Law of Demand – Definition, Explanation

The law of demand states that ceteris paribus (other things being equal)

  • If the price of good rises, then the quantity demanded will fall
  • If the price of a good falls, then the quantity demand will rise.

Example

At point (A) Price is £1.20 and the quantity demand is 40,000 tonnes. When the price falls to £0.90, the quantity demanded rises to 55,000 tonnes (point B)

demand-curve-law

If the price fell to £0.70, demand would rise to 75,000.

What explains the law of demand?

There are two factors that explain the inverse relationship between price and quantity demand.

1. Income effect. If prices rise, people will feel poorer after purchasing the more expensive goods. They will have less disposable income and so cannot afford to buy as much. If you have an income of £100, then an increase in the price of goods, your real income is effectively falling.

2. Substitution effect. If the price of one good rise, consumers will be encouraged to buy alternative goods which are now relatively cheaper than they were. For example, if the price of potatoes rises, it will encourage consumers to buy rice instead.

Demand Schedule

A demand schedule is a table showing the different quantities of a good that consumers are willing and able to buy at various prices for a particular period.

This is the market demand schedule for Netflix subscriptions

 

demand-schedule Demand Curve

The demand curve is a graph showing the relationship between the price of a good and the quantity demanded.

A demand curve can be for an individual consumer or the whole market (market demand curve)

Exceptions to the law of demand

Giffen Good. This is good where a higher price causes an increase in demand (reversing the usual law of demand). The increase in demand is due to the income effect of the higher price outweighing the substitution effect. The idea is that if you are very poor and the price of your basic foodstuff (e.g. rice) increases, then you can’t afford the more expensive alternative food (meat) therefore, you end up buying more rice because it is the only thing you can afford. These goods are very rare and require a society with very low income and limited consumer choices.

Veblen good/ostentatious good. This is where if the price rises, then some people may want to buy more because the higher price makes the good appear more attractive. For example, if designer clothing becomes more expensive than for some individuals, the higher price makes it more expensive. However, whilst individual demand curves may be upward sloping. The market demand curve is unlikely to be. Because although it may be more desirable not everyone can afford it. In fact, the super-rich wants to buy more – precisely because it is exclusive.

Nobody buys the cheapest. Another possibility is that in restaurants, the most popular wine is the second cheapest. This is due to the behavioural choices of consumers. When going out to a restaurant, people don’t like to buy the cheapest wine because it suggests you don’t care about giving diners a good meal. Therefore, often the second cheapest wine often sells more because people think they are getting better quality. Therefore, if you increase the price of the cheapest wine, its demand may actually rise.

Perfectly inelastic. If demand is perfectly inelastic, then an increase in the price has no effect on reducing demand. This may be good like salt, which is very cheap but essential.

Perfectly elastic. Demand is infinite at a certain price, therefore reducing the price will not change the quantity demanded.

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