What determines demand and what determines supply

Overview

Effective demand and explain why willingness alone is not enough, substitute good and complementary good.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define effective demand and explain why willingness alone is not enough.

   Model answer

   Effective demand is the quantity of a good that consumers are both willing and able to buy at each price in a given period. Wanting a good has no effect on the market unless the consumer can actually pay for it, because sellers respond to purchases rather than to wishes. A person who would love a sports car but cannot afford one contributes nothing to the demand curve for sports cars.

2. 2

   List the main factors that shift the demand curve for a good.

   Model answer

   Consumer income, the prices of substitutes and complements, tastes and fashion including advertising, the size and age structure of the population, expectations about future prices, and the availability and cost of credit. Government policy such as a subsidy paid to consumers, and seasonal factors, also shift demand. The price of the good itself is not on this list, because a change in that price moves the economy along the curve rather than shifting it.

3. 3

   Explain, with an example, how a rise in income affects demand for a normal good and for an inferior good.

   Model answer

   For a normal good, demand rises as income rises, so the demand curve shifts to the right: households with more income buy more restaurant meals at every price. For an inferior good, demand falls as income rises, so the curve shifts left: as households become better off they buy fewer own-brand basic foods and switch to premium alternatives. The classification depends on how consumers actually behave, not on the quality of the good in any absolute sense.

4. 4

   What is a substitute good, and how does a change in its price affect demand for the original good?

   Model answer

   A substitute is a good that satisfies a similar want and can be bought instead, such as tea and coffee. If the price of coffee rises, some consumers switch to tea, so the demand curve for tea shifts to the right at every price of tea. A fall in the price of coffee shifts the demand for tea to the left. Substitutes therefore move together in the sense that a price rise in one raises demand for the other.

5. 5

   What is a complementary good, and how does a change in its price affect demand for the original good?

   Model answer

   A complement is a good consumed together with another, such as printers and ink cartridges or cars and petrol. If the price of petrol rises sharply, the total cost of motoring rises, so demand for cars shifts to the left. A fall in the price of the complement shifts demand for the original good to the right. A rise in the price of one complement therefore reduces demand for the other.

6. 6

   Explain how expectations of a future price change affect current demand.

   Model answer

   If consumers expect a good to become more expensive soon, they bring purchases forward to avoid the higher price, so current demand shifts right. If they expect prices to fall, they postpone buying and current demand shifts left. This is why announced tax rises on cars or fuel are usually preceded by a surge in sales and followed by a slump, even though nothing about the good itself has changed.

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