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What’s it: The law of demand is a principle in microeconomics, stating a negative relationship between a good’s price and its quantity demanded. The quantity demanded increases when the price falls, assuming other factors are unchanged or ceteris paribus. On the other hand, the higher the price, the lower the quantity demanded.
One of the reasons for the negative relationship between quantity and price is explained by the concept of diminishing marginal utility. It tells us the price we are willing to pay less for each additional consumption we make. The reason is, we get a decrease in satisfaction each time we consume one more good.
Then, the law applies to most things around us. But, in specific cases, it doesn’t apply.
The law of supply and demand in economics
The laws of supply and demand are two fundamental concepts in economics. Economists explain both when we study supply-demand theory, which explains how a market economy allocates resources and determines the best prices for consumers and producers.
Both theories underlie an upward sloping supply curve (positive slope) and a downward sloping demand curve (negative slope). Both curves have two axes: the Y-axis represents the price, and the X-axis represents quantity.
The law of supply tells a positive relationship between quantity supplied and price. If prices rise, producers are willing to supply more. Conversely, if prices fall, they are willing to supply less.
If we plot each quantity supplied for each different price level, it will form the combined price and quantity points. Then, if we draw a line linking these points, it will form a straight line with a positive slope. That’s the supply curve.
Meanwhile, the law of demand states a negative relationship between quantity demanded and price. If prices rise, consumers are willing and able to buy less. Conversely, if prices fall, they are willing and able to buy more.
Just like plotting a supply curve, the quantity demanded for each different price level will form a straight line with a negative slope. That’s the demand curve.
Why is the law of demand important?
Alfred Marshall developed supply and demand curves to show the point at which the market is in equilibrium. Both curves are important for explaining market equilibrium and how consumers and producers respond to shocks (disequilibrium). And, in this case, the law of supply and demand forms the basis for constructing the supply and demand curves I mentioned earlier.
The law of demand explains our everyday phenomena. For example, we know what happens when the price goes up. An increase in price results in a decrease in the quantity demanded because the good becomes more expensive. To get the equivalent amount, we need more money. For example, if the price doubles, we only buy half of it or, in fact, don’t buy it at all because it is over our available budget.
How much effect does a price change have on the quantity demanded?
Economists answer this question on the topic of elasticity of demand. It describes how responsive the demand for a product changes when its price changes.
If the quantity changes a lot when the price changes slightly, we call it elastic demand. Consumers are very sensitive to price changes. Thus, the percentage change in price is less than the percentage change in quantity demanded. For example, if the price increases by 5%, the quantity demanded falls by more than 5%. And, if the price falls by 5%, the quantity demanded increases by more than 5%.
Conversely, if the quantity demanded changes little when the price changes significantly, it is inelastic in demand. This is because consumers are less sensitive to price changes. Thus, when the price increases by 5%, the quantity demanded falls less than 5%. And, if the price falls by 5%, the quantity increases by less than 5%.
How to draw the law of demand into a curve?
To plot the law of demand on a curve, we must estimate the quantity demanded for each different price level. For example, for $7, a consumer is willing to be able to buy 3 units. However, if the price drops to $6, the quantity he wants is 6 units. Then, if the price drops further to $4, he asks for 12 units.
Each price and quantity above represents a point on the curve. So, if we draw the combination above, we get three points. Then, we can draw a straight line through these three points. And that’s the demand curve. Here is an example of the curve (here, I used seven-point combinations).
What are the factors influencing demand?
Economists use price to describe the demand for a good. So, we can call it the main determining factor.
In addition to price, other factors influencing demand include:
- Consumer income
- Consumer tastes and preferences
- Prices of related goods, complements, or substitutes
- Future price expectations
The law of demand assumes the above factors are constant. Consumer income does not change, neither does the price of goods, tastes, price expectations, or prices of related goods. Thus, the consumer’s decision to buy an item is solely influenced by its price.
Why is the price the main determinant of demand?
The price has a significant effect and is relatively easy to isolate in developing the supply-demand theory. In addition, prices can provide value, represent interests, or are considered by two parties: producers and consumers. Meanwhile, the other factors above only represent considerations from consumers’ point of view, not producers.
For consumers, price affects their satisfaction. It represents the costs they have to incur to satisfy their needs and wants. If the price is equal to or lower than the benefits they receive, they are satisfied. Otherwise, they are not satisfied. So, in the market, they will try to bid at a lower price.
On the other hand, price affects producer profits. Their profits increase when they can sell the product at a higher price. Since their goal is to maximize profits, they will try to set a high price in the market.
Producers and consumers interact in the market to determine the equilibrium price. The low price demanded by consumers does not match what producers want. But, on the other hand, the high prices charged by producers are also not desired by consumers. And at the equilibrium price, both agree. In other words, it is the best price for both producers and consumers.
Does the law of demand describe all the economic phenomena around us?
The law of demand shows an inverse relationship between price and quantity demanded, and it applies to most situations in our lives. However, it does not apply to all goods and services. The two exceptions to the law are Giffen goods and Veblen goods.
Giffen goods. Their quantity demanded falls as their price falls. Consumers are less likely to want them when prices are lower because they think it indicates poor quality.
- They are a specific case of inferior goods. Examples are used clothes, cassava, and other low-quality foods. When consumer incomes fall, demand for used clothing increases. But, if the price decreases, they will think twice about buying it because the quality is probably worse.
Veblen goods. Their quantity demanded increases as their price rises. The higher the price, the more consumers like it.
- Luxury goods are a great example. Consumers perceive price not only as a cost but also as an extra utility. Thus, when prices rise, they get more utility or satisfaction. A higher price gives a higher prestige or image.
In short, the law of demand applies to normal goods consumed by most people. Meanwhile, Giffen goods are associated with the poor, and Veblen goods are associated with the rich, which are relatively small in number.
