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The Law of Demand, Income-Substitution Effects, and Demand Curve Shift Factors
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Del curso dictado por University of California, Irvine
Strategic Business Management - Microeconomics
9 calificaciones
De la lección
Supply and Demand
Conoce a los instructores
Dr. Peter NavarroProfessor
Paul Merage School of Business
Hi, professor Navarro here.
And in this second lesson,
we are going to drill down into two keywords that you've
heard often in your life, supply and demand.
Particular, I will show you how the forces of supply and demand lead to
an equilibrium in the market and thereby set market prices.
As part of this demonstration,
I will show you that the typical market price reaches
its competitive equilibrium at
precisely the point where the demand and supply curves cross.
That's where the forces of demand and supply are just in balance.
In addition, in this lesson,
we will do our own version of
economic gymnastics as I introduce you to important concepts like,
shifts in the demand and supply curves that reflect changing market conditions.
And here's your first key point.
The anticipation of, and reaction to market shifts in the demand and supply curves,
is one of the most important elements of business strategy.
I will illustrate that key point in this lesson with lots of useful examples.
At any rate, that's out.
Tell them what you're going to tell them, overview.
So let's now dig deep into the mysteries of supply and demand.
The 19th century Scottish philosopher and satirist Thomas Carlyle once said,
Teach a parrot the words supply and demand,
and you've got an economist.
Of course, economics is hardly that simple but
Carlyle's wry observation does hit on a basic nerve in economics.
Too with the concept of supply and demand,
rests at the core of any study of how the market system works.
To begin our mastery of some of the basic elements of supply and demand,
let's start with the five basic truisms about any supply and demand figure.
First, the price of the good or
service in question will always be labeled on the vertical axis.
Second, the quantity will always be labeled on the horizontal axis.
Third, the demand curve will always slope downward.
This reflects the intuitive idea that,
the lower the price of the product or service,
the more consumers will demand.
Fourth, the supply curve will always slope upward.
This reflects the equally intuitive idea that firms will offer more and more of
the product or service as the price offered in the marketplace rises.
Finally, the market equilibrium price and quantity may typically be
found where the supply and demand curves cross.
Now, besides these basic ideas,
I'm going to alert you to some additional subtleties about supply and demand
curves that we will soon be exploring in more detail.
First, the slope of either the demand or supply curve,
can range from the flat to the steep.
For example, this demand curve as drawn has a relatively flat slope.
This means that a small change in price results in a large change in quantity demanded.
And that's called elastic demand.
Conversely, a steeply slope demand curve like
this one is characterized by a large price change,
resulting in a small change in quantity demanded.
Such any elastic demand is typical of the markets for
goods that people in the vernacular just got to have.
Think of insulin for the diabetic or gasoline for motorists in affluent societies,
like America or Europe.
Now, here's an equally important subtlety.
Both the demand and supply curves can actually shift as well,
either inward or outward.
For example, a negative energy price shock due to, say,
a war of the Middle East where much of the world's global oil supply is,
can by raising the price of a key factor input
shift the supply curve of a manufacturing industry dependent on oil.
And the shift will be inwards to the left.
In this case, price rises from P1 to P2 and quantity falls from Q1 to Q2.
So the result of this negative energy price shock is a higher price and lower quantity.
Conversely, the discovery of so-called fracking technologies to recover
shell gas and oil at low cost may be viewed as a positive energy shock.
In this case, the supply curve shifts outward into the right.
Price of oil falls from P1 to P2,
and quantity increases from Q1 to Q2.
Okay, that's the big supply and demand picture.
Now let's do a little nuts and bolts work
here and start by building a sample demand curve.
In order to build the demand curve,
we have to have some data on price and quantity.
So after sending out our request to our marketing department,
perhaps we come up with a table like this,
provides the demand schedule for cornflakes.
So why don't you pause the presentation now,
take out a pencil and paper, or, more likely,
a computer tablet and stylus,
and try drawing a demand curve from this data? Give it a pause now.
Okay, does your figure and demand curve look like this?
Did you label your axes correctly?
So in this figure,
the consumer will buy 20 boxes of cornflakes at point E if the price is one.
What about at price of four?
Here, the consumer will buy only 10 boxes.
The obvious implication of this downward slope and demand curve is this,
the lower the price Ceteris Paribus,
the more units the consumer will demand.
And the higher the price Ceteris Paribus,
the less the consumer will demand.
And by the way,
the term Ceteris Paribus is a Latin word for holding other things constant.
This is a very critical assumption that economists
often make in supply and demand analysis.
Why? Because holding other things constant
allows us to draw supply and demand diagrams in two-dimensional space.
And we'll come back to explain that idea more fully in a moment.
For now, let's just drill down on why consumers
demand more of a product as its price falls.
It's not just common sense
that consumers will demand more of a product as its price falls,
It's also a principle based on
very careful scientific observation and what economists call,
The Law of Demand.
In fact, there are two components to the law of demand,
a substitution effect and an income effect.
Here is a useful way to think about the law of demand and
its two effects within the context of the price of say, beef.
If, for example, the price of beef rises,
consumers will tend to substitute other meats in their diet, like chicken or pork.
That is, quite literally, the substitution effect.
But check this out. When the price of beef rises,
consumers will also have less purchasing power.
So that portion, the increase of consumer purchases of, say,
chicken due to the reduction in consumer purchasing power,
is the income effect.
We'll talk more about the substitution and income effects in the next lesson.
In the meantime, let's cycle back to the assumption of Ceteris Paribus,
or holding other things constant.
In fact, this Ceteris Paribus assumption allows us not
just to draw supply and demand diagrams in two dimensional space,
it also helps us isolate the effects of specific changes in
a market that will manifest a so-called shift factors.
For example, in order to draw
the demand curve in a two-dimensional space of price and quantity,
we have to hold a bunch of other important things constant.
They also affect the demand curve.
Just what are these other things?
Well, three of the most important of these so-called shift factors are,
Consumer income, consumer taste and the prices of substitute products.
And here's the key idea.
If one of these shift factors changes, income, taste,
or the price in substitute,
the demand curve will either shift inward or outward.
Now, to see you wrapping your head around this concept of shift factors,
let's do a quick example.
Suppose that average consumer income rises,
which direction, do you think,
the demand curve is likely to shift in this case?
Inward into the left,
or outward into the right?
And please pause the presentation now to think about this,
then draw the shift either on a piece of paper or your computer.
Then, when you're ready, just resume the presentation.
So, did you draw your demand curve like this?
In this case, the demand curve will certainly shift outward into the right.
This is because consumers with more money in
their pockets will tend to buy more of everything.
Now, here's another brain twister for you.
Suppose, you were analyzing the market for oatmeal and the price of corn flakes falls.
Which way, do you think,
the demand curve for oatmeal is likely to shift, and why?
You determine that the demand curve
for oatmeal will shift in your right.
This is because oatmeal and corn flakes are substitutes for
each other in the broader market for breakfast cereal.
So, if the price of corn flakes goes down,
the demand for oatmeal will go down as consumers buy more corn flakes.
As for our third shift factor for the demand curve,
consumer taste, this is a really important one for businesses to keep track of.
To see why, suppose that tomorrow
the American Medical Association publishes a report that says,
People who eat prunes regularly live on average several years longer,
while people who eat onion rings,
every day, tend on average to live several fewer years.
Now once again, pause the presentation and write
down or draw on your paper or tablet, which way, you think,
the prune and onion ring demand curves will shift.
Now, check this figure. Did you draw your graphs correctly?
Now, to finish up the rest of this module,
take a few minutes to study this table.
It summarizes the effect of
the various shift factors on the demand curve in the automobile market.
Note that besides income,
the prices of related goods and changing consumer tastes,
the table includes two other important shift factors,
population and special influences.
From a business perspective,
these are precisely the kinds of shift factors your management
and forecasting teams will be wanting to chart very closely.
And perhaps, take profitable advantage of.
A letter of business tune team shed a bit more light on this subject.
Our economics team just came
in with a forecast of a major increase in
oil and gasoline prices over the next five years.
What is driving that price spike?
It appears to be a combination of rising turmoil in
many oil producing nations and more regulation of the shale oil industry.
Based on that forecast,
I'm going to recommend we increase our production of
more fuel efficient hybrid in all electric cars.
We should probably also reduce our production of gas guzzling sport utility vehicles.
And by the way,
the economics team has also detected a demographic bulge.
Yes, it appears that a lot of
young new car buyers with relatively lower incomes will be coming onto the market.
I guess, our marketing team should tailor a message to increase
our sales of small subcompact cars to first time young buyers.
Sounds like a solid plan.
Now, what's for lunch?
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