Understanding the Demand Curve: Shifts and Consumer Surplus

You've already had a brief introduction to demand. We're going to recap that material quickly then we're going to look at new material including two different ways of reading the demand curve, how demand curves shift, and consumer surplus. Okay, let’s go.

Here's the definition. A demand curve is a function that shows the quantity demanded at different prices. By quantity demanded, we mean the quantity that buyers are willing and able to purchase at a particular price. That's a little bit mysterious so let's give an example of a market and then show the demand curve in that market.

Here are some hypothetical numbers in a table which illustrate the idea of the demand curve for oil. Suppose that at a price of oil of $55 per barrel, the quantity of oil demanded would be five million barrels of oil per day. At a lower price, the quantity of oil demanded is going to be greater. Higher at for example, a price of oil per barrel of $5 a barrel, let's suppose that the quantity of oil demanded would be 50 million barrels a day. We can turn this table into a diagram, into a chart. Let's put the price of oil per barrel on the vertical axis and the quantity of oil demanded on the horizontal axis.

We can now graph our three points. Let's connect them with a line. That's the demand curve for oil. The demand curve for oil shows us the quantity demanded at each price. At a price of $55 per barrel, we can read from the demand curve that the quantity of oil demanded is five million barrels a day. At a price of $20 per barrel, the quantity demanded is greater, it would be, in this case, 25 million barrels of oil per day. At a price of $5 per barrel, the quantity demanded would be 50 million barrels per day.

A key point of the demand curve is that it slopes downwards. That is at a lower price, the quantity demanded is greater. That should be pretty intuitive. When the price of something falls, people want more of it. But we'll say a little bit more about that in a few minutes. We're going to be dealing with demand curves throughout the course, so it's very important that you be comfortable with reading them. In fact they can be read in two different ways.

The first method, the horizontal method, is the one I've already shown you. It says for example, at a price of $55 per barrel, we read horizontally over to the demand curve and down to find that at that price consumers are willing and able to purchase five million barrels of oil per day. At a price of $5 per barrel, consumers are willing and able to purchase 50 million barrels of oil per day.

The second way of reading the demand curve, the vertical method, begins at the bottom and works its way up. It tells us the maximum price that buyers are willing to pay for a particular unit of oil. We pick a quantity along the horizontal axis and we say for this quantity, for the fifth million barrel of oil, what is the maximum amount consumers are willing to pay? We read vertically up to the demand curve. We find that for the fifth million barrel of oil, consumers are willing to pay at most $55 for that barrel of oil. Similarly, pick another quantity. For the 25th million barrel of oil, consumer are willing to pay for that barrel at most $20. Both the horizontal reading and the vertical reading of the demand curve are useful. For some problems, it's easier to solve the problem using the horizontal reading. For other problems, it's easier to solve using the vertical reading. It's important that you'd be comfortable with both ways of reading the demand curve.

One further report in concept for this lecture is consumer surplus. Consumer surplus is the consumer's gain from exchange. It's the difference between the maximum price a consumer is willing to pay for a given quantity and the market price the consumer actually has to pay. Total consumer surplus is the sum of the consumer surplus of all buyers and graphically, consumer surplus is measured by the area below the demand curve and above the price. Again, that's a little bit mysterious and something of a mouthful but with a diagram, I think this will become clearer. This will also gives us a little bit of a chance to practice reading a demand curve vertically. So let's take a look.

Let's begin as usual with the demand curve and let's pick a particular quantity. Let's remember, from our vertical reading that the height of the demand curve at that quantity gives the maximum willingness to pay for that particular barrel of oil. In this case, the maximum willingness to pay for the barrel of oil indicated is a little bit below $80. Now suppose that the price of a barrel of oil is $20 per barrel, the willingness to pay is closer to 80 and the actual price is only 20. In other words, the person is required to pay 20 for something which they value at close to 80. The difference between the maximum willingness to pay and the actual price is again called consumer surplus. In this case, consumer surplus would be a little bit less than 60. We can indicate the consumer surplus by this green area. That might be the consumer surplus of one particular person who happens to really value oil and they value it a little bit less than 80 and they only have to pay 20 so their consumer surplus, again, is about 60.

Another consumer might value the oil less. They have a less value demand for the oil. Joe's consumer surplus is, let's say, down here. By adding up the consumer surplus for all consumers over all units, what we see is that the total consumer surplus is the area beneath the demand curve and above the price. We're just adding up the consumer surpluses for all individuals for all units of the good. In fact we often want to get a measure of this. When we have a linear demand curve, it's easy to quantify this.

Remembering from our high school geometry that the area of a triangle is equal to one half base times height. We can see that the total triangle here is 80 minus 20, so that's 60, times 90 divided by two, or 2,700. This would be in millions, 2.7 billion. That would be the total consumer surplus from this market for oil. Again we'll be using this calculation quite often, so just remind yourself of how to calculate the area underneath the triangle, which I know you're all familiar with.

That's it for this lecture, but let me tell you what we're going to do next time, because we haven't finished market demand. What we're going to do next time is to ask what could cause an increase or decrease in demand. An increase in demand is going to look like this, a shifting out of the demand curve. A decrease in demand will look like the reverse, namely a shifting in of the demand curve. We'll say more about that in the next lecture.