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# Demand and Supply Review for AP Economics (page 2)

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By — McGraw-Hill Professional
Updated on Mar 4, 2011

#### The Demand Curve

The residents of small midwestern town love to quench their summer thirsts with lemonade. Table 6.2 summarizes the townsfolk's daily consumption of cups of lemonade at several prices, holding constant all other factors that might influence the overall demand for lemonade. This table is sometimes referred to as a demand schedule.

The values in Table 6.2 reflect the Law of Demand: "Holding all else equal, when the price of a cup of lemonade rises, consumers decrease their quantity demanded for lemonade." It is often quite useful to convert a demand schedule like the one above into a graphical Representation, the demand curve (Figure 6.1).

#### Quantity Demanded versus Demand

The Law of Demand predicts a downward (or negative) sloping demand curve (Figure 6.1) If the price moves from \$1 to \$1.25, and all other factors are held constant, we observe a decrease in the quantity demanded from 60 to 40 cups. It is important to place special emphasis on "quantity demanded." If the price of the good changes and all other factors remain constant, the demand curve is held constant and we simply observe the consumer moving along the fixed demand curve. If one of the external factors change, the entire demand curve shifts to the left or right.

#### Determinants of Demand

So what are all of these factors that we insist on holding constant? These determinants of demand influence both the willingness and ability of the consumer to purchase units of the good or service. In addition to the price of the product itself, there are a number of variables that account for the total demand of a good like lemonade. These are:

• Consumer Income

Demand represents the consumer's willingness and ability to pay for a good. Income is a major factor in that "ability" to pay component. For most goods, when income increases, demand for the good increases. Thus, for these normal goods, increased income results in a graphical rightward shift in the entire demand curve. There are other inferior goods, fewer in number, where higher levels of income produce a decrease in the demand curve.

Example:

When looking to furnish a first college apartment, many students increase their demand for used furniture at yard sales. Upon graduation and employment in their first real job, new graduates increase their demand for new furniture and decrease their demand for used furniture. For them, new furniture is a normal good while used furniture is an inferior good.

• An increase in demand is viewed as a rightward shift in the demand curve. There are two ways to think about this shift.
1. At all prices, the consumer is willing and able to buy more units of the good. In Figure 6.2 below you can see that at the constant price of \$1, the quantity demanded has risen from two to three.
2. At all quantities, the consumer is willing and able to pay higher prices for the good.

Of course the opposite is, true of a decrease in demand, or leftward shift of the demand curve. In Figure 6.2 you can see that at the constant price of \$1, the quantity demanded has fallen from two to one.

• Price of Substitute Goods

Two goods are substitutes if the consumer can use either to satisfy the same essential function, therefore experiencing the same degree of happiness (utility). If the two goods are substitutes, and the price of one good X falls, the consumer demand for the substitute good Y decreases.

Example:

Mammoth State University (MSU) and Ivy Vine College (IVC) are considered substitute institutions of higher learning in the same geographical region. Ivy Vine College, shamelessly (wink, wink) seeking to increase its reputation as an "elite" institution, increases tuition while Mammoth State's tuition remains the same. We expect to see, holding all else constant, a decrease in quantity demanded for IVC degrees, and an increase in the overall demand for MSU degrees. (See Figures 6.3 and 6.4.)

• Price of Complementary Goods

Two goods are complements if the consumer receives more utility from consuming them together than she would receive consuming each separately. I enjoy consuming tortilla chips by themselves, but my utility increases if I combine those chips with a complementary good like salsa or nacho cheese dip. If any two goods are complements, and the price of one good X falls, the consumer demand for the complement good Y increases.

Example:

College students love to order late night pizza delivered to their dorm rooms. The local pizza joint decreased the price of breadsticks, a complement to the pizzas. We expect to see, holding all else constant, an increase in quantity demanded for breadsticks, and an increase in the demand for pizzas.

• Tastes and Preferences

We have different internal tastes and preferences. Collectively, consumer tastes and preferences change with the seasons (more gloves in December, fewer lawn chairs); with fashion trends (increased popularity of tattoos, return of bell-bottoms); or with advertising (low-carb foods). A stronger preference for a good is an increase in the willingness to pay for the good, which increases demand.

• Future Expectations

The future expectation of a price change or an income change can cause demand to shift today. Demand can also respond to an expectation of the future availability of a good.

Example:

On a Wednesday, you have reason to believe that the price of gasoline is going to rise \$.05 per gallon by the weekend. What do you do? Many consumers, armed with this expectation, increase their demand for gasoline today. We might predict the opposite behavior, a decrease in demand today, if consumers expect the price of gasoline to fall a few days from now. Demand can also be influenced by future expectations of an income change.

Example:

One month prior to your college graduation day you land your first full-time job. You have signed an employment contract that guarantees a specific salary, but you will not receive your first paycheck until the end of your first month on the job. This future expectation of a sizeable increase in income often prompts consumers to increase their demand for normal goods now. Maybe you would start shopping for a car, a larger apartment, or several business suits.

Example:

For years, auto producers have been promising more alternative fuel cars, but so far these cars are relatively difficult to find on dealership lots. Suppose the "Big 3" promise widespread availability of affordable electric and hydrogen fuel cell cars in the next 12 months. This expectation of increased availability in the future will likely decrease the demand of these cars today.

An increase in the number of buyers, holding other factors constant, increases the demand for a good. This is often the result of demographic changes or increased availability in more markets.

Example:

When the Soviet Union fractured and the Russian government began allowing more foreign investment, corporations such as Coca-Cola, IBM, and McDonald's found millions of new buyers for their products. Globally, the demand for colas, PCs, and burgers increased.

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