Price and Demand Relationship

The demand relationship is fundamental to managerial economics. It works from the premise that there is a negative relationship between price and quantity as illustrated in all our diagrams. However, this premise works from the presumption that the average consumer is both normal and rational, that is, the average consumer will on average buy more of the product when the price falls.

Think of your own shopping experiences: sometimes you do not know exactly the price of the product but you have a fair idea of the price range. So, if you were charged £10 for a cup of coffee there is a good chance that you would query it as you expected to pay less than £4. A straight line (linear demand with a slope Δp/Δq =1) is one illustration of the demand relationship but usually it is illustrated as a curve, hence the term, demand curve. The negative sloped demand relationship has an inbuilt continuity assumption that facilitates the construction of  a smooth curve to represent the demand at a point in time. For geometric accuracy we represent the demand relationship as a line. The economic intuition is the same: more is consumed at a lower price.

The demand line is represented with both an upper and lower bound on price. There is a higher bound on price determined by the income constraint of the consumer. Low price can often signal low quality to many consumers so there is a lower bound on price. Finally as price falls there is a movement along the demand line; however, as income increases (decreases) there is a shift in the demand to the right (left). The shift in the demand to the right, for example, represents the fact that with more income more is spent on purchases; alternatively, as population increases there is a greater demand for the product, hence the demand line shifts to the right to indicate the point that more is consumed at a given price.

Demand Shifts

The demand line is represented with both an upper and lower bound on price. There is a higher bound on price determined by the income constraint of the consumer. Low price can often signal low quality to many consumers so there is a lower bound on price. Finally as price falls there is a movement along the demand line; however, as income increases (decreases) there is a shift in the demand to the right (left). The shift in the demand to the right, for example, represents the fact that with more income more is spent on purchases; alternatively, as population increases there is a greater demand for the product, hence the demand line shifts to the right to indicate the point that more is consumed at a given price.

In this illustration of a shift in demand upwards, notice that the price has increased from 5 in (5,5) to 6 in (6,5) or from 8  in (8,2) to 10 in (10,2). Observe that the quantity does not change. As income increases, and there is an excess demand for the products, you will observe a temporary increase in price until supply and demand readjust. If not, the price increase, triggered by higher incomes will generate a cobweb effect and may indeed contribute to a price bubble. Alternatively, as income increases and supply and demand adjust, you would observe, for example, moving from (5,5) to (p,q), where p > 5 and q > 5.

Note: As you move the top cursor to the left you are activating a price increase; in line with normal rational consumer behaviour, consumers will on average consume less as prices increase. Notice that as the cursor moves that the (p,q) bundle represents less q with higher p.

Key Points

To understand the upper and lower bounds on price as determinants of a price equilibrium.

To note the importance of the slope (check ELASTICITY) of the demand line and shifts in a demand line.