The Nature of Demand (Edexcel A-Level Economics A): Revision Notes

The Nature of Demand

Introduction

Understanding how demand works is fundamental to studying economics. The demand and supply model helps explain how markets operate in the real world and is one of the most important analytical tools in economics. This note focuses on the demand side of this model, examining what influences consumer decisions and how these decisions shape market outcomes.

Rational decision making

Before examining demand, it's important to understand the assumptions economists make about how people make choices. These assumptions help build models that predict economic behaviour.

Consumer behaviour

Economists assume that consumers aim to maximise their utility (satisfaction). When you decide which products to buy, you're seeking to gain as much satisfaction as possible from the combination of goods you consume. This assumption that consumers act rationally to maximise utility forms the foundation of demand analysis.

Firm behaviour

Similarly, firms are assumed to aim for maximum profit. Profit is calculated as the total revenue from selling products minus the total cost of production. In other words, firms aim to maximise the difference between what they earn and what they spend.

Why these assumptions matter

These assumptions of rational behaviour are crucial because they allow economists to build predictive models. If we know consumers seek maximum satisfaction, we can anticipate how they'll respond to price changes or income changes. Without such assumptions, we couldn't understand or predict economic behaviour.

What is demand?

Demand refers to the quantity of a good or service that consumers are willing and able to buy at any given price during a specific time period. It's important to note both "willing" and "able" – a consumer must both want the product and have the money to purchase it.

Several factors influence how much of a product you choose to buy:

• The price of the good – This is the primary influence and affects the quantity you choose to buy
• The price of other goods – Particularly substitute products or complementary products
• Your income – This determines how much you can afford to purchase
• Your preferences – Everything else that influences whether you like or dislike a product

Think about your own purchasing decisions. When considering buying a product, you probably think about whether you can afford it, whether there are cheaper alternatives, whether you really need it, or whether your friends have it. All these factors shape your demand for the product.

Demand and the price of a good

Let's focus on how price affects demand, assuming all other factors remain constant (using the economic principle of ceteris paribus, meaning "other things being equal").

Marginal utility and diminishing marginal utility

When you consume a product, you gain utility (satisfaction) from it. However, the additional satisfaction you gain from consuming one more unit – known as marginal utility – typically decreases as you consume more of the product.

This is called diminishing marginal utility – the situation where you gain less additional utility from consuming a product the more of it you've already consumed.

This pattern influences how much you're willing to pay for additional units. Because extra units give you less satisfaction, you'd only be willing to pay lower prices for larger quantities.

The law of demand

This relationship between price and quantity demanded is so consistent that it's known as the law of demand: there is an inverse relationship between the quantity demanded and the price of a good or service, ceteris paribus. In simpler terms, when prices rise, people tend to buy less; when prices fall, people tend to buy more.

The demand curve

We can illustrate this relationship using a demand curve – a graph showing how much of a good consumers will demand at any given price.

The demand curve for tablet computers shown above slopes downwards from left to right. This downward slope reflects the law of demand: as price decreases, quantity demanded increases.

Here's the data behind this demand curve:

Price (£)	100	90	80	70	60	50	40	30	20
Quantity	0	3	7	15	25	40	60	85	120

At £100, no tablets are demanded. As the price falls to £20, demand increases to 120,000 tablets per period. This demonstrates the inverse relationship between price and quantity demanded.

Movements along and shifts in the demand curve

Understanding the difference between movements along a demand curve and shifts of the entire curve is crucial for economic analysis.

Movements along the demand curve

When the price of a good changes (and all other factors remain constant), we observe a movement along the demand curve. Economists use specific terminology:

• An extension of demand occurs when price falls and quantity demanded increases (movement down and to the right along the curve)
• A contraction of demand occurs when price rises and quantity demanded decreases (movement up and to the left along the curve)

Shifts of the demand curve

When any factor other than price changes, the entire demand curve shifts to a new position. This is called a change in demand:

• An increase in demand means the curve shifts to the right (more is demanded at every price)
• A decrease in demand means the curve shifts to the left (less is demanded at every price)

The diagram above illustrates this crucial distinction. Panel (a) shows a rightward shift of the entire demand curve, representing an increase in demand. Panel (b) shows a movement along a single demand curve, representing an extension of demand following a price fall.

Factors that shift the demand curve

Let's examine the main factors that cause the demand curve to shift position. These are sometimes called the conditions of demand.

Consumer incomes

Changes in consumer income significantly affect demand for most products, but the direction of the effect depends on the type of good.

Normal goods

A normal good is one where quantity demanded increases when consumer incomes rise. Most products fall into this category. For example, foreign holidays are a normal good – as people's incomes increase, they tend to demand more holidays abroad at any given price.

The left panel shows the market for foreign holidays. When consumer incomes increase, the demand curve shifts rightward from D₀ to D₁, meaning consumers demand more holidays at every price level.

Inferior goods

An inferior good is one where quantity demanded decreases when consumer incomes rise. These are typically basic or lower-quality products that people buy less of when they can afford better alternatives.

Bus journeys provide a good example. As people's incomes rise, they may switch to using taxis or buying their own cars, reducing their demand for bus travel at any given price.

The right panel in the diagram above shows how the demand curve for bus journeys shifts leftward from D₀ to D₁ following an increase in consumer incomes.

Extension: the Veblen effect

For some luxury goods, a "snob effect" or conspicuous consumption effect may occur. This was identified by economist Thorstein Veblen in the nineteenth century. Some people value certain goods more highly simply because they're expensive, as this signals wealth and status to others. Luxury watches like Rolex might benefit from this effect.

The price of other goods

Demand for a product can be affected by changes in the prices of related goods. There are two main types of relationships:

Substitute goods

Substitutes are products that can replace each other. Two goods are substitutes if demand for one good is likely to rise when the price of the other increases. For example, tea and coffee are substitutes for many consumers – if either becomes significantly cheaper, people may switch their consumption.

The diagram shows the tea and coffee markets. When the price of tea increases from P₀ to P₁ (left panel), some consumers switch to coffee. This causes the demand curve for coffee to shift rightward from Dc0 to Dc1 (right panel), as coffee becomes relatively more attractive.

Other examples of substitutes include:

• Different brands of breakfast cereals
• Butter and margarine
• Different smartphone brands

Complementary goods

Complements are products consumed together. Two goods are complements if an increase in the price of one good causes the demand for the other to fall. For example, cars and petrol are complements – if cars become very expensive, demand for petrol will fall as fewer people own cars.

This diagram illustrates tea and milk as complementary goods. When the price of tea increases from P₀ to P₁ (left panel), people buy less tea. This reduces demand for milk (right panel), shifting the demand curve leftward from Dm0 to Dm1.

Other examples of complements include:

• Breakfast cereals and milk
• DVD players and DVDs
• Tennis rackets and tennis balls

Consumer preferences

Almost any other factor influencing demand can be categorised as part of consumer preferences. These are the personal inclinations that determine whether you like or dislike a product.

Several factors can influence preferences:

• Personal tastes – Some people prefer dark chocolate while others prefer milk chocolate. These personal inclinations vary between individuals.
• Advertising and branding – Firms invest heavily in advertising to influence consumer preferences. Successful advertising campaigns can shift demand curves rightward by making products more desirable.
• Fashion and trends – Some people follow fashion trends, which can significantly influence demand. However, others deliberately reject trends.
• Social influences – Peer pressure and social norms can affect demand. You might be more likely to buy a product if your friends have it, or less likely to buy something if you want to stand out.

Preferences can change suddenly, causing rapid shifts in demand. A product might become fashionable, causing a surge in demand, or fall out of favour, causing demand to collapse.

The effect of time

For certain products, the timing of purchase matters. Not all goods are consumed immediately – some are bought as investments or in anticipation of future events.

Some consumers buy products expecting prices to rise in the future. For example:

• Fine wine or works of art purchased as investments
• Housing purchased before expected price increases
• High-tech products like smartphones, though these may be bought quickly before prices fall as production increases

Additionally, consumption patterns vary over time. Some goods aren't consumed instantly but over long periods. This can affect when purchases are made and how demand responds to price changes.

Individual and market demand

So far, we've discussed demand from an individual consumer's perspective. However, economists are often interested in market demand – the total demand from all potential buyers.

Market demand for a product (such as tablet computers) represents the combined demand from all potential buyers in the market. It can be calculated by adding up the quantities that all individual consumers would buy at each price level.

The same four factors that influence your individual demand (price, price of other goods, income, and preferences) also influence market demand. Additionally, the number of potential buyers in the market affects total market demand. More potential buyers means greater market demand at any given price.

Summary

Remember!