Consumer choice in a market

A market is an arrangement that brings buyers and sellers into contact to exchange goods or services. Consumers have many wants but limited income, so they must choose which wants to satisfy. As prices, incomes and preferences change, those choices may change too. Demand is therefore a dynamic decision-making process, not a fixed list of purchases.

Through their interaction, consumers and sellers help direct resources across the economy. Demand signals what consumers are willing and able to buy, and sellers react to those choices. This starts to address the unit’s central issue—how economic decision-makers pursue their objectives—by showing how consumers use scarce income to gain satisfaction from goods and services.

Demand and quantity demanded

Demand shows the quantities of a good or service that consumers are willing and able to buy at different possible prices during a specified period, other things being equal. Both conditions count. Wanting a concert ticket without enough purchasing power isn’t effective demand; being able to afford one but having no intention of buying it isn’t demand either.

Quantity demanded is the amount of a good or service that consumers are willing and able to buy at one particular price during a specified period. Demand covers the whole price–quantity relationship, whereas quantity demanded is one point on that relationship. Keep the distinction clear—it prevents plenty of muddled analysis later.

The law of demand

The law of demand is an economic principle stating that a rise in a good’s own price causes its quantity demanded to fall, while a fall in its own price causes its quantity demanded to rise, other things being equal. Price and quantity demanded therefore have an inverse, or negative, causal relationship.

Ceteris paribus is an analytical assumption that holds constant every relevant influence except the variable being studied. When applying the law of demand, we assume that income, preferences, expectations, the prices of related goods and the number of consumers don’t change. That isolates the effect of the good’s own price. For example, if cinema ticket prices rose at the same time as a major local festival made cinema-going more fashionable, the final change in purchases couldn’t be attributed to price alone.

The substitution effect

The substitution effect is the change in quantity demanded that occurs when a good’s price changes relative to the prices of alternative goods. Suppose rail fares rise but coach fares stay the same. Coach travel is now relatively cheaper, so consumers have an incentive to switch away from rail travel. As a result, the quantity of rail journeys demanded falls. If the price of rail travel falls, the incentive works in reverse.

The consumer’s money income doesn’t have to change. Instead, the available choices have become more or less attractive relative to one another.

The income effect

Real income is the purchasing power of a consumer’s money income, measured by the quantity of goods and services that the income can buy. The income effect is the change in quantity demanded caused when a price change alters this purchasing power.

If the price of a good rises, an unchanged money income can buy less than it could before. For an ordinary good, this fall in real income helps reduce quantity demanded. A price fall raises purchasing power, allowing the consumer to afford more. The income effect and substitution effect therefore work together to explain the usual downward-sloping demand relationship.

Diminishing marginal utility

Utility is the satisfaction or benefit that a consumer gains from consuming a good or service. Marginal utility is the additional utility gained from consuming one more unit of a good during a given period.

The law of diminishing marginal utility is the economic principle that, as a person consumes more of a good during a given period, the additional utility gained from each successive unit eventually falls, other things being equal. For example, the first serving of a meal may be highly satisfying. A second serving will usually add less satisfaction because the immediate want has already been partly met.

Consumers will generally purchase another unit only when its price is no greater than the benefit they expect to receive from it. Because later units give less additional utility, consumers are willing to buy them only at lower prices. Conversely, a higher price can be justified only for the smaller number of units that provide greater marginal utility. This gives a behavioural explanation for the inverse relationship between price and quantity demanded.

From the relationship to the diagram

A demand curve shows how much of a good or service consumers are willing and able to buy at different prices during a specified period, ceteris paribus. Price per unit goes on the vertical axis, while quantity demanded per period goes on the horizontal axis. By convention, the curve is labelled D.

Why does it slope downwards from left to right? The law of demand: lower prices correspond to greater quantities demanded, whereas higher prices correspond to smaller quantities demanded. The curve doesn’t have to be perfectly straight. What matters is the negative relationship.

For a properly drawn diagram, label both axes in full and include the time dimension for quantity where relevant. Label the curve D. Each point on the curve shows one price and the corresponding quantity demanded; the whole curve represents demand.

Individual and market demand

Individual demand shows the price–quantity relationship for one consumer who is willing and able to buy a good during a specified period. At the same price, consumers may demand different quantities because their incomes, circumstances and preferences differ.

Market demand is the price–quantity relationship found by adding the quantities demanded by every consumer in a market at each possible price. This is a horizontal summation: the quantities are added because all consumers face the same price.

Suppose one household would buy two loaves at a given price, while another would buy three. Together, they contribute five loaves to the market quantity demanded at that price. We repeat this process separately at every price. Prices aren’t added.

When the number of consumers rises, market demand increases because the total now includes more individual demands. That doesn’t necessarily change how much any existing consumer wants to buy.

What shifts demand?

A non-price determinant of demand is any factor apart from the good’s own current price that changes how much consumers are willing and able to buy at every possible price. A favourable change raises demand, shifting the curve right. An unfavourable change lowers demand and shifts it left. Work out the direction from the circumstances rather than memorizing a rule such as “factor up, demand up”.

Income

A normal good is a good for which demand increases when consumer income rises and decreases when consumer income falls, other things being equal. Higher income could, for example, shift demand for restaurant meals to the right.

An inferior good is a good for which demand decreases when consumer income rises and increases when consumer income falls, other things being equal. When incomes rise, some consumers may switch from basic instant meals to freshly prepared alternatives. Demand for instant meals then shifts left. “Inferior” refers to the income–demand relationship; it isn’t an objective judgement about quality.

Tastes and preferences

Tastes and preferences change consumers’ willingness to buy. Demand may rise because of favourable publicity, changing fashion or a successful advertising campaign. Health concerns can reduce demand, as can a product becoming unfashionable. For example, growing interest in home gardening may shift demand for vegetable seeds to the right.

Future price expectations

What consumers expect to happen to prices can affect present demand. If they expect the price of a storable good to rise soon, they may buy earlier and increase current demand. An expected price reduction may lead them to postpone purchases, decreasing current demand. The effect is strongest when consumers can realistically change when they make the purchase.

Prices of related goods

Substitutes are goods that satisfy a similar want and can be used in place of one another. Suppose the price of intercity coach travel rises. Demand for train travel may increase because it has become relatively cheaper. A fall in the coach fare may instead reduce demand for train travel.

Complements are goods that are typically consumed or used together. If games consoles become more expensive, fewer consoles may be bought, so demand for compatible games may fall. If console prices fall, demand for the games may increase.

Be precise about which curve shifts. A price change for one good shifts demand for the related good. It doesn’t cause movement along the related good’s demand curve, since that good’s own price hasn’t changed.

Number of consumers

When the number of consumers in a market increases, market demand rises and the curve shifts right. A decrease in consumer numbers reduces market demand, shifting the curve left. This can result from population changes, migration or entry into or exit from a particular consumer group.

A movement along the curve

A change in quantity demanded occurs when consumers change the amount they buy solely because the good’s own price has changed, ceteris paribus. On a diagram, this appears as movement between two points on the same demand curve.

When price falls, there is an extension of quantity demanded: a downward movement along the curve towards a greater quantity. When price rises, a contraction of quantity demanded occurs, shown by an upward movement towards a smaller quantity. Demand itself—the complete relationship—hasn't changed in either case.

A shift of the curve

A change in demand occurs when a non-price determinant changes the whole price–quantity relationship. The demand curve shifts to a new position.

An increase in demand shifts the curve right. At every given price, consumers are willing and able to buy a greater quantity. A decrease shifts it left, since they are willing and able to buy a smaller quantity at every given price. The good’s own price may not change initially.

A simple test is to ask what changed first. If the good’s own price changed, show movement along the existing curve. Shift the entire curve if the change came from income, preferences, expected future price, the price of a substitute or complement, or the number of consumers.

When drawing shifts, use a horizontal guide line to keep price fixed. This makes the change in quantity demanded at that same price easy to see. Clearly label the original and new curves—for example, D1 and D2—and add an arrow showing the direction of change.