Utility, Substitution and Demand

1: Demand

A graph that you see again and again in any introductory microeconomics course is the demand curve: sloping from top left to bottom right, it shows how the quantity demanded of a single good varies inversely with the price.

Why does quantity demanded decrease when price increases? One perspective might be to say that people spend effectively at random, so naturally the more things cost, the less of them they can buy. However, this does not account for all the phenomena of demand. For example, there are some goods (the inferior goods such as cheap sliced bread) which are demanded more when people have less money.

An alternative perspective on demand recognizes that people are rational agents, responding to incentives and disincentives and acting so as to get as much as possible of what they want. If something they repeatedly purchase becomes too costly, then they will find a substitute use for their money and time.

This is a limited form of rationality. We do not assume that agent’s behaviour reflects what is good for them, only that it reflects their desires. Similarly, it is not necessary to assume that the agent’s beliefs are true (although other important results in economics depend on assuming that the participants in a market have full and correct information), only that their choices reflect their beliefs.

The true cost of something is what you have to give up in order to get it. To get my Sunday night takeaway, I not only have to pay four pounds cash but also put myself at a slight risk of crime by venturing into a crime-ridden area of town at night. Leaving my flat to go to the takeaway also deprives me of some time and some comfort. In this case, the cost of the takeaway is the total of all the things that I have to give up, compared to a baseline option, which in this case is staying in and eating whatever is in my fridge.

Some of these factors might change. The takeaway might change its price. The weather might turn particularly treacherous or particularly pleasant. There might be a highly publicized spate of muggings or conversely an increase in street-lighting, affecting the perceived risk of crime. Any of these changes might result in a change in my decision.

It is these considerations that not only lead to the inverse relationship between demand and price but will even suggest a shape for the demand curve.