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Chapter 3
Demand Analysis and Optimal Pricing
predicted to grow by 42 seats. Thus, we confirm that there is a 42-unit rightward shift in the demand curve from old to new demand. Another way to think about the effect of the increase in regional income is to write down the equations for the market-clearing price for the old and new demand curves. These are P 290 Q/2 (old) P 311 Q/2 (new)
[3.6]
Thus, if your airline seeks to sell the same number of seats a year from now that it does today, it can do so while raising the coach ticket price by $21 (the difference between 311 and 290). To see this in Figure 3.1, fix the quantity and read the higher price off the new demand curve.
General Determinants of Demand The example of demand for air travel is representative of the results found for most goods or services. Obviously, the good’s own price is a key determinant of demand. (We will say much more about price later in the chapter.) Close behind in importance is the level of income of the potential purchasers of the good or service. A basic definition is useful in describing the effect of income on sales: A product is called a normal good if an increase in income raises its sales. In our example, air travel is a normal good. For any normal good, sales vary directly with income; that is, the coefficient on income in the demand equation is positive. As an empirical matter, most goods and services are normal. Any increase in consumer income is spread over a wide variety of goods and services. (Of course, the extra spending on a given good may be small or even nearly zero.) Likewise, when income is reduced in an economy that is experiencing a recession, demand falls across the spectrum of normal goods. For a small category of goods (such as certain food staples), an increase in income causes a reduction in spending. These are termed inferior goods. For instance, an individual of moderate means may regularly consume a large quantity of beans, rice, and ground meat. But, after experiencing an increase in income, the individual can better afford other foods and therefore reduces his consumption of the old staples. A third set of factors affecting demand are the prices of substitute and complementary goods. As the term suggests, a substitute good competes with and can substitute for the good in question. In the airline example, travel on one airline serving the same intercity route is a very close substitute for travel on the other. Accordingly, an increase in the price of the substitute good or service causes an increase in demand for the good in question (by making it relatively more attractive to purchase). Note that substitution in demand can occur at many levels. For
