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Excess Supply & Excess Capacity



Factors affecting demand for a product

Equations are omitted for technical reasons - download the original pdf

Economists are concerned only with what they describe as effective demand. Demand is only effective when the desire to buy is combined with the ability. Income is a flow of money over a period of time. For real income to rise, money income must increase faster than prices. Disposable income refers to income after compulsory deductions such as tax. A large part of this is committed to regular payments (rent, mortgage, energy, travel to work, basic necessities). The residual amount is known as discretionary income and is crucial to firms selling non-necessities. We also have to consider other factors that will affect demand for a product, such as: the price of substitutes - rival goods; the price of complements - goods which are jointly demanded, such as cars and petrol; the availability of credit; the liquidity of the potential buyer; expectations about the future. Effective demand mans demand backed by the ability to pay. Consequently, economists are centrally concerned with how the ability to pay is affected by economic forces. The economic determinants of demand are: (1) Price. As price goes up generally demand goes down. (2) Income. As real income increases consumer spending habits change. A large part of one's income is committed to regular payments, the remainder is called discretionary income. Obviously, as real income increases discretionary income increases. In this case, the general pattern is for consumers to switch from inferior (basic) to superior (luxury/differentiated) goods. "Inferior" here does not necessarily mean "bad", but indicates a product which is perceived to have less quality and to be less distinctive, and therefore to command a lower price. (3) The state of the economy as a whole - for example, whether the economy is booming, or in recession. This affects average incomes so the impact on a business is not really distinct from the second point. In a recession real incomes fall and consumers tend to switch from superior to inferior goods; this is called "trading down". The opposite process - "trading up" - occurs during (1) booms, (2) the general increase in living-standards; (3) improvements in income during the lifetime of a consumer or household; (4) existence of substitutes- that is, the more near alternatives there are to a product, the more likely consumers are to change from your product. (4) Substitutes. A substitute is an alternative to a product. For example, a substitute for tinned cat food is fresh raw meat. The one is not a perfect substitute for the other; however, one brand of tinned cat food can be almost identical in quality to another, and so constitute a perfect substitute. The more substitutes there are and the less difference there is between the substitutes, the more sensitive the demand for a product will be to changes in price. In other words, it is the presence of substitutes that determines whether the demand for a good will be elastic or inelastic.
Contents of
Excess Supply & Excess Capacity

1 Excess supply
2 Factors affecting demand for a product
3 Excess Capacity, risk premium and base rate, supernormal profit
4 Price as a proxy measure of value, normal demand
5 Car manufacturing in the context of excess capacity
6 Demographic Trends and demand

Related articles: (1) Determinants of Demand, (2)