Topic 1 Consumer Theory

The readings from Economics and the Business Environment include:

Chapter 1 this is reading concerning the business environment (internal and

external) and introduction to thinking like an economist.
Chapter 2 this reading concerns demand, supply and the market
mechanism.
Chapter 3 topics within this chapter include some background to demand, in
particular advertising and how firms can estimate their demand.

The readings from Economics for Business include:

Chapter 1 this introduces the Business Environment that firms compete in.
Chapters 2 4 these chapters look at both sides of the market and the
market works in practice.

Notes
We began with a discussion of the key internal and external factors that affect
businesses. Some suggestions included employees and wages; all stakeholders;
costs of production; suppliers; outsourcing; structure of the firm; ownership style;
inflation; unemployment; government policy; interest rates; taxation; exchange rate.
These are all key factors that will create opportunities and pose threats to firms and
many of these have seen significant changes over the past 10-20 years. Businesses
will always look ahead and aim to plan for the future, as the biggest problem that
businesses will face is that of uncertainty. The problem is that planning can only be
done for some contingencies. The credit crunch was something that no businesses
were expecting and so from 2007, businesses were operating in a world of
uncertainty. The problem of uncertainty is likely to be particularly problematic for plcs
listed on the stock exchange, as their performance is subject to the fluctuations of
the stock market. Numerous things will affect the demand and supply of shares and
will thus affect performance.
The focus of this topic is on the market environment of business and this is
comprised of demand and supply. Both sides of the market are essential. Without
firms, there would be no goods and services and no employment opportunities.
Without the public, there would be no workers and thus no one to produce goods
and services, but also no one to buy them. Both parties are essential for the
economy.
We started by looking at the demand side of the market and constructed the demand
curve. This is derived by varying the price and looking at how demand changes,
holding everything else constant (ceteris paribus). The demand curve slopes
downwards, due to the law of demand, which rests on two key effects: the
substitution effect and the income effect. The substitution effect refers to the idea

that when the price of a good falls, it becomes relatively cheaper and thus
consumers will substitute towards that good. The income effect refers to the concept
of real income. That is how much you can afford to buy. When the price of a good
falls, your real income rises, as you can afford to buy more and thus again demand
rises. These two effects together explain the downward sloping shape of the demand
curve.
A key distinction is the difference between a shift in the demand curve and a
movement along the demand curve. When the price of the good changes, there will
simply be a movement up or down along the demand curve (after all, thats how we
derive the demand curve). Any other factor that affects your demand for a good will
shift the whole curve, meaning more or less will be demanded at any given price.
Some key factors that will cause an increase in demand are: effective advertising; an
increase in income (for a normal good); an increase in the price of a substitute good;
a decrease in the price of a complementary good; expectations that prices will rise in
the future; population increase; seasonal demand changes. The opposite effects will
cause demand to shift to the left.
As well as deriving a demand curve intuitively, we can also look at the mathematical
properties of a demand function. A simple demand function will be written as Qd = a
bP. This simply states that the quantity demanded of a particular product has an
inverse relationship to the price of the good. In this case, we are holding everything
else constant and assuming that demand does not vary with other determinants.
However, a more realistic demand function would include numerous other variables.
To determine the sign of each variable, e.g. Y, C, you need to think about the
relationship between the quantity demanded and the variable. For example, if there
is a positive income effect (income rises and demand rises), then the variable Y will
have a positive sign showing this positive relationship. By plugging variables into a
demand function, we can derive the demand curve itself, as we did in slide 10.
The final thing we looked at in the lecture was a real-world demand function
showing the demand for lamb. Its important to note here that the function is based
on actual data, so the size of the coefficients (0.197 and 0.069 etc.) are estimates
from actual data and not just numbers that the researchers picked. There are
problems with estimated demand functions and that is that it assumes that all
variables not included in the function did not change over the period in question. The
more variables included in the function, the better it is likely to explain the demand
for lamb. However, as more variables are added, the function will become
increasingly complex and other problems, such as correlation between the variables
can become an issue. With the first estimated demand function, there are two key
strange effects. The income variable has a negative sign. This implies that lamb is
an inferior good, thus when income rises, demand for lamb will fall. This is strange,
as we would expect lamb to be a normal good. Secondly, the sign of the beef price
variable is negative, implying that beef and lamb are complements. Again, this is
strange, as it would imply that when the price of beef falls (the demand for beef will

rise), but the demand for lamb will also rise, because these products are consumed
together. Wed expect the opposite effect i.e. that beef and lamb are substitutes
(as is the case for pork).
The researchers determined that something else had changed, that was not included
in the model. That is, the model was mis-specified. And they were correct. During the
period in question there had been a change in tastes people were substituting
away from lamb and other meat products. Thus a new variable was included TIME.
They re-estimated the demand function and this time the variable for income (Y)
changed to have a positive sign, though a relatively small effect. This suggests that
before the TIME variable was included, the income variable was accounting for some
of the change in tastes. However, the price of beef variable is still negative. The
model was then re-estimated, but this time including two other variables. The lagged
consumption of lamb the intuition is that your consumption of lamb in 1990 will be
affected by your consumption of lamb in 1989 etc. That is, what you consumed last
year will affect your consumption this year. A second variable was added the price
of a complement potatoes. When these two variables were added, the income
variable remained positive and became a larger effect and the sign of the price of
beef variable changed to become positive, suggesting that beef and lamb are now
substitutes, as we would expect. More and more variables could be added in and
each time the regression runs, new coefficients will appear showing the relationship
between that variable and the demand for lamb. Every time a new variable is added,
the coefficients on the existing variables will change, as the model becomes better
and better.
Exercises:
1. Yes, the demand curve can slope upwards. In some cases, when the price of
a good rises, the demand for it will increase, in particular for giffen goods.
These can be goods that have such a big income effect that works in the
wrong direction. When the price falls, the substitution effect will still work as
normal (demand rises), but the good could be so inferior that there is a
negative income effect that offsets the substitution effect and so demand
slopes upwards. Other products can be goods that people purchase as
evidence of their status i.e. showing off! As the price rises, people buy the
good, because they can!
2. Numerous markets are of particular interest to the government. Examples
include demand for healthcare, education, housing, food, alcohol, cigarettes.
In each case, think about why the government will be so interested in the
demand in each of these markets and in turn what the government might do
to influence it.
3. As the demand for a good rises, price will rise. Firms will be encouraged to
produce more of the good (as well look at in more detail in the next lecture)
and so the demand for the inputs (or factors of production) used to produce
the good will also rise, pushing up their price.

4. The law of demand is useful to know, but perhaps doesnt tell a firm very
much. Simply knowing that when the price falls, demand will rise will not
provide much information to a firm. What is of more interest is when the price
falls, by how much will demand rise. We look at this in the next lecture.