FEATURED ENCYCLOPEDIA ENTRY
BASIC CONCEPTS, THE MARKETPLACE
By David R. Henderson
ne of the most important building blocks of economic analysis is the concept of demand. When economists refer to demand, they usually have in mind not just a single quantity demanded, but a demand curve, which traces the quantity of a good or service that is demanded at successively different prices.
The most famous law in economics, and the one economists are most sure of, is the law of demand. On this law is built almost the whole edifice of economics. The law of demand states that when the price of a good rises, the amount demanded falls, and when the price falls, the amount demanded rises.
Some of the modern evidence supporting the law of demand is from econometric studies which show that, all other things being equal, when the price of a good rises, the amount of it demanded decreases. How do we know that there are no instances in which the amount demanded rises and the price rises? A few instances have been cited, but most have an explanation that takes into account something other than price. Nobel laureate George Stigler
responded years ago that if any economist found a true counterexample, he would be “assured of immortality, professionally speaking, and rapid promotion” (Stigler 1966, p. 24). And because, wrote Stigler, most economists would like either reward, the fact that no one has come up with an exception to the law of demand shows how rare the exceptions must be. But the reality is that if an economist reported an instance in which consumption of a good rose as its price rose, other economists would assume that some factor other than price caused the increase in demand.
The main reason economists believe so strongly in the law of demand is that it is so plausible, even to noneconomists. Indeed, the law of demand is ingrained in our way of thinking about everyday things. Shoppers buy more strawberries when they are in season and the price is low. This is evidence for the law of demand: only at the lower, in-season price are consumers willing to buy the higher amount available. Similarly, when people learn that frost will strike the orange groves in Florida, they know that the price of orange juice will rise. The price rises in order to reduce the amount demanded to the smaller amount available because of the frost. This is the law of demand. We see the same point every day in countless ways. No one thinks, for example, that the way to sell a house that has been languishing on the market is to raise the asking price. Again, this shows an implicit awareness of the law of demand: the number of potential buyers for any given house varies inversely with the asking price.
Indeed, the law of demand is so ingrained in our way of thinking that it is even part of our language. Think of what we mean by the term “on sale.” We do not mean that the seller raised the price. We mean that he or she lowered it in order to increase the amount of goods demanded. Again, the law of demand.
Economists, as is their wont, have struggled to think of exceptions to the law of demand. Marketers have found them. One of the best examples involves a new car wax, which, when it was introduced, faced strong resistance until its price was raised from $.69 to $1.69. The reason, according to economist Thomas Nagle, was that buyers could not judge the wax’s quality before purchasing it. Because the quality of this particular product was so important—a bad product could ruin a car’s finish—consumers “played it safe by avoiding cheap products that they believed were more likely to be inferior” (Nagle 1987, p. 67).
Many noneconomists are skeptical of the law of demand. A standard example they give of a good whose quantity demanded will not fall when the price increases is water. How, they ask, can people reduce their use of water? But those who come up with that example think of drinking water or household consumption as the only possible uses. Even here, there is room to reduce consumption when the price of water rises. Households can do larger loads of laundry or shower quickly instead of bathe, for example. The main users of water, however, are agriculture and industry. Farmers and manufacturers can substantially alter the amount of water used in production. Farmers, for example, can do so by changing crops or by changing irrigation methods for given crops.
What the skeptics may have in mind is not that people would not cut back their purchases at all when the price of a good increases, but that they might cut back only a little. Economists have considered this thoroughly and have developed a measure of the degree of cutback, which they call the “elasticity of demand.” The elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. The greater the absolute value of this ratio, the greater is the elasticity of demand. When there is a close substitute for one firm’s brand, for example, a small percentage increase in that firm’s price may lead to a large percentage cut in the amount of the firm’s good demanded. In such a case, economists say that the demand for the good is highly elastic. On the other hand, when there are few good substitutes for a firm’s product, the firm might be able to raise its price substantially with only a small decrease in the quantity demanded resulting. In such a case, demand is said to be highly inelastic.
Interestingly, though, if a firm is in a position whereby it can increase a price substantially and reduce sales only a little, and if its owners want to maximize profits
, the firm is well advised to raise the price until it reaches a portion of the demand curve where demand is elastic. Otherwise, the firm is forsaking an increase in revenue that it could have had with no increase in costs. One important implication of this fact is that the elasticity of demand in a market is a negative test for whether the firms are acting together as a monopoly
. If, at the existing price, the elasticity of the market demand for the good is less than one, that is, if the demand is inelastic, then the firms are not acting monopolistically. If the elasticity of demand exceeds one—that is, if the demand is elastic—then we do not know whether they are acting monopolistically or not.
It is not just price that affects the quantity demanded. Income affects it too. As real income rises, people buy more of some goods (which economists call “normal goods”) and less of others (called “inferior goods”). Urban mass transit and railroad transportation are classic examples of inferior goods. That is why the usage of both of these modes of travel declined so dramatically as postwar incomes were rising and more people could afford automobiles. Environmental quality
is a normal good, and that is a major reason why Americans have become more concerned about the environment in recent decades.
Another influence on demand is the price of substitutes. When the price of Toyota Camrys rises, all else being equal, the quantity of Camrys demanded falls and the demand for Nissan Maximas, a substitute, rises. Also important is the price of complements, or goods that are used together. When the price of gasoline rises, the demand for cars falls.
About the Author
David R. Henderson is the editor of this encyclopedia. He is a research fellow with Stanford University’s Hoover Institution and an associate professor of economics at the Naval Postgraduate School in Monterey, California. He was formerly a senior economist with President Ronald Reagan’s Council of Economic Advisers.
Nagle, Thomas T. The Strategy and Tactics of Pricing: A Guide to Profitable Decision Making. Englewood Cliffs, N.J.: Prentice Hall, 1987.Stigler, George J. The Theory of Price. 3d ed. New York: Macmillan, 1966.Categories: Basic Concepts The Marketplace Enter your email address to subscribe to our monthly newsletter:
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