44 – Thinking like an economist 12: Hand it over!

The demand curve is a deceptively simple concept that economists use constantly. It has at least three different valid interpretations that make it useful in different roles.

“Now look! Give me a copy of the new Elvis Costello CD, right now. Hand it over!”

That’s a demand.

“I’d like to buy a copy of the new Elvis Costello CD please.”

According to economics, that constitutes demand too.

“Demand” is one of a number of words that have been given somewhat different meanings in economics than in common English. (Others that spring to mind include “public”, “surplus” and “cost”.)

Demand in economics does not carry any connotation of authority, rudeness or urgency. It simply refers to a consumer’s voluntary choice to purchase some quantity of a good. It’s a deceptively simple concept that economists use constantly.

How much would they choose to purchase? The answer to that question is their level of demand. It might be communicated in a most undemanding way. It might not even be communicated at all, in the case of some public goods for which free riding is possible (e.g. some environmental goods – see PD#22). But such goods still face demand from those who benefit from their consumption, albeit hidden demand.

Demand for a product can be affected by a number of variables, including characteristics of the consumers (their income, tastes, preferences), the availability and prices of other products that are seen as substitutes, and the price of the product itself. Economists being economists, we tend to take tastes and preferences for granted and focus on prices and, to a lesser extent, incomes. So much so that when we talk about a “demand curve” or a “demand function” we are usually referring to the relationship between demand and the product’s own price.

Everyone knows that when the price of a product rises, consumers choose to consume less of it.

Or do they? There can be some interesting exceptions to this rule. According to Bill Bryson in Made in America, “When Kentucky Fried Chicken introduced ‘Extra Crispy’ chicken to sell alongside its ‘Original’ chicken and sold it at the same price, sales were disappointing. But when its advertising agency persuaded it to promote ‘Extra Crispy’ as a premium brand and to put the price up, sales soared.”

An example close to my interests: in the late 1970s there was an Australian maker of high quality guitar amplifiers who tried to compete with established brands like Fender and Marshall by being very efficient and offering very low prices. They struggled on for a while with poor sales, before deciding that consumers were using price as an indicator of quality. They doubled their prices, and sales went up nicely.

But these price changes are confounded with marketing. Normally, higher price, lower demand. There are thousands of statistical studies that bear this out.

There are two main causal factors for this, both common sense. One is that as the price of a particular good goes up you can afford less of it (and of all goods, for that matter). The other is that at a higher price, the good is less attractive as a use for your hard earned cash than other things start to look.

For some goods, the quantity demanded drops away rapidly as price rises, while for others we are almost impervious to price changes. This reflects the strength of our psychological need or preference for the good, which depends in part on the availability of good substitute products. Even if we have a pretty fixed demand for fresh fish overall, demand for one species might fall rapidly as its price rises above that for another similar fish. They are good substitutes, making their individual demands more sensitive to price.

You might consider that economists are inordinately obsessed with demand curves. Perhaps we are obsessed, but it’s for good reasons. They are extremely useful and informative, especially when we turn them around and treat quantity as a function of price. That is, we ask the question, “If the quantity of a good available for consumption was limited to X, what would the price have to be to result in consumption of exactly X?” Neatly, you can read that off the demand curve derived by asking quite a different question.

The value of thinking about the relationship in this “inverse” way is two fold:

(a) it allows us to examine the otherwise complex interaction between demand and supply in a very simple way, including predicting what is likely to happen to price if either demand or supply shifts. You’ve all seen supply and demand curves overlaid.

(b) it provides information about the monetary value that consumers place on consumption of the good. This is useful for purposes such as benefit-cost analysis.

On the other hand thinking about quantity of demand as a function of price (i.e. the right way around) allows us to examine price as a tool for manipulating behaviour (e.g. see PD#41). Overall, it is suprising how many different ways there are to think about and use such an apparently simple relationship.

David Pannell, The University of Western Australia