Each household has a limited income. This income is usually fixed if at least one person has a job. The total household income is limited. A household cannot decide one month to spend all its money on milk and the next month on bread. There are various fixed cost items that households have. Items such as rent for a house, travelling costs in order to get to work and earn money, water and electricity, some people may have policies etc. The rest of the expendable income is divided into goods that provide the highest utility value.
For example, let us look at a household (or a family). We have Mr. Joe Smith (the husband), Mrs. Emily Smith (Wife), Andrew Smith (Son) and Cathy Smith (the daughter). Joe earns R3,000 a month and Emily earns R1,500 a month. The total household income is R4,500 a month since Andrew and Cathy are both at school and cannot earn any money (since they are very hard working pupils). Let’s look at their total household income and what can they affordAn example of a household expenditure per month and the percentage of each expenditure item of the total income.
|COMPONENT||INCOME||EXPENDITURE||% OF TOTAL|
|Water and electricity||300||6.7|
Remember the figures provided are fictitious and you can enter your own values to make them more realistic. From the example we can see that the Smith’s can only spend R800.00 on food (according to their budget). This will consist of meat, milk, bread, vegetables etc. Our focus is on the vegetable component. Lets estimate that it will be about R200.00 of the total income, that equals to 4.4% of the their income. Thus we assume that the Smith household will spend R200.00 per month on vegetables. Lets see what they can affordChanging the total household income will change the amount a household can spend on vegetables. The percentage of expenditure in terms of total income stays the same.
|CHANGE IN INCOME||TOTAL EXPENDITURE||% OF TOTAL INCOME|
In the last table we see that if they would lose R1,500/month they would only spend R133.33/ month on vegetables. If they each would receive an increase of R500.00/month, they would be able to spend R244.44 per month on vegetables. As their salaries increases, so will the amount increase which they can spend on various items, in our case vegetables.
This is very important since the household will now be able to buy more tomatoes lettuce or start buying vegetables that they have never used before.
Now if the whole community’s salary would change due to a project in the near vicinity, this would mean that suddenly there is more money in circulation. With more money one can buy more goods. This has a direct influence on the market place since with higher salaries more people would buy more vegetables thus the demand for the product will increase. The higher demand will result in a higher price. Now suddenly farmers see that for instance tomatoes are sold at a higher price so more farmers start to produce tomatoes, the net result is that the supply increases and matches the demand of all the households (with their increased salaries) and the price of the tomatoes falls again since there is enough tomatoes on the market to satisfy the demand.
In the above example which is extremely simplified one can see the interaction between household income (the money a household or person has to spend on various items), the demand for a product and the supply of a product.
It is important to note that the absolute value of vegetables has not changed, it still contains the same ingredients. The colour of tomatoes and spinach have not changed. What has changed is the people have more money to buy more produce, the production during the change stayed the same ( so the supply stayed the same) and the demand increased since the households or people could buy more of the goods.
Consider the following example to illustrate the value of a product. Imagine yourself in the middle of a Sahara desert. You have just found 100 diamonds each worth R1,000. You start your journey back home dreaming what you are going to do with all the money. As time passes you realize you have lost your way and all your water rations have been used. It is very hot (45°C) and you have no water. Suddenly a man appears on a camel with lots of water. Since water is a scarce commodity in the Sahara the man says you have to pay him for a glass of water. The only thing you have with you are the diamonds. Would you pay him with the diamonds or not? In this case it is a matter of life and death. So you pay him with three diamonds. That water was not enough and you ask for one more glass. He says three more diamonds will do but since you already had one the second glass would not be as satisfying as the first and you offer him only two diamonds, he obliges. After the second glass you are still thirsty and ask for a third glass. His response is two diamonds but you so no, I’ll give you my smallest diamond worth R50. He’s not happy with it and you are not willing to pay R1,000 for additional glass of water and you leave.
The point is with each additional glass of water you drank, the less utility or satisfaction you received and the less you will pay for the next glass of water. This applies to various other products. The less demand there is for a product the lower the price. If someone really wants something and there are only a limited number of the item, then he will be prepared to pay a lot more to obtain it. Thus by gaining the item he has received a high amount of satisfaction or a more technical term, utility from obtaining the product.
A classic example is petrol. Fuel is a scarce commodity, that is why it has such high inflation. The demand is also increasing since there are more vehicles in the world. The biggest problem the OPEC countries face is if the petrol price increases up to a certain level, an alternative fuel source will become profitable and that might replace petrol. This brings us the topic of substitution which we will briefly discuss in a later post.