Why does what we buy impact how much things cost?

What we buy, on both a regular basis and as occasional purchases, has an impact on how much we pay for products and services.  But why is that? 

This is the third article I’ve written about microeconomics.  The other two explore the concept of supply and demand and how it affects pricing as well as the impact of changes in income.  If you haven’t read them, then just follow the links:

Study tips: Understanding supply and demand

Study tips: Understanding supply and demand curves (advanced level)

The story so far

The price of goods and services is determined by the price mechanism (represented by shifts along the supply and demand curves due to price changes), market forces (which cause shifts of the curves) and the impact of the type of goods: normal (either inferior or luxury), necessity, substitute and complementary.  Whilst all three areas are related, it is the type of goods that I will focus on now.

Normal goods

Normal goods are the products or services we buy on a regular basis.  They will vary from person to person and are linked to our personal preferences and priorities.  As our income rises, generally, we buy more, so demand for these goods increases.  Normal goods can be sub-categorised as luxury goods and inferior goods.  For example, vegetables are a normal good, but you can buy organically grown heritage varieties, which would be considered a luxury good or a bag of supermarket own wonky veg, which would be classed as an inferior good.  

Overall demand for normal goods fluctuates with increases and decreases in our income.  However, more distinct and significant changes take place within the sub-categories.  As our income rises, we buy less inferior goods, maybe choosing to swap a supermarket’s own brand cake for one made by an artisan baker.  So an increase in income means a decrease in demand for inferior goods.

However, for luxury goods, an increase in income not only causes an increase in demand, as for any other normal good, but it results in a bigger percentage increase too.  This is because when our income increases, not only do we spend more, but we spend a larger proportion of it on luxury goods.  The result is that luxury goods are more price sensitive than other normal goods.  This means that if our income falls, we will cut back harder on luxury goods than other normal goods and reduce the proportion of our income that we spend on them.  For example, we might choose to go on a self-catered camping holiday instead of staying in an all-inclusive hotel, but we’ll still go away.

Necessity goods

Some goods and services are known as necessity goods.  For example, food, clothing, utility and housing costs, in other words, the things that we need to survive.  However, what a normal good is and what’s a necessity can be subjective.  I think we’d all agree that having water is a necessity but is access to multiple TV subscriptions?

A definition of a necessity good is a product or service that we buy regardless of any changes to our income.  Therefore, they are less sensitive to income and/or price changes than other types of goods.

Substitute goods

In the Comment about supply and demand curves, I used the example of a sim card as a substitute good.  This is because this type of good gives consumers choices, as it includes products and services that can be used for the same purpose.  So one sim card can be substituted for another because texts, calls and data are the same regardless of the supplier.  So, if the price of one increases, then demand for its substitute will increase as well.

That said, some products which, in theory, can be used for the same purpose, such as a games console, can be seen as completely different by the consumer.  Whilst I think that an Xbox and a Playstation are the same, my son has a completely different opinion and would most definitely not substitute one for the other, regardless of any changes in their prices.

Complementary goods

The last category of goods I’m going to cover is complementary ones.  These are items we buy together, like nachos and salsa, a mobile phone, a case and screen protector or a games console and a game. As these kinds of goods are linked, then if the price for one increases, then the demand for both will fall.

Summary

I said at the start that the price of goods and services is determined by the price mechanism, market forces and the impact of the type of goods.  We now know that generally:

• Increased income results in increased demand for normal goods
  • Demand for inferior goods is decreased by an increase in income
  • Increases in income cause a bigger percentage increase in demand for luxury goods
• Necessity goods are bought regardless of changes in income
• If the price of a good increases, then demand for its substitutes will rise
• Price increases for a good will result in reduced demand for its complementary goods.

Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.