Baetjer explains the “demand” half of “supply and demand.”
Howard Baetjer: Okay. Having talked about basic concepts in the first lectures, we’re going to go now in these next three to the wonderful apparatus of supply and demand, and how they can be used to think about and understand price determination — the way prices change, the way market quantities change. Now, we’re onto supply and demand. [00:00:30] Let me … for those who aren’t used to it yet I want to just sketch the whole picture quickly — so I’ll quickly put supply and demand together and show you the axis — then we’re going to go slowly and think much more carefully about what demand means, what does it mean for demand to increase or decrease. We’ll talk about the difference between demand and [00:01:00] quantity demanded — that’s an important distinction. We’ll talk about what changes in demand mean, and then on this section on demand we’ll talk about the main factors that can change demand. Okay?
First of all, as an introduction to supply and demand overall, let me just quickly sketch the supply and demand graph for you. By convention, we put price on the vertical axis, and we put quantity [00:01:30] on the horizontal axis. Okay? We’re looking at the relationship between price and quantity. The demand curve is downward sloping — D for downward sloping — the demand curve is downward sloping because, logically, at higher prices — other things being equal — people will want to buy a smaller quantity. Higher quantities are wanted for purchase when the price is lower, so that’s [00:02:00] why the demand curve slopes downward. The supply curve goes in the other direction and, logically, according to what we’ll talk about as the law of supply — if sellers, the suppliers, can only get low prices for their product — they wouldn’t be so excited about selling so much, so they’ll have smaller quantities at lower prices, but if prices that people will pay is high sellers will be excited about that, and they’ll be willing to offer a larger quantity for sale.
[00:02:30] We start with that, and then here is the magic point — this intersection is what the graph represents as the market equilibrium, and there’s a very strong tendency for the price that prevails in the market to be at that level. Very strong tendency. If markets are free there is a very powerful push and pull towards that price level, and, similarly, the equilibrium quantity down here — this will be the quantity [00:03:00] that changes hands in the market, in all of this is in a period of time. Anytime you say graph like this — unless otherwise specified — it means in a period of time. That’s the quantity that’s bought by some people, sold by others in a week, or in a month, or whatever the period might be. This is sort of the punchline.
This is where we are going to get — just as an overview for those who haven’t had the supply and demand analysis yet. Now, let’s focus in on demand, and what [00:03:30] we mean by demand. The basic insight is absolutely familiar to almost all of us. If a store wants to get rid of its summer clothing to make room to put on the shelves it’s fall clothing, what are they going to do? How can a store get rid of the clothing it has on the racks now? Say, “Lower their prices.”
Students: Lower their [00:04:00] prices.
Howard Baetjer: Okay. There is the law of demand. The point I want to make here is that everyone is familiar with it even if they never have heard that term before. The law of demand holds that other things being equal at higher prices people don’t want to buy as much, at lower prices they want to buy more. Okay? Now, demand refers to actual and potential buyers and the prices they are willing to pay. So, it’s the buyers [00:04:30] and the prices they’re willing to pay. It’s a representation of people who might be willing to buy this good — whatever it might be. Now, as we’ve said different people have different values, right? Different people will pay different amounts for things. They have different intensity of desire.
One of you earlier pointed out the case of an auction. At an auction, we discover how much different people are willing to pay for something. It’s the identical good, but different people are willing to pay different amounts for it. [00:05:00] Well, with the demand curve we try to represent that. In the absence of a graphical or conceptual representation like demand, we are faced with the fact that they are all these people who are interested in buying whatever good it is and they are in different places. Well, how do we organize it in our minds so we can think about it well? What we do is create a demand curve or a demand schedule. So, a demand curve or a demand [00:05:30] schedule is a way of organizing in our minds this great diversity of the buyers. What we do is we say, “Okay. Let’s suppose we could line them up. We’ll put whoever’s most willing to pay first, and then who’s going to pay the next amount, and then the next amount, and the next, and the next, and the next, and so on, and we’ll line them up mentally.”
That’s what a demand curve is. It’s not something that’s inherent in the nature of things. A demand curve [00:06:00] is a human artifact. It’s a really cool piece of, “Let’s think about it this way.” Okay? Now, if you will take a look please at the graph that I gave you on the table here with the … that imagines a very, very simple market for bottles of water, and the five different people whose names just by funny accident start with A, B, C, D, and E. I’ve made up for them just arbitrarily [00:06:30] different willingness to pay for additional bottles of water. You see this represented in the page in front of you or on the screen. We’ll imagine Arthur’s willing to pay three dollars for a first bottle. Once he has one, he’s willing to pay only a dollar for a second, and then he doesn’t even want a third, and similarly for the other imaginary characters in this market. Okay?
Well, how do we make sense of this complex reality — these different people with their different wishes? As I said, we line them up [00:07:00] in our imaginations, and we get this demand curve where Charlie, who’s willing to pay the most, is over there. He’s willing to pay ten dollars, so he’s the first one there, and he’s in that position. The person willing to pay the next most is Ellie, so she is in the second position willing to pay nine dollars. We arrange the various buyers in this market according to their willingness to pay in the manner that’s shown. You’re with me? That’s [00:07:30] what we do … In principle, guys, all demand curves are that way. Now, most of the time we’ll have something simple. We won’t have names on them.
We’ll just have the smooth curve drawn in a downward fashion, but when you see a demand curve like that, I recommend that you think of it, not as a line on a whiteboard or on a page, but think of it as representing different people. Every point on that curve is somebody who’s willing to pay that amount for one more of [00:08:00] whatever the good is. That’s what a demand curve represents. It represents people’s different willingness to pay for things. Okay? All right.
By convention, we put all values on the vertical axis. So, we put price on the vertical axis. In the case of a demand curve which really represents the value of each marginal good to each next buyer, on the vertical [00:08:30] axis we could label that willingness to pay or value to buyer. The downward slope that you’ll notice represents the law of demand we’ve talked about: other things being equal, at lower prices, people are willing to buy more. Again, think of a demand curve as representing human psychology. Representing human behavior. Don’t think of supply and demand graphs as exercises in geometry. All [00:09:00] right?
Now, there are two kinds of information represented by the curve. One is information about quantity for every price. A demand curve will give you a quantity that people are willing to buy at every different price. That’s one kind of information that a demand curve gives you. At any price, you might be interested in it will tell you the quantity demanded. I’ll repeat that because that’s sort [00:09:30] of fundamental. At any price, a demand curve shows you the quantity demanded at that price. Now, let’s turn it around. You can take it the other way. What does a demand curve tell us about any marginal quantity that might be purchased by the people in this market? Take, for example, the seventh bottle of water. What does them demand curve tells about that seventh bottle of water?
Student: [00:10:00] It will be valued at three dollars and go to-
Howard Baetjer: Good for you. It’s valued at three dollars to the buyer or its worth three dollars to the buyer. Good. So, for any marginal — any additional — unit that might be purchased the demand curve tells you the value to the purchaser. All right? Those are the two kinds of information that a demand curve gives us. Take a look at my description of Arthur, Betsy, Charlie, Donna, and Ellie. What do you notice under willingness [00:10:30] to pay about what happens to their willingness to pay for each additional or marginal bottle? Are they willing to pay more or less?
Howard Baetjer: Less. Why does that make sense? Take a moment and think. This is a standard principle in economics recall the principle of diminishing marginal utility. Meaning that with each additional or marginal unit of something we have the utility, or usefulness, [00:11:00] or value to us goes down. Why would the value or the utility of each additional unit of something decrease for us?
Student: Well, once you’ve already satisfied your thirst on the first bottle each subsequent bottle is less valuable.
Howard Baetjer: Sure. In this case when we are thinking about water for satisfying our thirst — if you’re thirsty that first bottle really matters, right? Once you’ve had the first one is the second one as attractive? No. You may still want a second bottle, but not as badly [00:11:30] as you wanted the first one. Okay? That’s the principle of diminishing marginal utility.
Here now, if we are talking about identical units, each additional identical unit of something will be of less value to someone because with the first unit he or she has satisfied the most urgent want for it. That’s the principle of diminishing marginal utility.
Now, quantity demanded — as we’ve just seen – is [00:12:00] meaningful at any price. At any price, we can see the different quantity demanded in a market from a demand curve. Demand is that whole curve. It’s that whole line. That whole jagged line. The demand is the entire set of relationships. Okay? You could answer it this way — you could say, “What does demand here say?” Well, it’s one bottle at ten dollars, two bottles at nine dollars, three bottles at seven dollars, and you could go right down and say it that way. That would be demand. [00:12:30] With reference to the graph, the demand is that entire curve. Not a position on the curve but the whole curve. To repeat: quantity demanded is a point that makes sense at some price. So, quantity demanded is that point at the price, but demand is the whole curve. Okay?
Let’s think now about the kinds of things that can increase the demand overall. If you look at the next piece of paper [00:13:00] that I’ve given you to look at — the next graph — I imagine that two new guys come into the market. One is named Frank, one’s name to Gary, and each of them has a different individual demand or desire for water. Frank will pay eleven dollars for a first bottle, and six for a second. Gary is willing to pay seven dollars for a first bottle, five for a second, and one for a third. Well, if we add the demand of those two guys to the demand we already [00:13:30] had in the market — we go from that curve on the left to the one on the right. I’ve plotted in there for you the willingness of each of those two men to buy water. Here the demand overall has increased. The whole curve has shifted out to the right. The whole set of relationships has changed. You’re with me?
Howard Baetjer: What has happened to quantity demanded [00:14:00] at every price? What has happened to quantity demanded and every price? It has …
Howard Baetjer: Increased. Okay, and that’s one meaning of an increased in demand. Thinking right and left about starting with prices an increase in demand means at any price quantity demanded is larger now. That’s thinking of it as a rightward shift, but we can also think of it as an upward shift. To repeat for summary purposes: [00:14:30] an increase in demand can be looked at as a rightward shift — meaning at any price the quantity demanded is greater — or it can be looked at as an upward shift in which we say that for any particular unit of this good its value has increased. Okay? That’s how to make sense of a demand curve. Now, let’s think about the kinds of factors that can change demand. I’ll give you a product [00:15:00] and a factor that can cause a change in demand, and you tell me does demand increase or decrease. Okay? Let’s take the market for assisted living facilities. This is actually something that — being a baby boomer — is a little unpleasant for me to think about, but it makes for a good example. As the baby boomers retire, what probably will happen to the demand for assisted living facilities?
Howard Baetjer: It will increase. God help [00:15:30] us all. How about … To give you the category, demographic changes can change demand: immigration, aging of population. I’m giving you now factors that, typically, will change demand. One of them is a demographic change. The change in population patterns, okay? Next one is tastes. What has happened in the United States to the demand for cigarettes [00:16:00] over the last four or five decades? What has happened to the demand for cigarettes?
Howard Baetjer: Decrease because people just aren’t interested in smoking so much — mostly for health reasons. So, different tastes will affect demand. What has happened to … The category here is substitute prices. Let’s think about Pepsi-Cola and Coca-Cola. What will happen to the demand for Coca-Cola [00:16:30] if Pepsi gets more expensive? If Pepsi gets more expensive will the demand for Coca-Cola increase or decrease?
Howard Baetjer: It will increase because people will turn away from … We call these substitutes. Coke and Pepsi are substitutes, so if the price of one substitute gets higher people will go to the other and increase the demand therefore for that. How about complement prices? Peanut butter and jelly are complements. We like to eat them together [00:17:00] on our sandwiches. If the price of jelly goes up — other things equal — what do you suppose will happen to the demand for peanut butter? Don’t say anything while I think it through. If jelly gets more expensive what’s the reason? What will happen to the demand for peanut butter?
Howard Baetjer: Decrease. Why?
Student: The demand for jelly will be decreased.
Howard Baetjer: Careful. The quantity demanded for jelly will decrease.
Student: Oh, yeah.
Howard Baetjer: If the price of jelly rises the [00:17:30] quantity demanded will decrease, right? If people are buying less jelly, they have less demand for peanut butter to go with it. So, prices of substitutes will affect demand of it substitutes.
Prices of complements will affect demand. Expectations. Suppose people in United States for some reason come to expect gasoline prices to be much higher next week. What will happen to demand today?
Howard Baetjer: Skyrocket.
Student: Way up.
Howard Baetjer: It’ll increase, okay? Because people will [00:18:00] want to fill up their tanks before prices go up. It’s really quite a wonderful … That sort of thing is an illustration of how wonderfully, rapidly markets will work. The minute people expect prices to be higher next week they’re higher today because demand increases. Finally, what we call derived demand: where the demand for an input product, a resource, is derived from the demand for what that resource is used to produce. [00:18:30] Let’s take housing. Suppose that housing is booming. As housing booms what will happen to the demand for two by fours with which to build houses? If housing booms demand for 2 x 4’s will …?
Howard Baetjer: Increase. Okay. Those are some of the kinds of things that affect demand in can change demand. That is, shift [00:19:00] the whole curve.