Law of demand

Law of demand

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In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, the law of demand is an economic law that states that consumers
Consumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...

 buy more of a good when its price decreases and less when its price increases (ceteris paribus
Ceteris paribus
or is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical...

).

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
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

 and its price are inversely related, other things remaining constant. That is, if the income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...

 of the consumer, prices of the related goods
Goods
Goods may refer to;*Good , physical product*Personal property, legal personal chattels...

, 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
Inverse relation
In mathematics, the inverse relation of a binary relation is the relation that occurs when you switch the order of the elements in the relation. For example, the inverse of the relation 'child of' is the relation 'parent of'...

 may be stated with causal relation as:


Where, is the quantity demanded of x goods

f is the function of independent variables contained within the parenthesis, and

is the price of x goods.

Hence, in the above model, the function
Function (mathematics)
In mathematics, a function associates one quantity, the argument of the function, also known as the input, with another quantity, the value of the function, also known as the output. A function assigns exactly one output to each input. The argument and the value may be real numbers, but they can...

 (f) is a varying one i.e., the law of demand postulates as the causal factor (independent variable) and is the dependent variable.

The two variables move in the opposite direction. When falls rises and the reverse. In regard to the question "by how much will quantity demanded rise?", the law is silent. For example, when 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 or is not competed by other.
  • The commodity is a normal good
    Normal good
    In economics, normal goods are any goods for which demand increases when income increases and falls when income decreases but price remains constant, i.e. with a positive income elasticity of demand...

     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. It should be noted that not all inferior goods are giffen goods, but all giffen goods are inferior goods. This is similar to how all men are humans but not all humans are men. A walkman is considered an inferior good but would not be a Giffen good.

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 a price change alone, we should not say increase or decrease but expansion or contraction. If one of the non-price 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 the 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. For substitutes if price of one will increase the demand of other will increase and for compliments if the price of one will increase the demand for other will decrease.

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 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.price itself is the most important determinant of demand for the product.

Consumption 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
Veblen goods
In economics, Veblen goods are a group of commodities for which people's preference for buying them increases as their price increases, as greater price confers greater status, instead of decreasing according to the law of demand. A Veblen good is often also a positional good...

 and Giffen goods.