The three reasons or assumptions that underlie the law of demand are the income effect, the substitution effect and diminishing marginal utility. The first two describe how consumers react when the price of a product changes. The income effect relates it to real income. Meanwhile, the substitution effect relates it to its relative price to substitute products and consumer choice.
Meanwhile, decreasing marginal utility relates the price we are willing to pay with the satisfaction we get from consuming the good.
How all three work, I will discuss below. In this early part I will review what the law of demand is and what are the determinants of demand.
What is the law of demand?
The law of demand states an inverse relationship between price and quantity demanded. An increase in price causes the quantity demanded to fall. On the other hand, a decrease in price causes the quantity demanded to increase. This law applies to almost everything around us.
The law of demand is one of two principles in microeconomics to explain market equilibrium. The other is the law of supply. Both underlie the demand and supply curves. And, when the two curves intersect, it results in market equilibrium . At the equilibrium point, the best price and quantity for producers and consumers are determined.
Back to the law of demand. It assumes other factors are constant or ceteris paribus . We isolate them and focus on the relationship between price and quantity.
But, in fact, many factors affect demand. Consumers not only consider price when they buy, but also consider their income.
In addition, they will also see the price trend. If they expect prices to rise in the next month, for example, they buy immediately before prices go up. Or, when prices are on a downward trend, they delay buying to get a lower price next month.
Another factor is the price of the related goods. They can be substitute goods or complementary goods. Because substitutes satisfy the same need, when the price of a product rises, consumers will switch to them. In addition, it also encourages consumers to reduce the demand for complementary goods .
Lastly, demand also depends on the tastes and preferences of consumers. When they are craving a product and have enough money, they will buy it.
Exceptions to the law of demand
The law of demand applies to most of our everyday products. But, it is not for all products.
There are specific cases where it doesn’t apply. Thus, an increase in price does not always lead to a decrease in the quantity demanded. Vice versa, a decrease in price does not always increase the quantity demanded.
The two exceptions to the law of demand are Veblen goods and Giffen goods.
Giffen goods . They are specific examples of inferior goods, i.e. goods for which their demand falls as consumer incomes rise. However, unlike other inferior goods, the demand for Veblen goods falls when their prices fall. Consumers associate lower prices with poorer quality.
Veblen goods . Their demand rises when prices rise, violating the law of demand. The higher the price, the more consumers want them. They associate a higher price with a higher prestige or image. Thus, consumers are increasingly satisfied and want them when prices rise.
What are the assumptions underlying the law of demand?
The negative relationship between price and quantity demanded is explained for three reasons. They form the assumptions that underlie the law of demand. The three are:
- Decreased marginal utility
- Income effect
- Substitution effect
diminishing marginal utility
Economists use the term utility to refer to the satisfaction we get from consuming goods and services. Meanwhile, marginal means additional or extra. Thus, we can define marginal utility as the extra satisfaction we get from each additional good we consume.
When we increase consumption, the satisfaction we get from one more good we consume decreases. For example, we are very hungry. The first plate will give the highest satisfaction and taste delicious. We then add a second plate, it also gives additional satisfaction, but not as delicious as the first plate because we are already quite full. The third plate will also give lower satisfaction than the second plate and so on. So, every time we add to the plate for the next meal, we get a decrease in satisfaction because we are getting fuller.
Such an illustration points us to diminishing marginal utility. Because we get diminishing satisfaction for the additional unit of consumption, we will only buy more when the price goes down.
In the above case, we are willing to add a second plate if it is cheaper. Otherwise, the first plate is enough to satisfy our hunger. Likewise, the third plate must be cheaper than the second plate in order for us to be willing to consume. Up to a point, we won’t want any more, because the marginal utility drops to zero (we’re full).
The income effect explains how price changes affect real income and our choices. Real income shows how much product we can get with our nominal income.
Say, we have income of $1,000. We can use it to buy 100 units of a product at $10 per unit. In this case, the income of 100 units represents our real income.
Now assume our nominal income is fixed. When the price of the product falls, our real income rises. Say, the price drops to $5 per unit. Now we can buy 200 units.
On the other hand, if the price increases to $20, we can only get 50 units using our income. In this case, our real income goes down.
Long story short, real income rises when prices fall and falls when prices rise. Thus, a change in price affects the real income we can spend, which in turn affects the quantity we demand.
The substitution effect explains our choices when the price of a product changes. If two products substitute for each other, they satisfy our same need. If the price of one changes, it will affect our choice.
Economists assume we are rational consumers. So, we tend to replace products with higher prices with cheaper ones. So, when the price of a product rises, we will choose its substitute.
Why did such a choice arise? The product and its substitutes satisfy the same need. So, choosing one means giving up the other. It doesn’t make sense to buy both at the same time.
Take Pepsi and Coca-Cola for example. They cater to our need for soft drinks. And, with the existing budget, we can’t buy both at once. So, when we have chosen Pepsi, we have given up Coca-Cola. And conversely, choosing Coca-Cola means giving up Pepsi. For example, when the price of Pepsi, we switch to Coca-Cola and vice versa, when the price of Coca-Cola rises, we switch to Pepsi.
From the illustration we know, when the price of a product rises, ceteris paribus, it reduces its quantity demanded because some consumers will turn to its substitutes. Conversely, if the price falls, ceteris paribus, some consumers switch from substitutes to the product, increasing the quantity demanded.