Demand Analysis

The Demand Curve

A demand curve is a graph showing the relationship between the price of a certain item and what consumers are willing to buy at the price.

Learning Objectives

Define the demand curve

Key Takeaways

Key Points

  • Demand does not only have to do with the need to have a product or a service, but it also involves the willingness and ability to buy it at the price charged for it.
  • The demand curve for all consumers together follows from the demand curve of every individual consumer. The individual demands at each price are added together.
  • The negative slope of the demand curve is often referred to as the “law of demand,” which means people will buy more of a service, product, or resource as its price falls.

Key Terms

  • Veblen good: A good for which people’s preference for buying them increases as a direct function of their price, as greater price confers greater status. As the price gets higher, demand rises.
  • straight rebuy: the repurchase of a good with no changes to the details of the order
  • Giffen good: A good which people consume more of as the price rises; Having a positive price elasticity of demand. As price rises, more is consumed which increases demand.
  • derived demand: when demand for a factor of production or intermediate good occurs as a result of the demand for another intermediate or final good

Demand

When clients want a product and are willing to pay for it, we say that there is a demand for the specific product. There has to be a demand for a product before a manufacturer can sell it. Demand does not only have to do with the need to have a product or a service, but also with the willingness and ability to buy it at the price charged for it.

Example of Demand: Andrew’s Grape Jam

Andrew and his mother, Mrs. Jeffries, decided to earn extra money by selling grape jam at the local craft market. Mrs. Jeffries would buy the ingredients and make the jam. Andrew would help his mother seal it in jars and they planned to sell it at the market on Saturday mornings.

Before starting to boil the jam, they decided to test the market to see whether people would be interested in buying their product. Mrs. Jeffries therefore boiled a few jars of jam and asked their friends and family if they were interested in buying it and how much they would be willing to pay for it. Everyone was encouraged to taste some of the jam before making a decision.

The results Mrs. Jeffries received is are illustrated in the graph which indicates the demand at different prices.

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Demand Curve: This graph shows the demand curve based on the number of jars and the price.

The line on the graph indicates the way in which the change in price brought about a change in demand. This is referred to as the demand curve. It specifies the amount of a product according to the demands for it at a specific price.

Demand Curve

In economics, the demand curve is the graph depicting the relationship between the price of a certain commodity (in this case Andrew’s jam) and the amount of it that consumers are willing and able to purchase at that given price. It is a graphic representation of a demand schedule.

The demand curve for all consumers together follows from the demand curve of every individual consumer: the individual demands at each price are added together.

Demand Curve Characteristics

According to convention, the demand curve is drawn with price on the vertical axis and quantity on the horizontal axis. The demand curve usually slopes downwards from left to right; that is, it has a negative association (two theoretical exceptions, Veblen good and Giffen good). The negative slope is often referred to as the “law of demand”, which means people will buy more of a service, product, or resource as its price falls.

Linear Demand Curve

The demand curve is often graphed as a straight line in the form Q = a – bP where “a” and “b” are parameters. The constant “a” “embodies” the effects of all factors, other than price, that affect demand.

If income were to change, for example, the effect of the change would be represented by a change in the value of “a” and be reflected graphically as a shift on the demand curve. The constant “b” is the slope of the demand curve and shows how the price of the good affects the quantity demanded.

The graph of the demand curve uses the inverse demand function in which price is expressed as a function of quantity. The standard form of the demand equation can be converted to the inverse equation by solving for P or P = a/b – Q/b.

Shift of a Demand Curve

The shift of a demand curve takes place when there is a change in any non-price determinant of demand, resulting in a new demand curve.

Non-price determinants of demand are those things that cause demand to change even if prices remain the same—in other words, changes that might cause a consumer to buy more or less of a good even if the good’s price remained unchanged.

Some of the more important factors are:

  • the prices of related goods (both substitutes and complements)
  • income
  • population
  • expectations

However, demand is the willingness and ability of a consumer to purchase a good under the prevailing circumstances. Thus, any circumstance that affects the consumer’s willingness or ability to buy the good or service in question can be a non-price determinant of demand. For example, weather could effect the demand for beer at a baseball game.

The Influence of Supply and Demand on Price

Changes in either supply or demand will move the market clearing point and change the market price for a good.

Learning Objectives

Apply the basic laws of supply and demand to different economic  scenarios

Key Takeaways

Key Points

  • There are four basic laws of supply and demand.
  • Since determinants of supply and demand other than the price of the good in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as “shifts” in the curves).
  • Responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.

Key Terms

  • equilibrium price: The price of a commodity at which the quantity that buyers wish to buy equals the quantity that sellers wish to sell.

Introduction

The amount of a good in the market is the supply and the amount people want to buy is the demand. Consider a certain commodity, such as gasoline. If there is a strong demand for gas, but there is less gasoline, then the price goes up. If conditions change and there is a smaller demand for gas, due to the presence of more electric cars for instance, then the price of the commodity decreases.

The factors influencing supply include:

  • Price – As the price of a product rises, its supply rises because producers are more willing to manufacture the product because it’s more profitable.
  • Price of other commodities – There are two types: competitive supply (If a producer switches from producing A to producing B, the price of A will fall and hence the supply will fall because it’s less profitable to make A), and joint supply (A rise in one product may cause a rise in another. For instance, a rise in the price of wooden bedframes may cause a rise in the price of wooden desks and chairs. This means supply of wooden bedframes, chairs, and desks will rise because it’s more profitable. )
  • Costs of production – If production costs rise, supply will fall because the manufacture of the product in question will become less profitable.
  • Change in availability of resources – If wood becomes scarce, fewer wooden bedframes can be made, so supply will fall.

Factors influencing demand include:

  • Income
  • Tastes and preferences
  • Prices of related goods and services
  • Consumers ‘ expectations about future prices and incomes that can be checked
  • Number of potential consumers

Supply and Demand As an Economic Model

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price). This results in an economic equilibrium of price and quantity.

The four basic laws of supply and demand are:

  • If demand increases and supply remains unchanged, then it leads to higher equilibrium price and higher quantity.
  • If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and lower quantity.
  • If demand remains unchanged and supply increases, then it leads to lower equilibrium price and higher quantity.
  • If demand remains unchanged and supply decreases, then it leads to higher equilibrium price and lower quantity.

Graphical Representation of Supply and Demand

Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the good, the standard graphical representation, usually attributed to Alfred Marshall, has price on the vertical axis and quantity on the horizontal axis, the opposite of the standard convention for the representation of a mathematical function.

Since determinants of supply and demand other than the price of the good in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as “shifts” in the curves). By contrast, responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.

A graph the plots the supply and demand for a product based on the price, supply, demand, and quantity sold.

Supply and Demand: The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

Equilibrium

Since the demand curve slopes down and the supply curve slopes up, when they are put on the same graph, they eventually cross one another. The point where the supply line and the demand line meet is called the equilibrium point.

In general, for any good, it is at this point that quantity supplied equals quantity demanded at a set price. If there are more buyers than there are sellers at a certain price, the price will go up until either some of the buyers decide they are not interested, or some people who were previously not considering selling decide that they want to sell their good. This process normally continues until there are sufficiently few buyers and sufficiently many sellers that the numbers balance out, which should happen at the equilibrium point.

Elasticity of Demand

Elasticity of demand is a measure used in economics to show the responsiveness of the quantity demanded of an item to a change in its price.

Learning Objectives

Identify the key factors that determine the elasticity of demand for a good

Key Takeaways

Key Points

  • Price elasticities are almost always negative; only goods which do not conform to the law of demand, such as a Veblen good and a Giffen good, have a positive PED.
  • In general, the demand for a good is said to be inelastic (or relatively inelastic) when changes in price have a relatively small effect on the quantity of the good demanded.
  • The demand for a good is said to be elastic (or relatively elastic) when changes in price have a relatively large effect on the quantity of a good demanded.
  • A number of factors can thus affect the elasticity of demand for a good.

Key Terms

  • Veblen good: A good for which people’s preference for buying them increases as a direct function of their price, as greater price confers greater status. As the price gets higher, demand rises.
  • conjoint analysis: Conjoint analysis is a statistical technique used in market research to determine how people value different features that make up an individual product or service.
  • Giffen good: A good which people consume more of as the price rises; Having a positive price elasticity of demand. As price rises, more is consumed which increases demand.

Elasticity of Demand: an Overview

Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price.

More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall.

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Elasticity of Demand: The price elasticity of demand equation shows how the demand for a good or service changes based on the price.

Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as a Veblen good and a Giffen good, have a positive PED.

In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded.

The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.

Revenue is maximized when price is set so that the PED is exactly one. The PED of a good can also be used to predict the incidence (or “burden”) of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales data, and conjoint analysis.

Determinants

The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes (“wait and look”). A number of factors can thus affect the elasticity of demand for a good:

  • Availability of substitute goods: The more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made. In other words, there is a strong substitution effect. If no close substitutes are available, the substitution of effect will be small and the demand inelastic.
  • Breadth of definition of a good: The broader the definition of a good (or service), the lower the elasticity. For example, Company X’s fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist.
  • Percentage of income: The higher the percentage of the consumer’s income that the product’s price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost. The income effect is thus substantial. When the goods represent only a negligible portion of the budget, the income effect will be insignificant and demand inelastic.
  • Necessity: The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as in the case of insulin for those that need it.
  • Duration: For most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy, or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic.
  • Brand loyalty: An attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand.
  • Who pays: Where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.

Yield Management Systems

Yield management systems enable organizations to adapt pricing in real-time based on various factors impacting demand.

Learning Objectives

Understand the purpose of projecting demand changes, and varying prices to capture opportunities

Key Takeaways

Key Points

  • Yield management systems are predicated on the idea that demand is not consistent over time for certain types of products and services. Predicting shifts in demand will therefore provide potential value to the organization.
  • By accurately predicting changes in demand over time or over consumer groups, organizations can produce a profit -maximizing pricing strategy through varying price points with demand.
  • Yield management is a multidisciplinary field, which requires buy in from financiers, accountants, marketers, strategists and often technical specialists in big data.
  • Knowing when to use yield management and when not to is an important strategic decision. Goods that are perishable, scarce, and which have a high fluctuation in willingness to pay are ideal for this model.
  • There are ethical concerns revolving around yield management however, as charging individuals based on their ability to pay and overall demand could be as exploitation.

Key Terms

  • yield management: The marketing strategy of identifying variance in demand, and aligning pricing strategies to maximizing profits.

Estimating Demand

When an organization begins determining the price of a given product or service, the objective is to optimize profit through maximizing revenues and minimizing cost. To do so, projections of demand and fulfilling that projected demand with the appropriate supply to maintain the optimal price point is a central strategic endeavor for a marketer. Forecasting demand and understanding the elasticity of the demand for various types of goods is greatly empowered by systems built to manage yield.

A graph that the plots the supply and demand for a product based on the price, supply, demand, and quantity sold.

Demand Shifts: Understanding fluctuations in demand is a critical component of yield management systems.

Yield Management Systems

A yield management system is based on pricing models which are variable, which is to say that the price of a given product or service will change consistently over time. A good example of this, just as a frame of reference, would be a flight ticket. The prices for a flight from city A to city B will be different per day, per time, per airline and even per website in which you are finding that ticket. This variable pricing model is designed to maximize revenue through identifying supply, demand and optimal yield.

When To Manage Yield

Yield management is quite a complex endeavor, as it takes into account multidisciplinary considerations such as marketing, operations, financial management, statistics, and strategy to build an optimized approach to pricing which iterates and evolves over time. As a result, it is only worth building into practice when it will generate significant returns.

Yield management functions best when the following conditions are met:

  •  There are a fixed amount of a given resource available (i.e. scarcity)
  • The resources are perishable, or time-sensitive in some way
  • There is a relatively high amount of fluctuation in regards to what consumers are willing to pay

Combining these three factors, we have scarce products which will likely expire and which are valued differently by different consumers. In these situations, managing yield through pricing properly based on timing and user can optimize profits.

Big Data

Effective yield management, like most intensive research projects, are best left to computers. Machine learning and the capacity to process large data streams (i.e. big data) can create highly reliable statistical models and segmentation of markets to enable an organization to target the appropriate consumer groups with the appropriate price at the appropriate time. This is generally accomplished through building forecasts utilizing huge data streams of past user behaviors.

For example, the price of a flight on a given day can take into account he day of the week, time of year, inflation, market conditions, competitive current pricing, and a wide variety of other data points in order to create a statistical spread of what the price should be set at.

Ethical Concerns

Yield management systems are very useful in specific industries, but are also somewhat controversial. The criticism of yield management is fairly intuitive. If companies can set prices based upon what type of consumer you are, and can identify demand with great accuracy, it is fairly easy for organizations to exploit consumers in specific situations.

For example, say you are stranded in a foreign country after flight cancellations, and need to get home to your two young children. You are there on business, and have an upper-middle class salary. A machine with all of that information can accurately predict that you are willing to pay a great deal more than someone else due to your dire situation. It would not be inaccurate to point out that this is somewhat predatory, and therefore potentially unethical behavior. You may pay thousands for the seat, while the person next to you paid less than 10% of what you paid.