small towns ► The seasonal pattern of vegetable prices ► Why many stand in crowded trains to go visit family ► The shape of waterfront properties ► Electricity prices and automatic switches ► Etc., etc., etc.

6. The Demand Function:Some Definitions The relationship between quantity consumed and the factors determining that: D = f (P, PS, PC, I, E, T, etc.) ■ Price of the good in question—determines the location along a demand curve ■ Other variables (relevant factors) determine the placement of a demand curve: ► Prices of related goods (substitutes and complements) ► Income of buyers ► Tastes (preferences) of buyers ► Expectations held by buyers, regarding the future ► Other matters particular to a certain good

7. The Role of Tastes ■ They are very hard to measure, so we generally ignore them, but we know they exist. ■ Look to marketing and psychology for guidance here, not economists! ■ For economists, tastes are often the unexplained portion of consumption

8. Expectations ■ Also difficult to measure — but important ■ When measurable, include in the analysis. But experience shows—measures are very poor predictors of actions. ■ Like tastes, these can be used to “explain” anything ► Don’t fall into this trap

9. This or that? ■ Substitutes: Essentially, goods used in place of each other—same geographic market; similar performance characteristics. What is a substitute in one market may not be seen by consumers as such in another market—orange juice and orange soda. ► Different brands of gasoline; robots in Renault factory in France v. workers in Renault factory in Russia (former Lada) paid $200 a month; movie theater v. movie rentals; corn or sugar in ethanol.

10. Related Goods ■ Complements: Essentially, goods used together ► Computer hardware and software; tennis balls and rackets; airplane travel and hotel rooms; Google maps and discount coupons; growing corn for ethanol and Deere tractors

11. Changes in the Price of Related Goods ■ Goods X and Y are substitutes if: ► A change in price of X changes demand for Y in same direction - Px up implies Dy up (Dy shifts to the right) - Px down implies Dy down (Dy shifts to the left) ► Effect of change in Py on Dx is also in same direction

12. More on the Prices of Related Goods ■ Goods V and W are complements if: ► A change in price of V changes demand for W in opposite direction: - Pv up implies Dw down (Dw shifts to left) - Pv down implies Dw (Dw shifts to right) ► Effect of a change in Pw on Dv is also in opposite direction

13. Changes in Income ■ Normal Goods: ► Change in income changes demand in same direction - Higher income causes increase in demand - Lower income causes decrease in demand ► ”Superior” good is a variant: change in demand due to income change is quite large ■ Inferior goods: ► Change in income changes demand in opposite direction - Higher income causes decrease in demand - Lower income causes increase in demand

14. Terminology:Used to avoid confusion ■ Changes in quantity demanded: ► Caused by changes in own price of good means movement along a given demand curve ■ Changes in demand: ► Caused by changes in other factors: - Prices of other goods - Income - Expectations, etc. ► Means a shift of the entire demand curve

15. Change in Price • A change in the price of a good means a movement along a demand curve. Price Pa Pb Demand Quantity/time Qa Qb

16. Change in Demand • A change in a factor that determines demand, besides the price of the good itself, causes the Demand curve to shift. Example: Increase in price of substitute or increase in income causes an increase in demand. Price Da Pa Db Quantity/time Qa Qb

17. Deriving a Real Demand Curve Define your market: Boulder, Colorado, over time; consumption of water by people served by city water; price per 1,000 gallons; billions gallons/yr. consumed by demanders. Year Price Quantity 1968 $0.28 29 1972 $0.36 19 1977 $0.50 13 1982 $0.74 9 Price .74 Demand .50 .36 .28 0 9 13 19 29 Quantity

18. What else would you want to know? The Demand curve plots the relationship between price and quantity demanded – nothing else – everything else is held constant But in the real world, other things are not constant, so what else would you want to know if you wanted to understand that market better? Name likely relevant factors:

19. Hard Test: Which Goods Are Complements, Which Are Substitutes? • Wine and beer. • Domestic shirts and imported shirts. • Oil from Iran and coal from China. • Paper and pencils. • Plate glass and brick/concrete

20. Demand analysis • How would demand for hair replacement be likely to change if the following occurs? • A fall in the price of hairpieces. • A rise in income. • A rise in the divorce rate.

21. Clever sales pitch • A British cellphone company promised new subscribers in November and December that all calls on Christmas Day, December 25, would be free. What would you expect happened to the volume of calls that day?

22. Question on changing demand • Trying to predict future demand, GE research showed that the average size of the American family was declining and so was the average square footage of houses. How would you think this impacted the demand for the design of, say, refrigerators?

23. Key Point from Peter Drucker Most important question sellers must ask: “What is value to the customer?” Sellers often think they know, but do not. The customers do not buy a product; they buy value. Demanders are buying a product to satisfy a want. Do not guess what customers want—always carefully evaluate what they want.