Law of demand

In economics, the law of demand is an economic law that states that consumers buy more of a good when its price decreases and less when its price increases (ceteris paribus).

The greater the amount to be sold, the smaller the price at which it is offered must be in order for it to find purchasers.

Law of demand states that the amount demanded of a commodity and its price are inversely related, other things remaining constant. That is, if the income of the consumer, prices of the related goods, and tastes and preferences of the consumer remain unchanged, the consumer’s demand for the good will move opposite to the movement in the price of the good.

Mathematical expression

The negative relation (i.e., higher price attracts lower demand & lower prices encourages high quantity to be bought by the consumers) is based on logic and experience. Mathematically, the inverse relation may be stated with causal relation as:

$Q_{x}=f(P_{x})$

Where, $Q_{x}$ is the quantity demanded of x goods
f is the function of independent variables contained within the parenthesis, and
$P_{x}$ is the price of x goods.

Hence, in the above model, the function (f) is a varying one i.e., the law of demand postulates $P_{x}$ as the causal factor (independent variable) and $Q_{x}$ is the dependent variable.

The two variables move in the opposite direction. When $P_{x}$ falls $Q_{x}$ rises and the reverse. In regard to the question "by how much will quantity demanded rise?", the law is silent. For example, when $P_{x}$ for a one-way rail ticket on the Acela Express from Boston's South Station to New York City's Penn Station falls from $111 to $105, ridership may rise from 1625 daily riders to 1825 daily riders or even to just 1626 daily riders. Thus the law of demand merely states the direction in which quantity demanded changes for a given change in price. Moreover, what the law states is hypothetical and not actual.

Assumptions

Every law will have limitation or exceptions. While expressing the law of demand, the assumptions that other conditions of demand were unchanged. If remain constant, the inverse relation may not hold well. In other words, it is assumed that the income and tastes of consumers and the prices of other commodities are constant. This law operates when the commodity’s price changes and all other prices and conditions do not change. The main assumptions are

• Habits, tastes and fashions remain constant
• Money, income of the consumer does not change.
• Prices of other goods remain constant
• The commodity in question has no substitute
• The commodity is a normal good and has no prestige or status value.
• People do not expect changes in the prices.

Exceptions to the law of demand

Generally, the amount demanded of good increases with a decrease in price of the good and vice versa. In some cases, however, this may not be true. Such situations are explained below.

Giffen goods

As noted earlier, if there is an inferior good of which the positive income effect is greater than the negative substitution effect, the law of demand would not hold. For example, when the price of potatoes (which is the staple food of some poor families) decreases significantly, then a particular household may like to buy superior goods out of the savings which they can have now due to superior goods like cereals, fruits etc., not only from these savings but also by reducing the consumption of potatoes. Thus, a decrease in price of potatoes results in decrease in consumption of potatoes. Such basic good items (like bajra, barley, grain etc.) consumed in bulk by the poor families, generally fall in the category of Giffen goods.

Commodities which are used as status symbols

Some expensive commodities like diamonds, air conditioned cars, etc., are used as status symbols to display one’s wealth. The more expensive these commodities become, the higher their value as a status symbol and hence, the greater the demand for them. The amount demanded of these commodities increase with an increase in their price and decrease with a decrease in their price. Also known as a Veblen good.

Expectation of change in the price of commodity

If a household expects the price of a commodity to increase, it may start purchasing greater amount of the commodity even at the presently increased price. Similarly, if the household expects the price of the commodity to decrease, it may postpone its purchases. Thus, law of demand is violated in such cases.

In the above circumstances, the demand curve does not slope down from left to right instead it presents a backward sloping from top right to down left as shown in diagram. This curve is known as exceptional demand curve.

Law of demand and changes in demand

The law of demand states that, other things remaining same, the quantity demanded of a good increases when its price falls and vice-versa. Note that demand for goods changes as a consequence of changes in income, tastes etc. Hence, the demand may sometime expand or contract and increase or decrease. In this context, let us make a distinction between two different types of changes that affect quantity demanded, viz., expansion and contraction; and increase and decrease.

While stating the law of demand i.e., while treating price as the causative factor, the relevant terms are Expansion and Contraction in demand. When demand is changing due to aprice change alone, we should not say increase or decrease but expansion or contraction. If one of the nonprice determinants of demand, such as the prices of other goods, income, etc. change & thereby demand changes, the relevant terms are increase and decrease in demand. The expansion and contraction in demand are shown in the diagram. You may observe that expansion and contraction are shown on a single DD curve. The changes (movements) take place along the given curve k.

Determinants of demand

After having understood the nature of demand and law of demand, it is easy to ascertain the determinants of demand. We have mentioned above that an individual demand for a commodity depends on desire for the commodity and his capability to purchase it. The desire to purchase is revealed by tastes and preferences of the individuals. The capability to purchase depends upon his purchasing power, which in turn depends upon his income and price of the commodity. Since an individual purchases a number of commodities, the quantity of a particular commodity he chooses to purchase depends on the price of that particular commodity and prices of the other commodities, as well as the relative amount of his income, or purchasing power.

So, the amount demanded (per unit of time) of a commodity depends upon

Prices of related commodities

When a change in price of the other commodity leaves the amount demanded of the commodity under consideration unchanged, we say that the two commodities are unrelated, otherwise these are related. The related commodities are of two types’ substitutes and complements. When the price of one commodity and the quantity demanded of the other commodity move in the same direction (i.e., both increase together and decrease together).

Income of the individual

The amount demanded of a commodity also depends upon the income of an individual. With an increase in income, increased amount of most of the commodities in his consumption bundle, though the extent of the increase may differ between commodities.

Tastes and preferences

It is quite well that the change in tastes and preferences of consumers in favor of a commodity results in smaller demand for the commodity. Modern business firms, which sell product with different brand names, rely a great deal on influencing tastes and preferences of households in favor of their products (with the help of advertisements, etc.) in order to bring about increase in demand of their products.

Tastes of the consumers

The amount demanded also depends on consumer’s taste. Tastes include fashion, habit, customs, etc. A consumer’s taste is also affected by advertisement. If the taste for a commodity goes up, its amount demanded is more even at the same price and vice-versa.

Wealth

The amount demanded of a commodity is also affected by the amount of wealth as well as its distribution. The wealthier are the people, higher is the demand for normal commodities. If wealth is more equally distributed, the demand for necessaries and comforts is more. On the other hand, if some people are rich, while the majority is poor, the demand for luxuries is generally less.

Expectations regarding the future

If consumers expect changes in price of a commodity in future, they will change the demand at present even when the present price remains the same. Similarly, if consumers expect their incomes to rise in the near future, they may increase the demand for a commodity just now.

Climate and weather

The climate of an area and the weather prevailing there has a decisive effect on consumer’s demand. In cold areas, woolen cloth is demanded. During hot summer days, ice is very much in demand. On a rainy day, ice-cream is not so much demanded.

State of business

The level of demand for different commodities also depends upon the business conditions in the country. If the country is passing through boom conditions, there will be a marked increase in demand. On the other hand, the level of demand goes down during depression.

Aggregate consumer demand or market demand

The market (also aggregate consumer) demand function is derived by adding all individual consumer demand functions. Aggregation adds three other non price determinants of demand - (1) the number of consumers (2) "the distribution of tastes among consumers" and (3) "the distribution of income among consumers of different tastes." Thus if the population of consumers increases all other things being held constant the market demand curve will shift out. Likewise, if the income distribution were to change in favor of a group of consumers with strong taste for same good "there would be an increase in demand for that good relative to other goods."

The factors that affect individual demand also affect market demand although the net effect can be ambiguous.

Macro concepts of demand

Individual demand, firms demand and industry demand are the micro concepts of demand. This is useful to manager in decision making as to determination of size of supplies etc. However, a manger has to know the macro concepts of demand as he operates within the macroeconomic environment. As such he much understands a few macro concepts of demand. As a matter of fact, national demand may influence the industry demand which in its turn may influence the firms demand. Some of the important macro-concepts of demand are illustrated below.

Effective demand

This refers to the aggregate volume of demand in an economy, (size of the market), which induces the manufacturers to adjust that demand by supply. Thus if demand is ‘effective’, it should create employment, induce output and generate income in the economy.

Consumption demand

Further information: Consumption function

It is a component of the effective demand. It is concerned with the demand for consumer goods i.e., consumption expenditure of a nation which depends on national income.

Investment demand

It is another component of effective demand. It has reference to the demand for investment goods i.e., investment expenditure in the national economy which is dependent on the net return on investment.

Demand for money

This refers to desire to hold money (liquidity) in hand. In any of the three motives i.e., transaction, precaution or speculation. Accordingly, we may speak of transaction demand for money to meet day-to-day exchange transactions. The precautionary demand for moneys to meet contingency requirements. The speculative demand for money has got long-term business use; it is mostly influenced by the market rate of interest. In fact, the rate of interest is the opportunity costs of holding money in hand for speculative purposes.

Demand for bonds

Since money and bonds are substitutes, the demand for bonds is related to the demand for money.

Limitation

• Change in taste or fashion.
• Change in income
• Change in other prices.
• Discovery of substitution.
• Anticipatory change in prices.
• Rare or distinction goods.

There are certain goods which do not follow this law. These include Veblen goods and Giffen goods.

See also

• Supply and Demand