Demand
Various quantities of a good or service that consumers are willing and able to buy at different possible prices during a particular time period, ceteris paribus.
The ceteris paribus assumption
Ceteris paribus is a latin expression that means "other things being equal". In an economics context, ceteris paribus indicates that all other variables other than those that are being analysed are unchanged or constant.
Assumptions underlying the Law of Demand(HL only)
The Law of Demand
The law of demand states that, as the price of a good increases, the quantity demanded decreases, ceteris paribus.
- The law of demand essentially suggest that there is a negative relationship between price and quantity demanded (as one increases, the other decreases).
- In order to understand this negative relationship, we need to analyse its underlying assumptions:
- The Law of Diminishing Marginal Utility.
- Income and substitution effects.
The Law of Diminishing Marginal Utility
Marginal utility
The satisfaction obtained from consuming one more unit of a good or service.
Law of Diminishing Marginal Utility
As more of a good is consumed, the additional satisfaction (marginal utility) gained from each extra unit decreases, and so consumers will only buy more of the good if its price falls.
Utility
Utility is the satisfaction that a consumer receives by consuming a good/service.
The Law of Diminishing Marginal Utility, indicates that:
- The marginal utility of a consumer from consuming one extra unit decreases as the quantity consumed increases (negative relationship).
- Therefore, as consumers increase their quantity consumed, they are only willing to buy more if the price of the good falls.
- This Law of Diminishing Marginal Utility is responsible for the Law of Demand (negative relationship between the price of a good and the quantity consumed).
- For example, suppose a person who likes burgers.
- Now imagine that this person eats one burger which he really likes. From this burger he gets a high utility, as he hasn't eaten burger in a while, and he was craving it
- Now imagine, that he buys another burger. He is still very happy that he gets to eat another burger, but he is maybe not as happy with this second burger as he was with the first one, because he is not so hungry anymore.
- After eating this second burger, our guy decides to buy one more burger. This third burger does not give provide him any marginal utility, because right now he is full and if he eats one more he will start to feel sick.
- Therefore, if your guys was willing to pay $10 for his first burger:
- He may only be willing to pay $8 for his next one (since he is not getting the same utility).
- He may be willing to pay only 6$ for his third burger (since this one provides him with even less utility).
- This example demonstrates the concept of diminishing marginal returns, as the extra satisfaction by the person who liked burgers decreased as he ate more burgers, which makes him want to pay less the more the quantity consumed increases.
- This negative relationship between the price of a good and the amount of it that is consumed is reflected in the Law of Demand.
Note that the term marginal means additional. For example:
- Marginal utility = additional utility for each extra unit produced.
- Marginal cost = additional cost for each extra unit produced.
Income and substitution effects
The income effect and the substitution effect are other assumptions that describe the negative relationship between price and quantity demanded:
Income effects
The income effect arises when:
- The price of a good changes.
- But the income of the consumers who buy this good does not change.
If the price of a good increases, whereas the consumer's income remains constant:
- The consumer now can buy less of that good.
- This is because the real income or the purchasing power of the consumer has decreased.
- Therefore, the higher the price, the lower the quantity of the good consumers are able to pay for (Law of Demand).
Contrarily, if the price of a good decreases, whereas the consumer's income remains constant:
- The consumer now can buy more of that good.
- This is because the real income or the purchasing power of the consumer has increased.
- Therefore, the lower the price, the higher the quantity of the good consumers are able to pay for (Law of Demand).
Suppose Sarah earns USD 50 a week and loves buying ice cream cones, which usually cost USD 5 each.
- At USD 5 per cone, Sarah can buy 10 ice cream cones with her weekly income.
Now, the price of an ice cream cone increases to USD 10:
- Sarah's income hasn't changed, it’s still USD 50.
- At USD 10 per cone, Sarah can now only buy 5 ice cream cones instead of 10.
This means Sarah's real income (her ability to purchase goods) has effectively decreased because she can now afford fewer cones with the same amount of money. This is the income effect in action.
NoteNotice how the income effect is a product of the ceteris paribus assumption. When considering the demand for a good (or service):
- The variables being analysed are the price and quantity of a good.
- We are not analysing the income of its consumers, and so we assume the consumer income to be constant (ceteris paribus assumption).
Substitution effect
The substitution effect occurs when:
- The price of a good changes
- But the prices of other substitute goods and the consumer's income remain constant.
If the price of a good increases, whereas consumer's income remain constant:
- Consumers will buy less of the good.
- This is because they will substitute it with cheaper alternatives.
If the price of a good decreases, whereas consumer's income remain constant:
- Consumers will buy more of the good.
- This is because it is now relatively cheaper compared to alternatives, and so they will stop buying the other alternatives to buy more of the now cheaper good instead.
Suppose Sarah has USD 50 a week to spend on her favourite drinks: coffee (USD 5 per cup) and tea (USD 3 per cup).
- At USD 5 per coffee cup, Sarah typically buys 5 cups of coffee and spends the rest on tea.
- If the price of coffee rises to USD 8 per cup, Sarah’s USD 50 now buys fewer coffee cups. Tea, at USD 3 per cup, becomes a more affordable option.
- Sarah decides to buy fewer coffee cups and more tea, substituting the relatively expensive coffee for cheaper tea.
This is the substitution effect in action, where Sarah adjusts her purchases due to the relative price changes of coffee and tea.
Note- The substitution effect assumes that consumers aim to maximize their utility by reallocating spending toward goods that offer better value as prices change.
- This concept is also based on the ceteris paribus assumption, meaning all other variables, such as income and the prices of other goods, remain constant while analysing the effects of a price change on one specific good.
Are that income and substitution effects mutually exclusive or can they happen both at the same time?
