The Analysis of Consumer Demand

again…. some more of my notes & revision from the Principles of Business Economics by Joseph G. Nellis and David Parker.

The Analysis of Consumer Demand is a crucial aspect of successful business management. Without an understanding of this, and its implications it is unlikely that a firm will be around for very long.

Consumer demand is affected by many things, some within the control of the managers, and some not. Uncontrollable conditions are those things that affect consumer demand, but that are not under the control of the firm itself such as the weather.

It is also understood that sometimes, consumers can act as theorised to maximise utility, but with imperfect information. A great example of this, would be an individual buying a car who later regretted his/her choice as the car was unreliable. If the consumer had had perfect information regarding the car’s engine it would be safe to say he/she would not have purchased it. This is known as Boundless Rationality.

The Market Demand Curve

Economist use the term ‘demand’ to mean the ‘effective demand‘ for a product in the market place. This is the amount consumers are willing to buy at a given price and over a given period of time. We can aim to visualise this with the use of a ‘Consumers Demand Curve’, which relates the quantity an individual consumer is willing to buy of a certain product over a range of conceivable prices.

We can then build the more useful Aggregate/Market Demand Curve for a good/service which shows the ‘total’ effective demand for a product over a given period of time. This can be achieved by summing the individual demand curves of consumers horizontally for any given price.

At any given price : Adam’s demand + Eve’s demand = Market Demand

The Law of Demand

As stated the Demand Curve shows the relationship between the Market Demand over a range of prices for the good/service, and thus the amount a company can expect to sell. It is understood that in general there is an inverse relationship between an increase in price and the aggregate demand for that product in the market place, assuming ceteris paribus (all other factors are held constant).

So why do people consume more of something the cheaper it becomes? Well, when people consume more of something in a given time period the total utility will tend to rise. However it should be noted that the marginal utility will tend to decrease with each purchase. This decline of marginal utility as units purchased increases can be attributed to the Law of Diminishing Marginal Utility. Therefore, we can assume that consumers will tend to maximise their utility buy spreading their purchases over many products (how much more can you get from your 10th car, than you got from your 9th?).

At some point the consumer will reach what is known as Consumer Equilibrium, that is to the say, the point where they are unable to redistribute their spending to acquire a higher utility.

Let us assume two goods, a and b and that consumer Equilibrium has been reached:

MUa/Pa =  MUb/Pb

If the price of a increases then

MUa/Pa < MUb/Pb

Therefore the consumer will purchase more of b so as to restore to Consumer Equilibrium. This will result in the Marginal Utility of ‘a’ will increase and the Marginal Utility of ‘b’ will decrease (Law of Diminishing Marginal Returns in effect) until once again

MUa/Pa = MUb/Pb

The Paradox of Values is seen when the cost of goods/services that are seen as necessary are actually lower than those that are not vital. A good example is how expensive diamonds are, but water is cheap.

Consumer Surplus

This is the increase in the price a consumer would be willing to pay for a good, rather than go without the good, than is actually paid for by the consumer. This can also be referred to as the ‘consumers rent’. However, in an auction based market place, where each person can bid to the maximum price he/she gives marginal utility of owning that product, eliminates Consumer Surplus, and gives rise to a Discriminating Monopolist.

As mentioned above it is vital for a business to understand the behaviour of demand, and there are some other determinants of demand that should be looked at. These include:

• the ‘own’ price – Po (as stated above the price is one of the major determinants)
• the price of substitute goods – Ps
• the price of complimentary goods – Pc
• levels of advertising – Aa,b,c,d….
• levels of disposable taxes – Yd
• wealth affects caused by stock market booms, rising house prices, windfall gains etc – W
• changes in consumer trends, tastes and preferences- T
• cost and availability of credit – C
• consumers expectations concerning future price changes and availability of prices – E
• changes in total population – POP

The conditions of demand are seen as those conditions, other than Po, that affect the demand curve.

The demand function is as follows:

Qd = f(Po, Ps, Pc, Aa,b,c, Yd, W, T, C, E, POP)

When Po changes it is expected that demand will move along the demand curve. However, when any other determinants of demand are altered, we would see a movement OF the demand curve.

It should also be noted….

The Income Effect

As Own Price (Po) of a product decreases, the consumer’s purchasing power increase as though their income was increasing. The opposite effect also applies, even though their income in unchanged.

The Substitution Effect

As Po falls, this product becomes cheaper than many competitors, and so consumers will begin to choose this over other products. This is know to the Substitution Effect.