Law of Demand Pro

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Economics Project Law Of Demand


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Table of contents

Acknowledgement

Introduction

Brief history

Deriving Demand

Importance of Law of Demand

Mathematical expression

Macro concepts of demand

Microeconomics Theory of Demand

Assumptions

Exceptions to the Law of Demand.


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Introduction

What Does Law Of Demand Mean?A microeconomic law that states that, all other factors being equal, as the price of a good orservice increases, consumer demand for the good or service will decrease and vice versa.

In economics, the law of demand is an economic law that states that consumers buy more of a

good when its price decreases and less when its price increases (ceteris paribus).

The greater the amount to be sold, the smaller the price at which it is offered must be, in

order for it to find purchasers.

Law of demand states that the amount demanded of a commodity and its price are inversely

related, other things remaining constant. That is, if the income of the consumer, prices of the

related goods, and tastes and preferences of the consumer remain unchanged, the consumersdemand for the good will move opposite to the movement in the price of the good.

The law of demand and its application to fundamental analysis of commodities rests upon anunderstanding of consumer behavior. The factors which characterize consumer choice and howindividual consumer responses are reflected in the market place are key components of thiseconomic theory. Understanding what factors have affected demand in the past will help todevelop expectations about demand in the future and the impact on market price.

Demand for a particular product or service represents how much people are willing to purchaseat various prices. Thus, demand is a relationship between price and quantity, with all otherfactors remaining constant. Demand is represented graphically as a downward sloping curve withprice on the vertical axis and quantity on the horizontal axis (figure 1)

Generally the relationship between price and quantity is negative. This means that the higher isthe price level the lower will be the quantity demanded and, conversely, the lower the price thehigher will be the quantity demanded. Market demand is the sum of the demands of allindividuals within the marketplace. Market demand will be affected by other variables in


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addition to price, such as various value added services including handling, packaging, location,quality control, and financing. Thus the demand for an agricultural commodity is typicallyderived from the demand for a finished product.

It is important to understand that a free market economy is driven not by producers but byconsumers. Ultimately the market value for any good or service is determined by its value tothe consumer. Higher prices mean higher profits and a higher profit provides you with theincentive and the means to expand production of those goods and services that consumers valuethe most. So profit driven expansion is the market's response to stronger buyer demand. Onthe other hand, when consumers are unwilling to buy what is offered at the current price, theseller will have to lower the price ultimately resulting in lower profits or losses to you theproducer. Losses reduce the producer's incentive to produce things that have weak demandwhich will ultimately force production cuts as farmers lose more and more money.

This is the discipline of the marketplace. Those who produce things that consumers are willingand able to buy are rewarded. Those who produce things that consumers don't want or can't buy

are penalized. Farmers must produce for the markets. They cannot expect to find or create aprofitable market for whatever they choose to produce.


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Brief history

The power of supply and demand was understood to some extent by several early Muslim

economists, such as Ibn Taymiyyah who illustrates.

"If desire for goods increases while its availability decreases, its price rises. On the otherhand, if availability of the good increases and the desire for it decreases, the price comes

down."John Locke's 1691 work Some Considerations on the Consequences of the Lowering of Interest

and the Raising of the Value of Money includes an early and clear description of supply and

demand and their relationship. In this description demand is rent: The price of any commodity

rises or falls by the proportion of the number of buyer and sellers and that which regulates

the price [of goods] is nothing else but their quantity in proportion to their rent.

The phrase "supply and demand" was first used by James Denham-Steuart in his Inquiry into

the Principles of Political economy, published in 1767. Adam Smith used the phrase in his 1776

book. The Wealth of Nations, and David Ricardo titled one chapter of his 1817 work Principlesof Political Economy and Taxation "On the Influence of Demand and Supply on Price". In The

Wealth of Nations, Smith generally assumed that the supply price was fixed but that its

"merit" (value) would decrease as its "scarcity" increased, in effect what was later called the

law of demand. Ricardo, in Principles of Political Economy and Taxation, more rigorously laid

down the idea of the assumptions that were used to build his ideas of supply and

demand. Antoine Augustin Cournot first developed a mathematical model of supply and demand

in his 1838 Researches into the Mathematical Principles of Wealth, including diagrams.

During the late 19th century the Marginalist school of thought emerged. This field mainly wasstarted by Stanley Jevons, Carl Menger, and Lon Walras. The key idea was that the price was

set by the most expensive price, that is, the price at the margin. This was a substantial change

from Adam Smith's thoughts on determining the supply price.

In his 1870 essay "On the Graphical Representation of Supply and Demand", Fleeming Jenkin in

the course of "introducing the diagrammatic method into the English economic literature"

published the first drawing of supply and demand curves therein, including comparative

statics from a shift of supply or demand and application to the labor market. The model was

further developed and popularized by Alfred Marshall in the 1890 textbook, Principles ofEconomics.


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Deriving Demand

(This section is takes one a bit beyond where one needs to go in introductory economics, but itillustrates how indifference curves are used.)

To show what the consumer should do to maximize utility, a budget line must be added to the

preferences shown in the indifference curves. The picture below adds one. Point a is notattainable because it lies to the right of the budget line. The consumer is indifferent betweenpoints b and d because they lie on the same indifference curve, but point d is cheaperthan b because d lies below the budget line. The consumer wants to get on the highestindifference curve affordable, and this will lead him to point c.

The effect of a rise in the price of good A is shown on the graph below. A higher priceof A means that less of A can be purchased, and hence the budget line moves to the left,

intersecting the vertical axis at a lower point. Point c is no longer possible and the consumermust move to a new position, which, assuming utility maximization, will be point b. Unless theindifference curves are peculiar, point b will represent less of good A than will point c, which iswhat the law of demand says will happen.

Looking at two different prices has produced two different points on an individual's demandcurve. By varying the price of good A, other points could be found and an entire demand curve


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for one individual consumer constructed. The market demand curve is obtained by adding up thedemand curves of all individuals.

The theory of consumer choice that the indifference curves embody is an elegant constructionwith which economists frame problems. One of its weaknesses is that a great many outcomesare consistent with it--though a downward-sloping demand curve can be derived from it, so toocan an upward sloping demand curve. Further, in recent years there has been a realizationamong economists that pictures such as those above may not be a good description of thedecision-making process when people must make decisions with partial information, with fuzzygoals, under conditions of risk and uncertainty, and when options are difficult to compare.Finally, there do seem to be cases in which people systematically violate the rules that thistheory says are rational


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Importance of Law of Demand:

(i) Determination of price. The study of law of demand is helpful for a trader to fix the priceof a commodity. He knows how much demand will fall by increase in price to a particular leveland how much it will rise by decrease in price of the commodity. The schedule of marketdemand can provide the information about total market demand at different prices. It helps

the management in deciding whether how much increase or decrease in the price of commodityis desirable.

(ii) Importance to Finance Minister. The study of this law is of great advantage to the financeminister. If by raising the tax the price increases to such an extend than the demand isreduced considerably. And then it is of no use to raise the tax, because revenue will almostremain the same. The tax will be levied at a higher rate only on those goods whose demand isnot likely to fall substantially with the increase in price.

(iii) Importance to the Farmers. Goods or bad crop affects the economic condition of thefarmers. If a goods crop fails to increase the demand, the price of the crop will fall heavily.The farmer will have no advantage of the good crop and vice-versa.

Summing up we can say that the limitations or exceptions of the law of demand stated above donot falsify the general law. It must operate.


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Mathematical expression

The negative relation (i.e., higher price attracts lower demand & lower prices encourages high

quantity to be bought by the consumers) is based on logic and experience. Mathematically,

the inverse relation may be stated with causal relation as:

Qx = f(Px)

Where, Qx is the quantity demanded of x goods

f is the function of independent variables contained within the parenthesis, and

Px is the price of x goods.

Hence, in the above model, the function (f) is a varying one i.e., the law of demand

postulates Px as the causal factor (independent variable) and Qx is the dependent variable.

The two variables move in the opposite direction. When Px falls Qx rises and the reverse. In

regard to the question "by how much will quantity demanded rise?", the law is silent. For

example, when Pxfor a one-way rail ticket on the Acela Express from Boston's South Station toNew York City's Penn Station falls from $111 to $105, ridership may rise from 1625 daily riders

to 1825 daily riders or even to just 1626 daily riders. Thus the law of demand merely states the

direction in which quantity demanded changes for a given change in price. Moreover, what the

law states is hypothetical and not actual.

Formula for Law of Demand:

Qdx = f (Px, M, Po, T,..........)

Here:Qdx= A quantity demanded of commodity x.f = A function of independent variables contained within the parenthesis.Px= Price of commodity x.Po = Price of the other commodities.T = Taste of the household.The bar on the top of M, Po, and T means that they are kept constant. The demand function can

also be symbolized as under:Qdx = f (Px) ceteris paribus

Ceteris Paribus.In economics, the term is used as shorthand for indicating the effect of oneeconomic variable on another, holding constant all other variables that may affect the secondvariable.


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Macro concepts of demand

Individual demand, firms demand and industry demand are the micro concepts of demand. This

is useful to manager in decision making as to determination of size of supplies etc. However, a

manger has to know the macro concepts of demand as he operates within the macroeconomic

environment. As such he much understands a few macro concepts of demand. As a matter of

fact, national demand may influence the industry demand which in its turn may influence thefirms demand. Some of the important macro-concepts of demand are illustrated below.

Effective demand

This refers to the aggregate volume of demand in an economy, (size of the market), which

induces the manufacturers to adjust that demand by supply. Thus if demand is effective, it

should create employment, induce output and generate income in the economy price itself is the

most important determinant of demand for the product.

Consumption demand

It is concerned with the demand for consumer goods i.e., consumption expenditure of a nationwhich depends on national income.

Investment demand

It is another component of effective demand. It has reference to the demand for investment

goods i.e., investment expenditure in the national economy which is dependent on the net return

on investment.

Demand for moneyThis refers to desire to hold money (liquidity) in hand. In any of the three motives i.e.,

transaction, precaution or speculation. Accordingly, we may speak of transaction demand for

money to meet day-to-day exchange transactions. The precautionary demand for moneys to

meet contingency requirements. The speculative demand for money has got long-term business

use; it is mostly influenced by the market rate of interest. In fact, the rate of interest is the

opportunity costs of holding money in hand for speculative purposes.

Demand for bonds

Since money and bonds are substitutes, the demand for bonds is related to the demand formoney.


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Limitations

Change in taste or fashion. Change in income Change in other prices. Discovery of substitution. Anticipatory change in prices. Rare or distinction goods.[3]There are certain goods which do not follow this law. These include Veblen goods and Giffen

goods.


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Microeconomics Theory of Demand

Demand

Demand is defined as the quantity of a good or service that consumers are willingand able to buy at agiven price in a given time period. Each of us has an individual

demand for particular goods and services and the level of demand at each marketprice reflects the value that consumers place on a product and their expectedsatisfaction gained from purchase and consumption.

Market demand

Market demand is the sum of the individual demand for a product from eachconsumer in the market. If more people enter the market and they have theability to pay for items on sale, then demand at each price level will rise.

Effective demand and willingness to pay

Demand in economics must be effective which means that only when a consumers'desire to buy a product is backed up by an ability to pay for it does demandactually have an effect on the market. Consumers must have sufficient purchasingpower to have any effect on the allocation of scarce resources. For example, whatprice are you willing to pay to view a world championship boxing event and how muchare you prepared to spend to watch Premiership soccer on a pay-per-view basis?Would you be willing and able to pay to watch Elton John perform live through a

subscription channel?

Auctions of film posters

Classic film posters are fetching thousands of pounds as more and more privatecollectors vie for a piece of cinema history. The prices that collectors are preparedto pay for film posters continues to rise, some of the buyers are hoping for afinancial return whereas others are just willing and able to pay for the satisfactionthat comes from owning a small slice of cinema memorabilia.

Latent Demand

Latent demand is probably best described as the potential demand for a product.It exists when there is willingness to buy among people for a good or service, butwhere consumers lack the purchasing power to be able to afford the product.Latent demand is affected by advertising where the producer is seeking toinfluence consumer tastes and preferences.


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The concept of derived demand

The demand for a product X might be strongly linked to the demand for a relatedproduct Y giving rise to the idea of a derived demand.

For example, the demand for steel is strongly linked to the demand for newvehicles and other manufactured products, so that when an economy goes into a

downturn or recession, so we would expect the demand for steel to decline likewise.The major producer of steel in the UK is Corus. They produce for a wide range ofdifferent industries; from agriculture, aerospace and construction industries toconsumer goods producers, packing and the transport sector. Steel is a cyclicalindustry which means that the total market demand for steel is affected bychanges in the economic cycle and also by fluctuations in the exchange rate.

The Law of Demand

Other factors remaining constant (ceteris paribus) there is an inverse relationshipbetween the price of a good and demand.

y As prices fall, we see an expansion of demandy If price rises, there will be a contraction of demand.

The ceteris paribus assumption

Understanding ceteris paribus is the key to understanding much ofmicroeconomics. Many factors can be said to affect demand. Economists assume allfactors are held constant (ie do not change) except one the price of the productitself. A change in a factor being held constant invalidates the ceteris paribusassumption

The Demand Curve

A demand curve shows the relationship between the price of an item and thequantity demanded over a period of time. There are two reasons why more isdemanded as price falls:

y The Income Effect: There is an income effect when the price of a goodfalls because the consumer can maintain current consumption for lessexpenditure. Provided that the good is normal, some of the resultingincrease in real income is used by consumers to buy more of this product.


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y The Substitution Effect: There is also a substitution effect when the priceof a good falls because the product is now relatively cheaper than analternative item and so some consumers switch their spending from the goodin competitive demand to this product.

The demand curve is normally drawn in textbooks as a straight line suggesting alinear relationship between price and demand but in reality, the demand curve willbe non-linear! No business has a perfect idea of what the demand curve for aparticular product looks like, they use real-time evidence from markets to estimatethe demand conditions and they accumulated experience of market conditions givesthem an advantage in constructing demand-price relationships.

A change in the price of a good or service causes a movement along the demand

curve. A fall in the price of a good causes an expansion of demand; a rise in pricecauses a contraction of demand. Many other factors can affect total demand -when these change, the demand curve can shift. This is explained below.

Shifts in the Demand Curve Caused by Changes in the Conditions of Demand

There are two possibilities: either the demand curve shifts to the right or it shiftsto the left.In the diagram below we see two shifts in the demand curve:


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y D1 D3 would be an example of an outward shift of the demand curve (or anincrease in demand). When this happens, more is demanded at each price.

y A movement from D1 D2 would be termed an inward shift of the demandcurve (or decrease in demand). When this happens, less is demanded at eachprice.

The conditions of demand

The conditions of demand for a product in a market can be summarised as follows:

D = f (Pn, PnPn-1, Y, T, P, E)

Where:

Pn = Price of the good itselfPnPn-1 = Prices of other goods e.g. prices of Substitutes and ComplementsY = Consumer incomes including both the level and distribution of incomeT = Tastes and preferences of consumersP = The level and age-structure of the populationE = Price expectations of consumers for future time periods


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Changing prices of a substitute good

Substitutes are goods in competitive demand and act as replacements for anotherproduct.

For example, a rise in the price of Esso petrol should cause a substitution effectaway from Esso towards competing brands. A fall in the monthly rental charges ofcable companies or Vodafone mobile phones might cause a decrease in the demandfor British Telecom services. Consumers will tend over time to switch to thecheaper brand or service provider. When it is easy and cheap to switch, thenconsumer demand will be sensitive to price changes.

Much depends on whether consumers have sufficient information about prices fordifferent goods and services. One might expect that a fall in the charges from one

car rental firm such as Budget might affect the demand for car rentals from AvisHertz or Easycar. But searching for price information to get the best deal in themarket can be time consuming and always involves an opportunity cost. Thedevelopment of the internet has helped to increase price transparency therebymaking it easier for consumers to compare relative prices in markets.

Changing price of a complement

Two complements are said to be in joint demand. Examples include: fish and chips,DVD players and DVDs, iron ore and steel.

A rise in the price of a complement to Good X should cause a fall in demand for X.For example an increase in the cost of flights from London Heathrow to New Yorkwould cause a decrease in the demand for hotel rooms in New York and also a fall inthe demand for taxi services both in London and New York.A fall in the price of a complement to Good Y should cause an increase in demandfor Good Y. For example a reduction in the market price of computers should leadto an increase in the demand for printers, scanners and software applications.

Change in the income of consumers

Most of the things we buy are normal goods. When an individuals income goes up,their ability to purchase goods and services increases, and this causes an outwardshift in the demand curve. When incomes fall there will be a decrease in thedemand for most goods.


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Change in tastes and preferences

Changing tastes and preferences can have a huge effect on demand. Persuasiveadvertising is designed to cause a change in tastes and preferences and therebycreate an outward shift in demand. A good example of this is the recent surge in

sales of smoothies and other fruit juice drinks.

Discretionary income

Discretionary income is disposable income less essential payments like electricity &gas and, especially, mortgage repayments. An increase in interest rates often meansan increase in monthly mortgage payments reducing demand. And during 2005 and2006 we have seen a sharp rise in the cost of utility bills with a series of hikes inthe prices of gas and electricity. This has eaten into the discretionary incomes of

millions of households across the UK. The discretionary incomes of people sufferingfrom fuel povertyhave become a major current issue.

Interest rates and demand

Many products are bought on credit using borrowed money, thus the demand forthem may be sensitive to the rate of interest charged by the lender. Therefore ifthe Bank of England decides to raise interest rates the demand for many goodsand services may fall. Examples of interest sensitive products include householdappliances, electronic goods, new furniture and motor vehicles. The demand for

housing is affected by changes in mortgage interest rates.


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Assumptions

Every law will have limitation or exceptions. While expressing the law of demand, the

assumptions that other conditions of demand were unchanged. If remain constant, the inverse

relation may not hold well. In other words, it is assumed that the income and tastes of

consumers and the prices of other commodities are constant. This law operates when the

commoditys price changes and all other prices and conditions do not change. The mainassumptions are

Habits, tastes and fashions remain constant Money, income of the consumer does not change. Prices of other goods remain constant The commodity in question has no substitute The commodity is a normal good and has no prestige or status value. People do not expect changes in the prices.

Exceptions to the law of demand

Generally, the amount demanded of good increases with a decrease in price of the good and vice

versa. In some cases, however, this may not be true. Such situations are explained below.

Giffen goods

As noted earlier, if there is an inferior good of which the positive income effect is greater than

the negative substitution effect, the law of demand would not hold. For example, when the price

of potatoes (which is the staple food of some poor families) decreases significantly, then a

particular household may like to buy superior goods out of the savings which they can have nowdue to superior goods like cereals, fruits etc., not only from these savings but also by reducing

the consumption of potatoes. Thus, a decrease in price of potatoes results in decrease in

consumption of potatoes. Such basic good items (like bajra, barley, grain etc.) consumed in bulk

by the poor families, generally fall in the category of Giffen goods. It should be noted that not

all inferior goods are giffen goods, but all giffen goods are inferior goods. This is similar to how

all men are humans but not all humans are men. A walkman is considered an inferior good but

would not be a Giffen good.

Commodities which are used as status symbolsSome expensive commodities like diamonds, air conditioned cars, etc., are used as status

symbols to display ones wealth. The more expensive these commodities become, the higher

their value as a status symbol and hence, the greater the demand for them. The amount

demanded of these commodities increase with an increase in their price and decrease with a

decrease in their price. Also known as a Veblen good.


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Expectation of change in the price of commodity

If a household expects the price of a commodity to increase, it may start purchasing greater

amount of the commodity even at the presently increased price. Similarly, if the household

expects the price of the commodity to decrease, it may postpone its purchases. Thus, law of

demand is violated in such cases.

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n the above circumstances, the demand curve does not slope down from left to right instead itpresents a backward sloping from top right to down left as shown in diagram. This curve is

known as exceptional demand curve.

Law of demand and changes in demand

The law of demand states that, other things remaining same, the quantity demanded of a good

increases when its price falls and vice-versa. Note that demand for goods changes as a

consequence of changes in income, tastes etc. Hence, the demand may sometime expand or

contract and increase or decrease. In this context, let us make a distinction between two

different types of changes that affect quantity demanded, viz., expansion and contraction; andincrease and decrease.

While stating the law of demand i.e., while treating price as the causative factor, the relevant

terms are Expansion and Contraction in demand. When demand is changing due to a price change

alone, we should not say increase or decrease but expansion or contraction. If one of the non-

price determinants of demand, such as the prices of other goods, income, etc. change & thereby

demand changes, the relevant terms are increase and decrease in demand. The expansion and

contraction in demand are shown in the diagram. You may observe that expansion and

contraction are shown on a single DD curve. The changes (movements) take place along the givencurve k.

Determinants of demand

After having understood the nature of demand and law of demand, it is easy to ascertain the

determinants of demand. We have mentioned above that an individual demand for a commodity

depends on desire for the commodity and the capability to purchase it. The desire to purchase

is revealed by tastes and preferences of the individuals. The capability to purchase depends

upon his purchasing power, which in turn depends upon his income and price of the commodity.

Since an individual purchases a number of commodities, the quantity of a particular commodityhe chooses to purchase depends on the price of that particular commodity and prices of the

other commodities, as well as the relative amount of his income, or purchasing power.

So, the amount demanded (per unit of time) of a commodity depends upon

Prices of related commodities

When a change in price of the other commodity leaves the amount demanded of the commodity

under consideration unchanged, we say that the two commodities are unrelated, otherwise these


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are related. The related commodities are of two types substitutes and complements. For

substitutes if price of one will increase the demand of other will increase and for compliments

if the price of one will increase the demand for other will decrease.

Income of the individual

The amount demanded of a commodity also depends upon the income of an individual. With an

increase in income, increased amount of most of the commodities in his consumption bundle,though the extent of the increase may differ between commodities.

Tastes and preferences

It is quite well that the change in tastes and preferences of consumers in favor of a commodity

results in smaller demand for the commodity. Modern business firms, which sell product with

different brand names, rely a great deal on influencing tastes and preferences of households in

favor of their products (with the help of advertisements, etc.) in order to bring about increase

in demand of their products.

Tastes of the consumersThe amount demanded also depends on consumers taste. Tastes include fashion, habit, customs,

etc. A consumers taste is also affected by advertisement. If the taste for a commodity goes

up, its amount demanded is more even at the same price and vice-versa.

Wealth

The amount demanded of a commodity is also affected by the amount of wealth as well as its

distribution. The wealthier are the people, higher is the demand for normal commodities. If

wealth is more equally distributed, the demand for necessaries and comforts is more. On the

other hand, if some people are rich, while the majority is poor, the demand for luxuries isgenerally less.

Expectations regarding the future

If consumers expect changes in price of a commodity in future, they will change the demand at

present even when the present price remains the same. Similarly, if consumers expect their

incomes to rise in the near future, they may increase the demand for a commodity just now.

Climate and weather

The climate of an area and the weather prevailing there has a decisive effect on consumersdemand. In cold areas, woolen cloth is demanded. During hot summer days, ice is very much in

demand. On a rainy day, ice-cream is not so much demanded.

State of business

The level of demand for different commodities also depends upon the business conditions in the

country. If the country is passing through boom conditions, there will be a marked increase in

demand. On the other hand, the level of demand goes down during depression.


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Aggregate consumer demand or market demand

The market (also aggregate consumer) demand function is derived by adding all individual

consumer demand functions. Aggregation adds three other non price determinants of demand -

(1) the number of consumers (2) "the distribution of tastes among consumers" and (3) "the

distribution of income among consumers of different tastes."[1] Thus if the population of

consumers increases all other things being held constant the market demand curve will shift

out. Likewise, if the income distribution were to change in favor of a group of consumers with

strong taste for same good "there would be an increase in demand for that good relative to

other goods."

The factors that affect individual demand also affect market demand although the net effect

can be ambiguous.


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Exceptions to the law of demand

(a) Ostentatious consumption

Some goods are luxurious items where satisfaction comes from knowing both the price of thegood and being able to flaunt consumption of it to other people! The demand for the product is

a direct function of its price.

A higher price may also be regarded as a reflection of product quality and some consumers areprepared to pay this for the snob value effect.

Examples might include perfumes, designer clothes, and top of the range cars. Consider thecase of VI which is considered to be the most exclusive perfume in the world. Only 475 bottleshave been produced and bottles have been selling for 47,500 each a classic case of payingthrough the nose for an exclusive good.

Goods of ostentatious consumption are known as Veblen Goods and they have a high-incomeelasticity of demand. That is, demand rises more than proportionately to an increase in income.

(b) Speculative Demand

The demand for a product can also be affected by speculative demand. Here, potential buyersare interested not just in the satisfaction they may get from consuming the product, but alsothe potential rise in market price leading to a capital gain or profit. When prices are rising,speculative demand may grow, adding to the upward pressure on prices. The speculative demandfor housing and for shares might come into this category and we have also seen, in the last few

years, strong speculative demand for many of the worlds essential commodities.

Speculation drives the prices of commodities to fresh highs

World commodity prices have reached new highs this year helped by an increase in the rate ofeconomic growth in the global economy. Among the metals that have achieved record pricelevels are copper, zinc, gold and platinum; prompting sceptics to question how much longer pricescan continue rising. Many market experts believe that the demand for commodities has beenspurred by heavy speculator activity. For example, pension funds and hedge funds have been

investing in commodity mutual funds over recent years leading to increased demand for preciousmetals. Prices have risen quickly because commodity producers are unable to raise outputsufficiently to meet unexpectedly strong demand.Source: Adapted from news reports, July 2006

The non-linear demand curve and the idea of price points

So far in our introductory theory of demand, we have drawn the demand curve for a product tobe linear (a straight line). In many real world markets this assumption of a linear relationship


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between price and quantity demanded is not realistic. Many price-demand relationships are non-linear and an example of this is provided in the chart above, used to illustrate the idea of price-points.

Price points are points on the demand curve where demand is relatively high, but where a smallchange in price may cause a sizeable contraction in demand leading to a loss of total revenue forthe producer.

Price points can be justified in a number of ways:

y A price rise at the price point may make the product more expensive than a closesubstitute causing consumers to change their preferences

y Customers may have become used to paying a certain price for a type of product and ifthey see a further price rise, this may cause them to revalue how much satisfaction theyget from buying and consuming something, leading to a decline in demand

y There may be psychological effects at work, supermarkets for example know theimportance of avoiding price points - 2.99 somehow seems cheaper than 3.00 despitethe tiny price difference

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