Theory of Demand | tutor2u Economics
Study notes

Theory of Demand

  • Levels: GCSE, AS, A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period

Effective and latent demand in markets

Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming it. Economists give this a term - utility

Effective Demand

  • Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an ability to pay for it

Latent Demand

  • Latent demand exists when there is willingness to buy among people for a good or service, but where consumers lack the purchasing power to be able to afford the product.
Understanding market demand

Derived Demand

The demand for a product X might be connected to the demand for a related product Y – giving rise to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for new vehicles and other manufactured products, so that when an economy goes into a recession, so we expect the demand for steel to decline likewise.

Steel is a cyclical industry which means that market demand for steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate.

Zinc is a good example of a product with a strong derived demand. It has a wide-range of end users such as galvanised zinc used in cars and new buildings, die-casting used in door furniture and toys, brass and bronze used in taps and pipes. And also rolled zinc (used in roofing, guttering and batteries) and in chemicals used in making tyres and zinc cream.

Transport as a Derived Demand

The demand for transport is the number of journeys consumers or firms are willing and able to purchase at various prices in a given time period. Transport is rarely demanded for its own sake, the journey, but for what the journey enables e.g. commuting, taking a holiday or distribution. When an economy is growing, there is an increase in derived demand for commuting, business logistics and transport for holiday purposes.

The Law of Demand

There is an inverse relationship between the price of a good and demand.

  1. As prices fall, we see an expansion of demand.
  2. If price rises, there will be a contraction of demand.

Ceteris paribus assumption

Many factors affect demand. When drawing a demand curve, economists assume all factors are held constant except one – the price of the product itself. Ceteris paribus allows us to isolate the effect of one variable on another variable

The Demand Curve

A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. There are two reasons why more is demanded as price falls:

1. The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain the same consumption for less expenditure. Provided that the good is normal, some of the resulting increase in real income is used to buy more of this product.

2. The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and some consumers switch their spending from the alternative good or service.

The Law of Demand
  • As price falls, a person switches away from rival products towards the product
  • As price falls, a person's willingness and ability to buy the product increases
  • As price falls, a person's opportunity cost of purchasing the product falls

Note: Many demand curves are drawn as straight lines to make the diagrams easier to interpret

The chart below shows average season ticket prices for English Premier League clubs. What factors affect the willingness and ability to pay for a season ticket? Why is there such a large difference in prices?

Average season ticket prices (in £s) for Premier League clubs
Individual and market demand

Income and Substitution Effects and the theory of demand

Income effect

  • A fall in price increases the real purchasing power of consumers
  • This allows people to buy more with a given budget
  • For normal goods, demand rises with an increase in real income

Substitution effect

  • A fall in the price of good X makes it relatively cheaper compared to substitutes
  • Some consumers will switch to good X leading to higher demand
  • Much depends on whether products are close substitutes

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