Consumer Demand

What Is Consumer Sovereignty?

The foundation of the U.S. economy is the market where consumers and producers meet to exchange money for goods and services. Consumers create demand for something, and producers supply it at a price that is negotiated by both parties. The government also plays a role, but for this topic, we will focus on the consumer. 

Many economists believe in consumer sovereignty. Simply put, this means that consumers are the main drivers in deciding what goods and services will be produced in any given market. In most cases, producers won’t bring things to the market unless they are filling a demand from consumers.

How do consumers affect the market? They bring their demands and their income to the market. With their purchasing power, they force producers to give them what they want at prices they can accept. When more consumers value a good or service, the price is relatively high. When few people value it, the price is relatively low. 

Watch this video to see an example of how consumers and producers around the world negotiate to bring us roses on Valentine’s Day:

As the price of an item increases, more and more consumers will stop purchasing it, and the quantity demanded will decrease. This illustrates the law of demand, which states that there is an inverse (opposite) relationship between the price of something and the quantity of it that consumers are willing and able to buy. Because every good or service is replaceable over time, consumers continuously shop around for replacements and substitutes.

Every consumer has a limited amount of money available to spend. People planning for secure and comfortable living usually have set budgets. So, when the price of something in their budget changes, the purchasing power of their income changes.

The law of demand shows that as the price of one item goes up, people consume less of it. When the price falls, they consume more. When people see an item in a store at a 50 percent discount, their behavior shifts. They pause, think, and become more likely to buy more of it. When the price of an item rises, the opposite happens: people who were drawn to it become less likely to make a purchase.

Imagine you have a teacher who shows off a new cell phone. She says it was purchased as a buy-one-get-one-free offer and asks if anyone wants the second one. How many hands go up? Probably most of the class, right? Who doesn’t want a new, free cell phone? What if she changes her mind and decides to sell the phone instead? How many hands stay up if she offers to sell the phone for $1? $5? $25? $125?

Very likely, fewer and fewer hands will stay up as the price goes up. That seems logical, doesn’t it? The higher the price, the fewer consumers will demand that item. That’s what the law of demand is all about.

The Law of Demand’s Impact

As early economists observed the economic choices people made, they noticed specific, predictable patterns. Over time, as prices and other factors changed, both consumers and producers responded in predictable ways. These behaviors were so predictable, economists called them the law of demand. The term is useful for describing how you and other consumers will respond to an item’s price change.

The law of demand is a relationship between opposites—price and quantity demanded—when all other factors are held constant. Simply put: When the price goes up, people buy less of something, and when the price goes down, people buy more of it.

When Prices Change

When consumers, like you, face price increases, for reasons known and unknown, it creates an incentive to change what and how much they consume. There are two reasons why: the substitution effect and the income effect. These two effects help further explain the opposite relationship between prices and amounts consumed.

Substitution Effect

Imagine you discover a new food truck around the corner from your school. The food is great...and cheap! The word gets out, and soon many students are visiting the truck at lunchtime. You notice that the prices go up a little bit every day. How long will you continue to buy? Economists predict that there is a price the food truck will charge you for your lunch that is a breaking point. When the price reaches that level, you’ll try another, less expensive option for lunch.

This example illustrates the substitution effect. When the price of an item increases, many people will buy substitutes—and the demand for the item will decrease.

Every good or service is replaceable over time, so consumers continuously shop around for substitutes. As the price of an item increases, more and more consumers turn away from purchasing it, and the quantity demanded decreases. A similar phenomenon occurs when the price of the original item falls. If people have settled for a substitute item that they feel is inferior to the original, they often return to the original when the price returns to the lower price point.

Remember that economic reasoning means identifying and evaluating alternatives, then making a decision.

When the price of something you need or want increases, you can consider your alternatives and search for substitutes. When you find something that is a better deal and provides more value at a lower price, you can make the switch and purchase the substitute  instead.

Income Effect

Price and quantity demanded can also move in opposite directions because of the income effect. Remember the food truck. Let’s say you’re going to the food truck and the price of tacos increases. Suddenly the income you set aside for lunch has less purchasing power. In reaction, you reduce the amount you spend on tacos and shift to buying something else for lunch.

Economists predict that, based on your income, you’ll either buy fewer lunches at the food truck that raises its prices or go somewhere else with lower-priced options. This is the income effect. Similarly, if prices drop, your purchasing power increases, and you’ll be more likely to increase the number of trips to the food truck or the number of tacos you purchase. 

Remember, everyone has a limited amount of income available to spend, and people planning for secure and comfortable living usually have set budgets. When prices change, purchasing power changes, too. If the price of food increases while income remains the same, the purchasing power of that income decreases. If the price of utilities goes down, purchasing power increases because money that would have been spent on utilities is now available for other uses. Bottom line, when the price of an item goes up, the quantity demanded goes down because the purchasing power of income is squeezed.

The Impact of Price Changes

The income effect and the substitution effect both help explain the negative relationship between price and quantity demanded by consumers like you. If the price of something you normally buy increases, you buy less to stay on budget, given your income. Take gas, for example. If the price of a gallon of gas jumps from $3.00 to $3.50 per gallon over the course of a month, you will buy less gas because the income budgeted for gas does not go as far at $3.50 per gallon. If the price of gas drops, quantity demanded increases. Your budget goes farther.

Summary

The law of demand states that price and quantity demanded are inversely related. When producers and consumers come to the market together, it is consumers who come with the demand and the money to buy what they are demanding. This is sometimes referred to as consumer sovereignty, with consumers being the main drivers in the market. It’s important to understand the role that consumer demand plays in producers’ decisions of what products to make and what prices to charge.