The Demand Curve and How It Works
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. That's 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 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 change, the entire demand curve shifts. That's 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. That's the total demand in society. It has the same determinants of demand, plus the number of potential buyers in the market.
The Two Types of Demand Curves
The demand curve plots the demand schedule on a graph. The shape of the curve will tell you how much price affects demand for a product.
Elastic demand is when a price decrease causes a significant increase in quantities bought. 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 percent, you might buy three times as much as you usually would. That's because you know you'll use it and you'll just put the extra in the freezer. If demand is perfectly elastic, the curve looks like a horizontal flat line.
Inelastic demand is when 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. Freezing them changes them. You won't buy three bunches even if the price falls 25 percent. If demand is perfectly inelastic, the curve looks 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.
If any determinants of demand other than 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 example, 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 the one package and be glad it's 25 percent 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. An example of this is gasoline prices. When the price of oil goes up, all gas stations must raise their prices to cover their costs. Oil prices comprise 71 percent of gas prices. Even if the price drops 50 percent, drivers don’t stock up on extra gas. That's why, when the price skyrockets from $3.20 to $4.00 a gallon, people get upset. They can't cut back their driving to work, school and the grocery store.
As a result, they are forced to pay more for gas. That’s an inelastic aggregate demand curve.
High gas prices lower their incomes for things other than gas. Income is another determinant of demand. That means the demand curve for other things they would like to buy, like ice cream, will drop. This is called a demand shift. In this case, the entire demand curve for ice cream shifts to the left. Since buyers have less income, they will purchase a lower quantity of ice cream even if ice cream prices don’t rise.