Demand: Study Guide (Microeconomics 2.1)

Markets need property rights, incentives and constraints

Unit 1 asked how an economy decides what to produce. In a market economy, much of the answer comes from buyers and sellers trading. This topic looks at the buyers’ side.

Trade only works well when property rights are clear. A property right is a legally protected right to own, use and sell something. When you pay for a phone, you expect it to be yours, and you expect the law to back you if someone takes it. If ownership were unclear, or a seller could take the good back, few people would pay much for anything. A well-defined system of property rights is what makes buying worthwhile.

Buyers also respond to incentives. An incentive is anything that rewards or penalises a choice. Price is the most important one: a lower price rewards buying more. But buyers also face constraints, limits on what they can do:

• Income: you cannot spend more than you have (or can borrow).
• Time: a cinema trip takes three hours; a busy student may not have them.
• Laws and regulations: an age limit, a licence requirement or a ban can stop some people buying at any price.

Demand describes how buyers behave once all of these are taken into account.

What demand means

Demand is the quantity of a good that buyers are willing and able to buy at each possible price, during a given period, with all other influences held constant.

Three phrases in that definition matter:

• Willing and able. Wanting a sports car is not demand unless you can pay for it.
• At each possible price. Demand is a whole list of price-quantity pairs (a demand schedule), or a whole curve, not one number.
• Other influences held constant. Economists call this ceteris paribus (“other things equal”). We change only the good’s own price and watch what happens.

Quantity demanded is one number: the amount buyers want at one particular price.

The law of demand

The law of demand says that, other things equal, when the price of a good rises, the quantity demanded falls; when the price falls, the quantity demanded rises. Price and quantity demanded move in opposite directions.

On a graph, price goes on the vertical axis and quantity on the horizontal axis. Because of the law of demand, the demand curve slopes downward. A change in the good’s own price moves buyers along the curve. The curve itself stays where it is.

Why the demand curve slopes downward

Three ideas explain the law of demand. Suppose the price of a cup of chai at a college café falls from $4 to $2.

1. Substitution effect. Chai is now cheaper compared with coffee, juice and other drinks. Some buyers switch from those drinks to chai.
2. Income effect. A lower price raises your purchasing power (your real income). With a weekly drinks budget of $20, you could afford 5 cups at $4 but 10 cups at $2. Feeling richer, you can buy more chai. (This is the normal case. You will meet goods where extra income reduces purchases below.)
3. Diminishing marginal utility. From Topic 1.6, each extra cup gives less extra satisfaction than the one before. You will only buy an extra cup, which you value less, if the price falls.

The third idea leads to a powerful way of reading a demand curve. A buyer keeps buying while the marginal benefit (MB) of the next unit is at least the price. So the height of the demand curve at any quantity shows the marginal benefit of the last unit bought. The demand curve is a marginal benefit curve.

From marginal benefit to individual demand

Throughout this guide we use the café at Larkfield College, a fictional college. Three students buy chai there. Their marginal benefit from each cup in a week, valued in dollars, is:

Cup	1st	2nd	3rd	4th	5th	6th	7th	8th
Dina’s MB ($)	7	6	5	4	3	2	1	–
Felix’s MB ($)	6	5	4	3	2	1	–	–
Hana’s MB ($)	8	7	6	5	4	3	2	1

Each student buys every cup whose MB is at least the price. At $4, Dina buys her 1st to 4th cups (MB $7, $6, $5, $4) but not the 5th (MB $3). So her quantity demanded at $4 is 4 cups. Repeating this at each price gives each student’s individual demand schedule:

Price per cup	Dina	Felix	Hana
$1	7	6	8
$2	6	5	7
$3	5	4	6
$4	4	3	5
$5	3	2	4

Each schedule obeys the law of demand: a higher price, a smaller quantity.

Worked example 1: market demand and a movement along the curve

Question. Use the three schedules above. (a) Build the market demand schedule for chai at the Larkfield café. (b) The café raises its price from $2 to $4 per cup. Find the change in market quantity demanded and describe it on a graph. (c) Use marginal benefit to explain why Dina buys fewer cups.

(a) Market demand is the sum of the individual quantities demanded at each price. Add across each row:

Price per cup	Dina + Felix + Hana	Market quantity demanded (cups per week)
$1	7 + 6 + 8	21
$2	6 + 5 + 7	18
$3	5 + 4 + 6	15
$4	4 + 3 + 5	12
$5	3 + 2 + 4	9

Because we add quantities at the same price, this is called horizontal summation: on a graph, you add the curves sideways, not up. A real market has thousands of buyers, but the method is the same.

(b) At $2, quantity demanded is 18 cups. At $4, it is 12 cups. Change = 12 − 18 = −6 cups per week.

Only the own price changed. Incomes, tastes and the prices of other drinks did not. So the curve does not move. Buyers move along D from point a to point b. This is a decrease in quantity demanded, not a decrease in demand.

(c) At $2, Dina buys every cup with MB of at least $2: her 1st to 6th cups. At $4, the 5th cup (MB $3) and 6th cup (MB $2) are no longer worth the price, so she drops them. She now buys 4 cups.

Check. Over the prices in the table, the market schedule falls by 3 cups for every $1 rise, so the points lie on a straight line, quantity demanded = 24 − 3 × price. At $4 this gives 24 − 12 = 12. The line is only a summary of the steps: at $8, Hana still buys her 1st cup (MB $8), and only above $8, the highest MB of any buyer, does nobody buy.

Change in quantity demanded versus change in demand

This distinction appears in almost every exam question on markets.

	Change in quantity demanded	Change in demand
Caused by	the good’s own price	any determinant of demand (not own price)
On the graph	movement along the existing curve	the whole curve shifts
Words to use	“quantity demanded rises / falls”	“demand increases / decreases”

An increase in demand shifts the curve to the right: buyers want more at every price, and each unit’s marginal benefit is higher. A decrease in demand shifts it to the left.

The determinants of demand

These are the influences, other than own price, that shift demand:

• Income. For a normal good, higher income increases demand. For an inferior good, higher income decreases demand, because buyers switch to something they prefer (for example, from bus travel to a car, or from the cheapest rice to a better brand).
• Prices of related goods.
  • Substitutes can be used in place of each other (chai and coffee). If the price of a substitute falls, demand for this good decreases.
  • Complements are used together (chai and biscuits). If the price of a complement falls, demand for this good increases.
• Tastes and preferences. Fashion, advertising, health news or habit can raise or lower demand.
• Expectations. If buyers expect the price to rise next month, demand now increases. Expected higher future income can also raise demand now.
• Number of buyers. More buyers (a bigger population or new customers arriving) increases market demand.

Constraints from laws and regulations work through these determinants. For example, a new minimum age for buying a good reduces the number of buyers who can legally purchase it, so market demand decreases.

Worked example 2: shifting the demand curve

Question. Return to the Larkfield café. Treat each event separately, starting from the market schedule in Worked example 1 (call it D₁). (a) The college raises its student grant. Chai is a normal good, and each student now buys one more cup at every price. Find the new schedule D₂. (b) A rival café cuts the price of coffee. Each student’s MB from every cup of chai falls by $1. Find the new schedule D₃. (c) Compare quantity demanded at $3 on D₁, D₂ and D₃.

(a) Three students each add one cup, so the market adds 3 cups at every price:

Price	D₁	D₂ (grant rises)	D₃ (coffee cheaper)
$1	21	24	18
$2	18	21	15
$3	15	18	12
$4	12	15	9
$5	9	12	6

(b) If every MB value falls by $1, each student now buys one fewer cup at each price. For example, Dina’s MB is now $6, $5, $4, $3… so at $4 she buys 3 cups instead of 4. Adding the three students gives the D₃ column: 3 fewer cups at every price. Coffee is a substitute for chai, so a cheaper substitute decreases demand for chai.

(c) At $3: D₁ gives 15 cups, D₂ gives 18 (3 more) and D₃ gives 12 (3 fewer). The price is the same in each case, so these are shifts, not movements along a curve.

Interpretation. A shift can be read two ways. Sideways: at $3, buyers now want 18 cups instead of 15. Up: on D₂, the 15th cup now has a marginal benefit of $4 instead of $3. Both say the same thing: buyers value chai more than before.

Quick classification. Use the same café:

Event	Effect	Graph
The price of chai rises	quantity demanded falls	movement up along D
Biscuits (a complement) become cheaper	demand increases	shift right
A health report praises chai	demand increases	shift right
A new student residence opens next to the café	demand increases (more buyers)	shift right
The student grant is cut (chai is a normal good)	demand decreases	shift left
A rule bans drinks in the library, where many students study	demand decreases (a legal constraint)	shift left

Common misconceptions

• “A fall in price increases demand.” A fall in the good’s own price increases quantity demanded. Demand (the whole curve) does not change.
• “Demand rises, so the price rises, so demand falls again.” This mixes a shift with a movement. Treat the shift first; the effect on price is the subject of Topic 2.7.
• “Higher income always increases demand.” Only for normal goods. For inferior goods, higher income decreases demand.
• “If the price of a substitute falls, demand for this good rises.” It falls: buyers switch to the cheaper substitute.
• “Market demand is the average of individual demands.” It is the sum of quantities demanded at each price.
• “Add demand curves vertically.” Add quantities at the same price: horizontally.
• “Wanting something is demand.” Demand needs willingness and ability to pay.
• “An increase in demand moves the curve up and to the left.” An increase moves it to the right (or, equally, up): more is wanted at every price.

Where this leads

Next you will build the sellers’ side of the market in Topic 2.2, Supply. Then you will measure how strongly quantity demanded responds to price (Topic 2.3) and put demand and supply together to find equilibrium (Topic 2.6). Test yourself with the practice questions, then use the revision notes and the checklist to consolidate. To review marginal benefit and diminishing marginal utility, see the marginal analysis study guide.