A market is any institution or method that brings together buyers and sellers of particular goods, services, or resources. Some examples include farmers markets, stock exchanges, malls, help wanted ads, and LinkedIn.com. In many markets, such as a farmers market, buyers and sellers may haggle over price; in others, the interaction is entirely electronic, such as when an investor places an order for stocks.
To understand how individual markets operate, one must understand demand and supply and how they are related to market prices. To simplify this analysis, we will start with a highly competitive market, with many buyers and sellers, and no one buyer or seller can significantly influence the market price. Highly competitive markets include markets selling fruits and vegetables, grains, currency, and stocks of large companies.
Demand is the relationship between the price of a product and the quantity demanded for that product at that price. A demand schedule is a table that shows the relation between product prices and the quantity demanded at each price. The quantity demanded is the amount of goods that buyers are willing and able to purchase at a specific price.
The law of demand states that there is an inverse relationship between price and quantity demanded that applies to virtually everything sold — as prices rise, the quantity demanded falls; when prices drop, the quantity demanded increases.
Why is the demand for a product inversely related to its price? For several reasons. As prices rise, fewer people will be able to purchase the product, since some people will not have enough money – this is the income effect. Furthermore, people buy products for their utility — how much satisfaction they will receive by purchasing the product. As prices rise, the utility of the product for many people will be less than its price, so fewer people will buy it. Even those who do buy the product will buy less, since the marginal utility of each additional item decreases. When the marginal utility of a product falls below its price, then people will not buy anymore. Hence, higher prices will cause the marginal utility of the product to fall below its price sooner, thereby cutting off demand. When prices are lower, people feel they are getting more value for their money.
There may also be a substitution effect, where people switch to a lower priced item that is comparable to other higher priced items, such as substituting watermelon for cantaloupe if watermelon prices are lower than cantaloupe prices.
The Demand Curve
The possible prices of a product and the amount demanded at each quantity is often depicted in a graph with the price on the vertical axis and the quantity demanded on the horizontal axis. This produces a downward sloping curve or line. The demand curve not only applies to individuals, but also applies to the entire market. The market demand is simply the sum of each individual demand. Note that since the demand curve is more a heuristic aid than a schedule of actual demand, it is often depicted as a straight line.
Determinants of Demand and Shifts in the Demand Curve
Although prices are usually the major determinant of demand, there are also other determinants of demand, which include the number of consumers in the market, their preferences, their incomes, and the prices of related goods. When there is a shift in demand caused by something other than the price, then there is a shift in the entire demand curve, where the quantity demanded at each price is different from the previous demand curve. If demand changes because of a price change, then this represents a shift along demand curve, but the demand curve itself remains the same. This occurs, of course, because the demand curve relates product prices to product demand.
A change in demand is often caused by a change in technology — superior technology is generally preferred over older technology. In the 20th century, film was in high demand. Now that most cameras are digital, film has all but disappeared.
Another factor that causes a shift in demand is the number of buyers. The number of buyers may increase because of population growth or because technology has allowed suppliers to sell to a much larger market. For instance, the Internet has greatly expanded the marketplace for many goods, allowing even a small company to sell to the entire world. The demand for health services is greatly increasing and is anticipated to continue to increase not only because of the much larger number people who are living longer than ever, but also because of insurance provided by private companies and the government that makes healthcare more affordable.
For most products, an increase in income generally increases the demand for products, because higher incomes make many more products more affordable. However, some products actually decline in sales with increasing income, such as used cars, used computers, or cheap clothing. A normal good is a good where demand increases with increasing income. When the demand for a good is inversely related to income, the good is referred to as an inferior good. So, for instance, when a person strikes it rich, they will probably trade in their Toyota Yaris for a Lexus.
Demand may shift when the prices of related goods change. There are 2 types of related goods: substitute goods, which are goods that can be used in place of other goods, and complementary goods, which are goods that are used together.
Examples of substitutes include different kinds of meats, different kinds of fruits and vegetables, different types of cars, and so on. Products are substitutes when the changing price of one causes a proportional change to the demand for the other. So, if the price of Pepsi rises, then the demand for Coke will increase.
Complements are goods that are used with other goods, so their demand rises or falls inversely with the complementary good. So, for instance, as more people in China and India are able to afford cars, then there will be a greater demand for gasoline, oil and other products for motor vehicles. When products are complements, the price of one good causes a proportional change in demand for the other good.
Independent goods are goods that lack a price-demand relationship with other goods — thus, they are neither substitutes nor complements to the other goods. However, there is some relationship among all goods, since people only have so much money, so their demand for some goods will have some effect on demand for other goods in the marketplace.
Changing price expectations can also create shifts in demand. If prices are expected to increase, then many consumers may buy more of the product now to lock in the savings. Common examples include the many sales conducted by retailers that expire at specific times, or the increase in demand for housing when interest rates are expected to rise.
Expected changes in income will also affect current demand. When people feel insecure about their job, they generally buy less, as was evidenced by the 2007-2009 Great Recession. Conversely, expected increases in income will increase the confidence of the consumer, thus increasing current demand.
Sometimes, demand will also be affected by the availability of the good or service. For instance, the demand for bankruptcy lawyers greatly increased before the law changed in 2005 that made getting a bankruptcy discharge more difficult.
New information can also change buyers' tastes. Positive information can increase demand, while negative information has the opposite effect. So, for instance, the recent news about the benefits of vitamin D have greatly increased the sales of vitamin D supplements. Advertising generally increases product demand because it disseminates positive information about the product. Public campaigns can also significantly influence demand. For instance, the public campaign against cigarette smoking caused a steep leftward shift in the demand curve for cigarettes, while increasing cigarette taxes increases cigarette prices, shifting demand along the demand curve.
Surge Pricing Works Because Price Is Not the Only Demand Determinant
Most taxi services set a specific price, which is often determined by the public utility commission, but ridesharing services, such as Uber, set their own prices. By using the Uber app, people needing taxi services can request a pickup through the app, providing the required information, such as the destination, then the app will show them the price. The customer can then accept or reject the price. Uber drivers are also free to work whenever they want; they can let Uber know when they are available through the app.
The unique characteristic of taxi services is that supply responds readily to price. Demand, on the other hand, is not so price-sensitive. Think about it. When you need a taxi, you want to get one quickly to go where you want to go. You're not in a position to really price shop, since you're probably standing at some public place somewhere, anxious to go somewhere else. In the taxi business, there are certain times when demand greatly increases, and this demand has nothing to do with prices. For instance, during a snowstorm, even people with cars call taxis, because they do not want to drive in the snow and take a significant chance of being in an accident. So, during a snowstorm, some people may have to wait for hours for a taxi. Another time when there's a greatly increased need for taxis is during New Year's Eve, because most people want to be able to drink but they don't want to drive home afterwards. Demand also increases after major events, such as concerts or festivals. In these situations, price is not a significant factor: availability is much more important.
To meet this temporary increased demand, Uber introduced surge pricing, so that when demand increases, prices increase by an amount commensurate with the increased demand, which draws more drivers to go out and provide services for Uber. This flexibility allows Uber to respond to market forces very quickly. Some people call it price gouging, but it is an effective technique to increase supply to meet demand.
Surge pricing wouldn't work if price was the only determinant of demand. That surge pricing directly increases supply directly reflects the increased quantity due to increased price, so supply moves along the supply curve set by price. The demand curve, on the other hand, is shifted rightward, so that demand is higher at every price on the demand curve. If price was the only thing that mattered for the demand side, then surge pricing would not work, because as prices increased, demand would decrease.