Understanding Demand: Curves and Shifts

Hello! Welcome to the first lesson of our second module, "Supply, Demand, and Market Equilibrium."

In our last lesson, we explored how incentives, particularly prices, drive the choices of individuals and firms. We established that when the price of a good changes, it alters the incentive for consumers to buy it. Today, we'll formalize this relationship by building the first half of the most fundamental model in economics: the demand curve. This is the cornerstone for understanding how markets work, and it builds directly on our previous discussions of choice and incentives.

By the end of this lesson, you will be able to plot and interpret a demand curve and identify the key factors that cause it to shift.

1. The Law of Demand and the Demand Curve

At its core, "demand" in economics is more than just wanting something. It represents the quantity of a good or service that consumers are both willing and able to purchase at various prices during a specific time period. The "ability" to buy is crucial; this is what economists call effective demand.

This relationship between price and quantity is governed by a fundamental principle: the Law of Demand.

To get a clear understanding of what demand is, how the law of demand works, and how we represent it graphically, please watch the beginning of the following video.

As the video explained, the demand curve is a graphical representation of the relationship between price and quantity demanded.

A key point to note, which might differ from conventions in your engineering or IT background, is that economists place price (the independent variable, in a sense) on the vertical y-axis and quantity (the dependent variable) on the horizontal x-axis. This is a historical convention started by economist Alfred Marshall that has stuck.

Why does the demand curve slope downwards?

The video touched on this, but let's formalize the two main reasons behind the Law of Demand:

1. The Substitution Effect: When the price of a good falls, it becomes cheaper relative to other goods. Consumers will substitute away from more expensive goods and toward the cheaper one. For example, if the price of coffee drops, some tea drinkers might switch to coffee.
2. The Income Effect: When the price of a good falls, the purchasing power of a consumer's income increases. They can now buy the same amount of the good for less money, leaving them with extra money to spend. This "increase" in real income can lead them to buy more of the good.

These two effects work together to cause the quantity demanded to increase as the price falls, giving the demand curve its characteristic downward slope.

A crucial assumption we make when drawing a demand curve is ceteris paribus, a Latin phrase meaning "all other things being equal." This means that when we trace the relationship between price and quantity demanded, we assume that all other relevant factors—like your income, the price of tea, and your preference for coffee—are held constant.

2. Shifts in the Demand Curve

But what happens when those "other things" don't stay equal? A change in any factor other than the price of the good itself will cause the entire demand curve to shift.

• An increase in demand means consumers want to buy more of the good at every price level. This is shown as a rightward shift of the demand curve (from D₀ to D₁).
• A decrease in demand means consumers want to buy less of the good at every price level. This is shown as a leftward shift of the demand curve (from D₀ to D₂).

The following video offers a great visual explanation of what a shift in demand means.

3. What Causes Demand to Shift?

Now, let's dive into the specific non-price factors that cause these shifts. The following reading from the OpenStax textbook Principles of Economics provides a comprehensive overview. Your goal here is to understand each "shifter" and be able to predict whether it will cause an increase or decrease in demand.

To reinforce these concepts and give you a helpful mnemonic, let's return to the EconplusDal video, which organizes the shifters with the acronym PASIFIC.

Let's summarize these key demand shifters:

• Population: Changes in the size or demographic makeup of the population.
• Advertising: Affects tastes and preferences.
• Substitutes (price of): Goods used in place of one another (e.g., butter and margarine).
• Income: Affects purchasing power. We must distinguish between:
  • Normal Goods: Demand increases as income rises.
  • Inferior Goods: Demand decreases as income rises.
• Fashion and Tastes: Subjective preferences of consumers.
• Interest Rates: Affects the cost of borrowing for large purchases (e.g., cars, houses).
• Complements (price of): Goods used together (e.g., gasoline and cars).

(Note: You can also include Expectations about future prices or income as another key shifter.)

4. Movement Along the Curve vs. a Shift of the Curve

It is absolutely essential to distinguish between a change in quantity demanded and a change in demand.

• A change in quantity demanded is a movement along a single demand curve, caused only by a change in the price of the good itself.
• A change in demand is a shift of the entire demand curve (left or right), caused by a change in one of the non-price shifters we just discussed.

This image provides a perfect visual summary of the distinction.

Conclusion

In this lesson, we have constructed the first essential component of a market model. You now have the tools to analyze how consumers behave in response to changes in price and other economic factors.

Here are the main takeaways:

• The demand curve illustrates the Law of Demand: an inverse relationship between a good's price and the quantity consumers are willing and able to buy, ceteris paribus.
• A change in the good's own price causes a movement along the demand curve (a change in quantity demanded).
• A change in a non-price factor (like income, tastes, prices of related goods, population, or expectations) causes a shift of the entire demand curve (a change in demand).

We have now thoroughly examined the buyer's side of the market. In our next lesson, we will turn our attention to the seller's side. We will build the supply curve, which captures the relationship between a good's price and the quantity that producers are willing to sell.