The Demand Curve and How It Works
Understanding the Relationship Between Price and Demand
The demand curve is a visual representation of how many units of a good or service will be bought at each possible price. It plots the relationship between quantity and price that's been calculated on the demand schedule, which is a table that shows exactly how many units of a good or service will be purchased at various prices.
As you can see in the chart, the price is on the vertical (y) axis, and the quantity is on the horizontal (x) axis. This chart plots the conventional relationship between price and quantity. The lower the price, the higher the quantity demanded. As the price decreases from p0 to p1, the quantity increases from q0 to q1.
The Law of Demand
This relationship follows the law of demand, which states that the quantity demanded will drop as the price rises, all other things being equal. The relationship between quantity and price will follow the demand curve as long as the four determinants of demand don't change. These determinants are:
- Price of related goods or services
- Income of the buyer
- Tastes or preferences of the buyer
- The expectation of the buyer (especially about future prices)
If any of these four determinants changes, the entire demand curve shifts because a new demand schedule must be created to show the changed relationship between price and quantity.
Demand curves are also used to show the relationship between quantity and price in aggregate demand, which is the total demand in society. It has the same determinants of demand, plus the number of potential buyers in the market.
The 2 Types of Demand Curves
The example above provides a general overview of the relationship between price and demand. But in the real world, different goods show different relationships between price and demand levels. This produces different degrees of demand elasticity.
In an elastic demand situation, a price decrease causes a significant increase in the quantities bought (and vice versa). Like a stretchy rubber band, the quantity demanded moves a lot with just a little change in prices.
An example of this would be ground beef; if prices drop just 25%, you might buy three times as much as you usually would because you know you'll use it eventually and can put the extras in the freezer. If demand is perfectly elastic, the curve looks almost like a horizontal flat line.
In a situation involving inelastic demand, a price decrease won't increase the quantities purchased. An example of this is bananas. No matter how cheap they are, there's only so many you can eat before they spoil. You won't buy three bunches even if the price falls 25%. If demand is perfectly inelastic, the curve looks almost like a vertical straight line.
The reason you react more to a sale on ground beef than a sale on bananas is because of the marginal utility of each additional unit. Marginal utility refers to the usefulness (utility) of each additional unit the further out on the margin you go. Because you can freeze ground beef, the third package is just as good to you as the first. The marginal utility of ground beef is high. Bananas lose their consistency in the freezer, so their marginal utility is low.
Shifting the Curve
If any determinants of demand other than the price change, the demand curve shifts. If demand increases, the entire curve will move to the right. That means larger quantities will be demanded at every price. If the entire curve shifts to the left, it means total demand has dropped for all price levels. For instance, if you just lost your job, you might not buy that third package of ground beef, even if it is on sale. You might just buy one package and be glad it's 25% off.
Aggregate or Market Demand Curve
The market demand curve describes the quantity demanded by the entire market for a category of goods or services, such as gasoline prices. When the price of oil goes up, all gas stations must raise their prices to cover their costs. Oil prices comprise 70% of gas prices; even if the price drops 50%, drivers don’t generally stock up on extra gas. That's why when the price skyrockets by $0.50–$1 per gallon, people get upset. They can't cut back their driving to work, school, or the grocery store, and are forced to pay more for gas. That’s an inelastic aggregate demand curve.
High gas prices lower people's disposable incomes for things other than gas, and that means the demand curve for those other things will drop. This is called a demand shift, and in this case, the entire demand curve for other goods shifts to the left. Since buyers have less income, they will purchase a lower quantity of a product even if its price doesn't rise.