ENGINEERING ECONOMICS : NOTES LAW OF DEMAND

 

The Demand Curve

 

What is a demand curve? A demand curve illustrates on a graph how much of a particular good or service people are willing to buy as its price changes.

When the price for a good or service goes down, demand tends to increase. That’s why stores can look a little crazy on Black Friday: retailers cut prices to ensure that they’ll be “in the black” for the year and shoppers load up on presents for Christmas.

On a graph, the demand curve slopes downward with prices indicated on the vertical axis and the quantity demanded on the horizontal axis. Every good or service has its own demand curve, but they function the same way.

Oil is a crucial good throughout the world, so let’s take a look at its demand curve. When the price for oil is high internationally  let’s say $55 per barrel, the quantity demanded might be five million barrels. Oil has a lot of uses, but some of them are considered low-value and there are substitute goods available. So if the price of oil is on the high end, demand for these low-value uses will be lower.

However, oil has a number of high-value uses without many substitutes. For example, planes requires oil for jet fuel. At that high price of $55 per barrel, you’re still going to need to pay up in order to fly a plane. But at that same price, drivers may opt to carpool, switch to a vehicle that can use ethanol or a hybrid car, or take fewer trips to avoid the high price of gas.

Now, when oil drops to $20 or even $5 per barrel, many more barrels are demanded. Suddenly, it makes sense to use oil instead of finding substitute goods or economizing for oil’s low-value uses.

We’ll cover more details in the video and demonstrate graphing the demand curve. But demand is only one piece of the puzzle for this first section. The supply curve and the equilibrium price and quantity are up next.

 

The Law of Demand states that the quantity demanded for a good or service rises as the price falls, ceteris paribus (or with all other things being equal). The other-things-being-equal assumption is very important in law because the demand for goods also varies with several other factors tha

1. The Substitution Effect

The Substitution Effect occurs when there is a change in the price of a product. For example, we say that the price of olive oil has gone up. In comparison to olive oil, other cooking oils such as canola oil or peanut oil suddenly seem less expensive. Therefore, people will switch to a close substitute if the price goes up and the demand will increase.

To put it another way, if the price of a substitute of good X goes up, then good will become relatively cheaper and people will move towards good X. There will be an increase in demand for good X.

o take a real-world example, consider Coke and Pepsi. They are universally recognized to be good substitutes for each other. The Substitution Effect states that when the price of Coke goes up, then more people will more likely purchase Pepsi.

2. The Income Effect

The Income Effect also occurs when there is a change in the price of a product. For example, let’s say you buy four loaves of bread a month and then one day the price of a loaf of bread goes up. This increase in price will likely mean that you cannot afford to buy four loaves. Instead, you buy two. You’ve lowered your demand for bread because the price increase has reduced your disposable income. You won’t necessarily stop buying bread or switch over to something cheaper; you buy less.

Stated differently, if the price of good X rises, then the consumer’s purchasing power will drop and then people will tend to buy less of good X will the same income. The Income Effect simply means that when a good becomes more expensive then people can afford less of it.