The Allocation of Resources - Demand

Objective: Drawing and Interpretation of the Demand Diagram

This section focuses on understanding the law of demand and how it is visually represented using a demand diagram. We will learn to draw demand curves and interpret their changes in response to shifts in various factors.

1. The Law of Demand

The law of demand states that, ceteris paribus (all other things being equal), as the price of a good or service increases, the quantity demanded decreases, and vice versa. This inverse relationship is the fundamental principle underlying the demand curve.

Example: If the price of apples rises, people will buy fewer apples and may switch to other fruits.

2. The Demand Curve

A demand curve is a graphical representation of the relationship between the price of a good and the quantity demanded at different price levels. It typically slopes downwards from left to right.

Key Characteristics:

• Downward Sloping: Reflects the inverse relationship between price and quantity demanded.
• Positive Relationship: As price decreases, quantity demanded increases.
• Indicates Consumer Preferences and Income (for normal goods).

3. Factors that Shift the Demand Curve

Changes in factors other than the price of the good can cause the entire demand curve to shift. These shifts are represented by changes in demand, rather than just changes in quantity demanded (which is a movement *along* the curve).

The main factors that can shift the demand curve are:

1. Consumer Income:
   • Normal Goods: An increase in income leads to an increase in demand.
   • Inferior Goods: An increase in income leads to a decrease in demand. (e.g., cheap generic brands)
2. Consumer Tastes and Preferences: Changes in consumer tastes (influenced by advertising, trends, etc.) can shift the demand curve.
3. Prices of Related Goods:
   • Substitute Goods: If the price of a substitute good increases, demand for the original good increases. (e.g., if the price of coffee rises, demand for tea increases).
   • Complementary Goods: If the price of a complementary good increases, demand for the original good decreases. (e.g., if the price of petrol rises, demand for cars decreases).
4. Expectations about Future Prices: If consumers expect prices to rise in the future, they may increase their current demand.
5. Population Size and Composition: A larger population or a population with a higher proportion of consumers can increase demand.

4. Drawing and Interpreting Demand Diagrams

A demand diagram shows the relationship between the price and quantity demanded of a good. It typically has the following components:

Price (P)	Quantity Demanded (Q)
$P_1$	$Q_1$
$P_2$	$Q_2$

Steps to Draw a Demand Diagram:

1. Draw the Axes: The horizontal axis represents the quantity demanded, and the vertical axis represents the price.
2. Plot Points: Plot several points on the diagram to represent different price-quantity combinations. Remember the law of demand – as price increases, quantity demanded decreases.
3. Draw the Curve: Draw a smooth curve connecting the plotted points. This is the demand curve. It slopes downwards from left to right.
4. Shifts in the Curve: If there is a change in a factor other than the price of the good, the entire demand curve will shift. A shift to the left indicates a decrease in demand, and a shift to the right indicates an increase in demand.

5. Example: Impact of a Change in Consumer Income

Consider the demand for a luxury car. This is a normal good. If consumer income increases, the demand for luxury cars will increase, resulting in a shift to the right of the demand curve. This leads to a higher equilibrium price and a higher equilibrium quantity.

6. Example: Impact of a Change in the Price of a Substitute Good

Suppose the price of tea increases. Tea and coffee are substitutes. If the price of tea increases, consumers will switch to coffee, leading to an increase in the demand for coffee and a shift to the right of the demand curve for coffee. This results in a higher equilibrium price and a higher equilibrium quantity of coffee.

7. Price Elasticity of Demand (Further Study)

While not directly part of the diagram drawing objective, understanding price elasticity of demand is crucial. It measures the responsiveness of quantity demanded to a change in price. A steep demand curve indicates high price elasticity, while a flatter curve indicates low price elasticity.