Lecture 3 Lecture 3

The Law of DemandThe Law of Demand

■ ■ Our objectives:Our objectives:

► ► Explain individual choices among Explain individual choices among unlimited wants in a world of limited unlimited wants in a world of limited resourcesresources

► ► Develop a theory that helps us better Develop a theory that helps us better understand and predict human actions understand and predict human actions

►►What do people (our customers) want?What do people (our customers) want?

A Simple(?) Application of A Simple(?) Application of Law of Demand Saved Law of Demand Saved PepsiPepsi

1931 Pepsi was bankrupt.1931 Pepsi was bankrupt.

It and Coke both produced 6 oz (1/6It and Coke both produced 6 oz (1/6thth liter) drink bottles.liter) drink bottles.

Years of advertising had not worked for Years of advertising had not worked for Pepsi.Pepsi.

It then made and sold 12 oz (1/3 liter) It then made and sold 12 oz (1/3 liter) bottles of soda for twice the usual price—bottles of soda for twice the usual price—no results.no results.

It then sold 12 oz (1/3 liter) bottles for It then sold 12 oz (1/3 liter) bottles for same price as Cokesame price as Coke’’s 6 oz bottles.s 6 oz bottles.

Sales sky rocketed; the company was Sales sky rocketed; the company was saved.saved.

Demand Is Very Difficult

What we measure in demand is a reflection of individual desires not the actual desires.

Daniel Bernoulli, a mathematical genius who lived in Switzerland, noted, in 1738, that people seek goodness or pleasure (utility).

That is, we do not seek smartphones because they are smartphones but because they are useful and give us pleasure. Use and pleasure cannot be measured, only approximated.

This is behind the law of demand.

A Note on Value, Scarcity, A Note on Value, Scarcity, and Price as Related to and Price as Related to DemandDemand

Why do people want what they want?Why do people want what they want? The diamond-water paradox.The diamond-water paradox. Scarcity need not ≠ highly valued (snake meat)Scarcity need not ≠ highly valued (snake meat) Low cost need not ≠ low value (lock box key)Low cost need not ≠ low value (lock box key) Markets reflect what people value in relationship Markets reflect what people value in relationship

to current availability.to current availability. Demand is our best understanding of what people Demand is our best understanding of what people

value—given current conditions.value—given current conditions. Demand reflects information from many different Demand reflects information from many different

people that market participants process.people that market participants process.

The Law of DemandThe Law of Demand

■■ Holding all other relevant factors constant, Holding all other relevant factors constant, the lower (higher) the price of a good, the the lower (higher) the price of a good, the greater (lower) will be the quantity greater (lower) will be the quantity demanded.demanded.

► ► Like all scientific propositions, it is a Like all scientific propositions, it is a ceteris ceteris paribus paribus ((““other things equalother things equal”” or or ““other other things constantthings constant””) statement) statement

► ► Note on terminologyNote on terminology: : - Price means opportunity cost;- Price means opportunity cost;- Good means anything people value- Good means anything people value

Why focus on the Law of Why focus on the Law of Demand?Demand?

It is the most powerful proposition in It is the most powerful proposition in economics that helps us explain many economics that helps us explain many things.things.

► ► Irrigation design in arid and wet climatesIrrigation design in arid and wet climates

► ► Building heights in cities compared to small townsBuilding heights in cities compared to small towns

► ► The seasonal pattern of vegetable pricesThe seasonal pattern of vegetable prices

► ► The shape of waterfront propertiesThe shape of waterfront properties

► ► Electricity prices and automatic switchesElectricity prices and automatic switches

► ► Etc., etc., etc.Etc., etc., etc.

ExampleExample

Law of Law of Demand Demand applies to all applies to all ““goodsgoods”” – legal – legal or illegal. Price or illegal. Price goes up, goes up, people people demand less.demand less.

Improper Application Can Hurt a Improper Application Can Hurt a CompanyCompany

The Demand Function:The Demand Function:Some DefinitionsSome Definitions

The relationship between quantity consumed and the The relationship between quantity consumed and the factors determining that: D = f (P, Pfactors determining that: D = f (P, PSS, P, PCC, I, E, T, , I, E, T, etc.)etc.)

■ ■ PricePrice of the good in question—determines the of the good in question—determines the location location alongalong a demand curve a demand curve

■ ■ Other variables (relevant factors) determine the Other variables (relevant factors) determine the placementplacement of a demand curve: of a demand curve:

► ► Prices of related goods (substitutes and Prices of related goods (substitutes and complements)complements)

► ► Income of buyersIncome of buyers► ► Tastes (preferences) of buyersTastes (preferences) of buyers► ► Expectations held by buyers, regarding the futureExpectations held by buyers, regarding the future► ► Other matters particular to a certain goodOther matters particular to a certain good

The Role of TastesThe Role of Tastes

They are very hard to measure, so we They are very hard to measure, so we generally ignore them, but we know they generally ignore them, but we know they exist.exist.

Look to marketing and psychology for Look to marketing and psychology for guidance here, not economists!guidance here, not economists!

For economists, tastes are often the For economists, tastes are often the unexplained portion of consumptionunexplained portion of consumption

ExpectationsExpectations

Difficult to measure or operationalize — but real.Difficult to measure or operationalize — but real.

When measurable, include in the analysis. But When measurable, include in the analysis. But experience shows—measures are very poor experience shows—measures are very poor predictors of actions. The Consumer Confidence predictors of actions. The Consumer Confidence Index (Conference Board) was at 115 in June Index (Conference Board) was at 115 in June 2007; down to 26 in March 2009. Ex post. (59 in 2007; down to 26 in March 2009. Ex post. (59 in July 2011)July 2011)

Like tastes, these can Like tastes, these can ““explainexplain”” anything so anything so become useless. become useless.

“Consumer Confidence” or Expectations may not square with actions.

University of Michigan Consumer Sentiment Index; Useful But Not Great

This or that? SubstitutesThis or that? Substitutes

Essentially, goods used in place of each otherEssentially, goods used in place of each other—similar performance characteristics. But a —similar performance characteristics. But a substitute in one market may not be in substitute in one market may not be in another market—orange juice and orange another market—orange juice and orange soda.soda.

► ► Different brands of gasoline; robots in Different brands of gasoline; robots in Renault factory in France v. workers in Renault factory in France v. workers in Renault factory in Russia; (1/100 industrial Renault factory in Russia; (1/100 industrial workers in China; 11/100 in U.S.; 14/100 in workers in China; 11/100 in U.S.; 14/100 in Japan); movie theater v. download movie at Japan); movie theater v. download movie at home; shipping hard drives by FedEx rather home; shipping hard drives by FedEx rather than send data by Internet (Google does it). than send data by Internet (Google does it).

Related Goods: Related Goods: ComplementsComplements

Essentially, goods used togetherEssentially, goods used together

► ► Computer hardware and Computer hardware and software; software;

tennis balls and rackets; airplane tennis balls and rackets; airplane travel and hotel rooms; Google travel and hotel rooms; Google maps and discount coupons; maps and discount coupons; growing corn for ethanol and growing corn for ethanol and Deere tractorsDeere tractors

Changes in the Price of Related Changes in the Price of Related GoodsGoods

■ ■ Goods X and Y are Goods X and Y are substitutessubstitutes if: 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

More on the Prices of Related More on the Prices of Related GoodsGoods

■ ■ Goods V and W are Goods V and W are complementscomplements if: if:

► ► A change in A change in price of Vprice of V changes changes demand demand for Wfor W in opposite direction: in opposite direction:- Pv up implies Dw down (Dw shifts to left)- Pv up implies Dw down (Dw shifts to left)

- Pv down implies Dw (Dw shifts to right)- Pv down implies Dw (Dw shifts to right)

► ► Effect of a change in Pw on Dv is also in Effect of a change in Pw on Dv is also in oppositeopposite direction direction

Changes in IncomeChanges in Income

■ ■ Normal Goods: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

Terminology:Terminology:Used to avoid confusionUsed to avoid confusion

■ ■ Changes in Changes in quantity demanded:quantity demanded:Caused by changes in price of a good means Caused by changes in price of a 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

Summarizing the Demand Curve

The demand curve is a simple way of The demand curve is a simple way of expressing a complex market.expressing a complex market.

Strip it to the essentials to think about Strip it to the essentials to think about it.it.

The curve represents the individual The curve represents the individual values of many different existing and values of many different existing and potential demanders.potential demanders.

All that information is imagined to be All that information is imagined to be captured in that little curve to help us captured in that little curve to help us focus our thinking about the basics.focus our thinking about the basics.

Change in PriceChange in Price

A change in the price of a good A change in the price of a good means a movement along a means a movement along a demand curve.demand curve.

Quantity/timeQa Qb

Demand

Price

Pa

Pb

Change in DemandChange in Demand

A change in a factor that determines demand, A change in a factor that determines demand, besides the price of the good itself, causes the besides the price of the good itself, causes the Demand curve to shift.Demand curve to shift.

Example: Increase in price of substitute or increase in Example: Increase in price of substitute or increase in income causes an increase in demand. income causes an increase in demand.

Price

Quantity/time

Pa

Da

Db

Qa Qb

Deriving a Real Demand Deriving a Real Demand CurveCurve

Define your market:Define your market:Boulder, Colorado, over time; Boulder, Colorado, over time;

consumption of water by people consumption of water by people

served by city water; price per served by city water; price per

1,000 gallons; billions gallons/yr.1,000 gallons; billions gallons/yr.

consumed by demanders.consumed by demanders.

YearYear Price Price QuantityQuantity

19681968 $0.28 $0.28 29 29

19721972 $0.36 $0.36 19 19

19771977 $0.50 $0.50 13 13

19821982 $0.74 $0.74 9 9

Price

Quantity

Demand

9 13 19 29

.74

.50

.36

.28

0

What else would you want to know?What else would you want to know?

The Demand curve plots the relationship The Demand curve plots the relationship between price and quantity demanded – between price and quantity demanded – nothing else – everything else is held constantnothing else – everything else is held constant

But in the real world, other things are not But in the real world, other things are not constant, so what else would you want to constant, so what else would you want to know if you wanted to understand that know if you wanted to understand that market better?market better?

Name likely relevant factors:Name likely relevant factors:

Demand analysisDemand analysis

How would demand for hair How would demand for hair replacement treatment be likely replacement treatment be likely to change if the following to change if the following occurs?occurs?

1.1. A fall in the price of treatment.A fall in the price of treatment.

2.2. A rise in income. A rise in income.

3.3. A rise in the divorce rate.A rise in the divorce rate.

Clever sales pitchClever sales pitch

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

Question on changing Question on changing demanddemand

Trying to predict future demand, GE Trying to predict future demand, GE research showed that the average research showed that the average size of the American family was size of the American family was declining and so was the average declining and so was the average square footage of houses.square footage of houses.

How would you think this impacted How would you think this impacted the demand for the design of, say, the demand for the design of, say, refrigerators?refrigerators?

Key Point from Peter Key Point from Peter DruckerDrucker

Most important question sellers must ask:Most important question sellers must ask:

““What is value to the customer?What is value to the customer?””Sellers often think they know, but do not. The Sellers often think they know, but do not. The

customers do not buy a product; they buy customers do not buy a product; they buy valuevalue..

Demanders are buying a product to satisfy a Demanders are buying a product to satisfy a want. Do not want. Do not guessguess what customers want— what customers want—carefully evaluate what carefully evaluate what theythey want. want.

Evaluate products from customersEvaluate products from customers’’ viewpoint, viewpoint, not how the producer knows it works.not how the producer knows it works.