In the previous article on Basic Economics you have come across different concepts of economics. Now let us try to understand one of the most important concepts of economics “Law of Demand” and how does it works.
Introduction to the Law of Demand:
The law of demand defines the negative relationship between the price of a product and the quantity demanded. Alfred Marshall defines it as “the amount demanded increases with a fall in price, and diminishes with a rise in price”. It states that the lower the price of a product, the larger the quantity that will be demanded, other things (Income, taste of the consumer, population, and the price of other products) being constant. Thus, it expresses an inverse relation between price and demand.
In the figure, it is represented by the slope of the demand curve, which is normally negative throughout its length. The inverse price- demand relationship is based on other things remaining equal. This phrase points towards certain important assumptions on which this law is based.
Assumptions of the Law of Demand:
- There is no change in the tastes and preferences of the consumer;
- The income of the consumer remains constant;
- There is no change in customs;
- The commodity to be used should not confer distinction on the consumer;
- There should not be any substitutes of the commodity;
- There should not be any change in the prices of other products;
- There should not be any possibility of change in the price of the product being used;
- There should not be any change in the quality of the product; and
- The habits of the consumers should remain unchanged. Given these conditions, the law of demand operates. If there is a change even in one of these conditions, it will stop operating.
Given these assumptions, the law of demand is explained in terms of Table and Figure.
The above table shows that when the price of say, Apple, is Rs. 5 per unit, 100 units are demanded. If the price falls to Rs.4, the demand increases to 200 units. Similarly, when the price declines to Rs.1, the demand increased to 600 units. On the contrary, as the price increases from Re. 1, the demand continues to decline from 600 units.
In the figure, point P of the demand curve DD1 shows demand for 100 units at the Rs. 5. As the price falls to Rs. 4, Rs. 3, Rs. 2 and Re. 1, the demand rises to 200, 300, 400 and 600 units respectively. This is clear from points Q, R, S, and T. Thus, the demand curve DD1 shows an increase in demand of apples when its price falls. This indicates the inverse relation between price and demand.
Reasons of operation of Law of Demand
The Law of Diminishing Marginal Utility
The operation of law of demand can be explained on the basis of the law of diminishing marginal utility. The law states that as more of a commodity is purchased, its marginal utility to the consumer will be less and less. Therefore the consumer while purchasing the commodity values less and less the additional units of the commodity. So, he will purchase more only if the price falls. Suppose a consumer derives satisfaction worth Rs.5 from the first apple and Rs.3 worth of satisfaction from the second apple. If the price per unit of apple is Rs.5 then he will purchase only one unit to equalize prices with utility. If the price of apple Rs.3 each, then he will purchase two units. This shows when the price falls, the consumer purchase more. Thus the law of demand is nothing but a reflection of the law of diminishing marginal utility.
When the price of a good falls, the real income of the consumer rises. If the consumer has Rs.15 and price per unit of apple is Rs.5. then he can purchase 3 units of apple. If the price falls to Rs.3 then to purchase same 3 units, the consumer will spend Rs.3×3 = Rs.9. This leaves a surplus of Rs.6 with the consumer. Thus a fall in price has the same effect of increase in money income and hence is known as the income effect of a price reduction. The consumer can purchase some more units of the good with the surplus income released through the fall in price. Therefore when price falls amount purchased increases. When the price rises, the consumer’s real income falls. This reduces his expenditure on the good leading to the fall in demand.
Another effect of changes in the price of a good is the substitution effect. When the price of a good falls, other things remaining constant, the goods becomes cheaper in comparison to other goods. The consumer will substitute the cheaper goods for the costlier goods so that he will gain. If the price of fish falls, the consumer to some extent will substitute it for meat leading to the rise in demand for fish. On the other hand, if the price of a good rises, the good becomes costlier in demand for fish. On the other hand, if the price of a good rises, the good becomes costlier in comparison to other goods, hence other goods will be purchased to some extent in its place. This will lead to the fall in demand of the commodity whose price has risen.
Change in the Number of Consumers
With the change in the price of a good, number of consumers willing to purchase the commodity also changes. For example, when the price falls, the consumers who were on the borderline of their ability can now come to the market to buy it as it is now affordable to them. The existing consumers will no doubt purchase more. The combined result is the rise in quantity demanded as price falls.
Exceptions to the Law of Demand:
In certain cases, the demand curve slopes up from left to right, i.e., it has a positive slope. Under certain circumstances, consumers buy more when the price of a commodity rises, and less when the price falls, as shown by the D curve in Figure. Many causes are attributed to an upward sloping demand curve.
If shortage is feared in anticipation of war, people may start buying for building stocks or for hoarding even when the price rises.
During a depression, the prices of commodities are very low and the demand for them is also less. This is because of the lack of purchasing power with consumers.
(iii) Giffen Paradox:
If a commodity happens to be a necessity of life like wheat and its price goes up, consumers are forced to curtail the consumption of more expensive foods like meat and fish, and wheat being still the cheapest food they will consume more of it. The Marshallian example is applicable to developed economies.
In the case of an underdeveloped economy, with the fall in the price of an inferior commodity like maize, consumers will start consuming more of the superior commodity like wheat. As a result, the demand for maize will fall. This is what Marshall called the Giffen Paradox which makes the demand curve, to have a positive slope.
(iv) Demonstration Effect:
If consumers are affected by the principle of conspicuous consumption or demonstration effect, they will like to buy more of those commodities which confer distinction on the possessor, when their prices rise. On the other hand, with the fall in the prices of such articles, their demand falls, as is the case with diamonds.
(v) Ignorance Effect:
Consumers buy more at a higher price under the influence of the “ignorance effect”, where a commodity may be mistaken for some other commodity, due to deceptive packing, label, etc.
Marshall mentions speculation as one of the important exceptions to the downward sloping demand curve. According to him, the law of demand does not apply to the demand in a campaign between groups of speculators. When a group unloads a great quantity of a thing on to the market, the price falls and the other group begins buying it. When it has raised the price of the thing, it arranges to sell a great deal quieter. Thus, when price rises, demand also increases.
(vii) Necessities of Life:
Normally, the law of demand does not apply on the necessities of life, such as food, cloth, etc. Even the price of these goods increases, the consumer does not reduce their demand. Rather, he purchases them even the prices of these goods increase often by reducing the demand for comfortable goods. This is also a reason that the demand curve slopes upwards to the right.
Thus, from the above, it is clear that how the law of demand works and operates, its assumptions and its exemptions.