The law of demand says that quantity demanded varies inversely with price, other things constant. Thus, the higher the price, the smaller the quantity demanded; the lower the price, the greater the quantity demande Demand, Wants, and Needs Consumer demand and consumer wants are not the same. As we have seen, wants are unlimited. You may want a new Mercedes-Benz SL600 Roadster convertible, but the $139,100 price tag is likely beyond your budget (that is, the quantity you demand at that price is zero). Nor is demand the same as need. You may need a new muffler for your car, but a price of $300 is just too high for you right now. If, however, the price drops enough say, to $200 then you become both willing and able to buy one.
The Substitution Effect of a Price Change
What explains the law of demand? Why, for example, does the quantity demanded increase if the price declines? The explanation begins with unlimited wants confronting scarce resources. Many goods and services can help satisfy particular wants. For example, you can satisfy your hunger with pizza, tacos, burgers, chicken, or hundreds of other foods. Similarly, you can satisfy your desire for warmth in the winter with warm clothing, a home-heating system, a trip to Hawaii, or in many other ways. Clearly, some alternatives are more appealing than others (a trip to Hawaii is more fun than warm clothing). In a world without scarcity, everything would be free, so you would always choose the most attractive alternative. Scarcity, however, is the reality, and the degree of scarcity of one good relative to another helps determine each good’srelative price.
The Substitution Effect of a Price Change
What explains the law of demand? Why, for example, does the quantity demanded increase if the price declines? The explanation begins with unlimited wants confronting scarce resources. Many goods and services can help satisfy particular wants. For example, you can satisfy your hunger with pizza, tacos, burgers, chicken, or hundreds of other foods. Similarly, you can satisfy your desire for warmth in the winter with warm clothing, a home-heating system, a trip to Hawaii, or in many other ways. Clearly, some alternatives are more appealing than others (a trip to Hawaii is more fun than warm clothing). In a world without scarcity, everything would be free, so you would always choose the most attractive alternative. Scarcity, however, is the reality, and the degree of scarcity of one good relative to another helps determine each good’srelative price.
Notice that the definition of demand includes the other-things-constant assumption. Among the “other things” assumed to remain constant are the prices of other goods. For example, if the price of pizza declines while other prices remain constant, pizza becomes relatively cheaper. Consumers are more willing to purchase pizza when its relative price falls; they substitute pizza for other goods. This idea is called the substitution effect of a price change. On the other hand, an increase in the price of pizza, other things constant, increases the opportunity cost of pizza that is, the amount of other goods you must give up to buy pizza. This higher opportunity cost causes consumers to substitute other goods for the now higher-priced pizza, thus reducing their quantity of pizza demanded. Remember that it is the change in the relative price the price of one good relative to the prices of other goods that causes the substitution effect. If all prices changed by the same percentage, there would be no change in relative prices and no substitution effect.
The Income Effect of a Price Change
A fall in the price of a good increases the quantity demanded for a second reason. Suppose you earn $30 a week from a part-time job, so $30 is your money income. Money income is simply the number of dollars received per period, in this case, $30 per week. Suppose you spend all that on pizza, buying three a week at $10 each. What if the price drops to $6? At that lower price, you can now afford five pizzas a week. Your money income remains at $30 per week, but the drop in price increases your real income that is, your income measured in terms of what it can buy.
The Income Effect of a Price Change
A fall in the price of a good increases the quantity demanded for a second reason. Suppose you earn $30 a week from a part-time job, so $30 is your money income. Money income is simply the number of dollars received per period, in this case, $30 per week. Suppose you spend all that on pizza, buying three a week at $10 each. What if the price drops to $6? At that lower price, you can now afford five pizzas a week. Your money income remains at $30 per week, but the drop in price increases your real income that is, your income measured in terms of what it can buy.
The price reduction, other things constant, increases the purchasing power of your income, thereby increasing your ability to buy pizza. The quantity of pizza you demand will likely increase because of this income effect of a price change. You may not increase your quantity demanded to five pizzas, but you could. If you decide to purchase four pizzas a week when the price drops to $6, you would still have $6 remaining to buy other stuff. Thus, the income effect of a lower price increases your real income and thereby increases your ability to buy pizza and other goods, making you better off. The income effect is reflected in Walmart’s slogan, which trumpets low prices: “Save money. Live better.” Because of the income effect, consumers typically increase their quantity demanded when the price declines.
Conversely, an increase in the price of pizza, other things constant, reduces real income, thereby reducing your ability to buy pizza and other goods. Because of the income effect, consumers typically reduce their quantity demanded when the price increases. The more important the item is as a share of your budget, the bigger the income effect. That’s why, for example, some consumers cut back on a variety of purchases when the price of gasoline spikes, as it did in 2012. Again, note that money income, not real income, is assumed to remain constant along a demand curve. A change in price changes your real income, so real income varies along a demand curve. The lower the price, the greater your real income.
Conversely, an increase in the price of pizza, other things constant, reduces real income, thereby reducing your ability to buy pizza and other goods. Because of the income effect, consumers typically reduce their quantity demanded when the price increases. The more important the item is as a share of your budget, the bigger the income effect. That’s why, for example, some consumers cut back on a variety of purchases when the price of gasoline spikes, as it did in 2012. Again, note that money income, not real income, is assumed to remain constant along a demand curve. A change in price changes your real income, so real income varies along a demand curve. The lower the price, the greater your real income.
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