Supply and Demand are the main components of a market and determine how the price of a product is determined.
The demand curve shows the inverse relationship between the price and the quantity bought based on that price. There are 2 main reasons for this inverse relationship:
- Willingness To Pay: As the price of a good rises, its price may exceed its marginal utility in which case the consumer becomes unwilling to pay for the good. Furthermore, the consumer may switch to substitutes instead
- Ability to Pay: As the price rises, the consumer may be unable to produce the real income in order to afford the good which means the quantity demanded will be lower. Examples of this would be luxury cars.
The type of good in relation to to others being sold also has an influence on its demand, goods can be classified into 2 types of good in relationship to other goods:
- Complement goods: A complement good, as said in the name, is complementary with another good which means that as the demand of one good rises, so will the demand of the other. The best example of this would be as the sale of movie tickets rises, so will the popcorn sales.
- Substitute goods: A substitute good is a good which will increase in demand as the demand of another good decreases. An example of that would products in a perfect competition market.
2 theories explain the influence of price and income on customers:
- Income effect: The theory suggests that as an agents income rises or the price of a good decreases, they can afford more of the product and so the demand rises
- Substitution effect: This suggests that as the price of good decreases, the demand for it will increase. This is because customers are attracted to the least costly option.
The type of good will also have an impact on the demand curve:
- Inferior Good: As the income as a consumer increases, the demand of the good will reduce. An example may be food brands who are differentiated for their low price
- Normal Goods: A good who’s demand will increase with the income of the customer
- Giffen Good: A good who’s demand will increase as its price increases and examples of this would be securities and stocks.
Shifts of the Curve:
Movements in the demand curve can be caused by many things. For example, if the product becomes more popular, the demand curve may shift to the right because the demand for the product is going to rise at every price level. Alternatively, if there is a decrease in demand as the product becomes less popular, then the demand curve is going to shift to the left.
As discussed by the income effect, the influence an increase in income will cause a shift in the demand curve. For normal goods the curve is going to shift to the right while for inferior goods, they are going to shift to the left.
Movements Along the Curve:
The point at which you produce at determines both the quantity produced and also the price at which you are going to sell at. However, you could decide to change the point at which you produce at, for example, you may decide to increase the price which leads to a decrease in demand which is also known as a demand contraction. Alternatively, you may choose to decrease the price which will increased the demand due to the substitution effect which leads to an increase in demand also known as a demand expansion/extension.
The reason the demand curve is usually curved is because of the law of marginal returns which is a law suggesting that as the quantity of a product is bought, the marginal utility of the consumption of the addition product is going to increase. If the marginal utility is constant then the demand curve is going to be a straight line like the first image while if the marginal utility changes, the gradient represents the marginal utility and so it causes the curving nature of the curve. Typically, a rational customer will only consume a product until the marginal utility= marginal cost of the product.