What Is the Law of Demand in Economics?

What Is the Law of Demand in Economics?

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The Law of Demand states that ceteris paribus (if all else held constant), the quantity demanded of a good or service decreases as its price increases. Conversely, demand increases for goods and services as price decreases. This reflects an inverse relationship between price and quantity and can be visually expressed on a supply and demand diagram through a downward-sloping demand curve (illustrated below) or in tabular format through a demand schedule. This seemingly simple concept, rooted in the innate human desire to optimise choices, holds immense significance for consumers and businesses to policymakers and financial analysts.

The Law of Demand is opposite to the Law of Supply, which states that ceteris paribus, the quantity supplied of a good or service increases as the price increases, and equally, the quantity supplied decreases as the price decreases; the supply curve is reflected in an upward facing curve on a supply and demand diagram, as shown below.

The price of goods or services can be found on the vertical axis, while the quantity demanded is located on the horizontal axis. You may also note that the market equilibrium is where supply and demand curves intersect: the equilibrium price (also referred to as market-clearing price) and equilibrium quantity. This is essentially the point that suppliers supply just enough of a good or service to satisfy demand.  

Exploring The Law of Demand: How it Works

When the price of a good or service increases, consumers are less willing (or able) to consume and this leads to a decrease in the quantity demanded. This is logical and will be clear for many of us. Equally, a decrease in price typically translates to an increase in the quantity demanded, as consumers are incentivised to purchase more. Demand, as defined by economists, is the amount of a good (or service) that consumers are willing to pay (or the ability to pay) at each price level.

The relationship between price and quantity occurs for several reasons. Decreasing Marginal Utility (DMU) is one such factor and means that consumers will want to pay less for a good or service the higher the amount that they have of it. The additional satisfaction (referred to as marginal utility by economists) they derive from each unit decreases. The market price, according to the neoclassical demand model, determines the number of units that would be consumed. For example, imagine shopping for jeans with a market price of 5 USD. If a consumer is willing to pay for a second pair of jeans for 10 USD, the consumer would get their second pair of jeans; if the consumer is willing to pay 5 USD for a third pair, they would also be able to purchase these, but if their willingness to pay for a fourth pair decreased to 3 USD, they would not be able to get a fourth pair as their willingness to pay is lower than the market price (or given price). So, our imaginary consumer would continue to purchase jeans until their willingness to pay or their marginal utility is the same as the asking price.

Another reason behind the Law of Demand is that consumers strive to maximise their utility with their limited resources. When prices rise, they are forced to make choices, often substituting towards cheaper alternatives or consuming less of the expensive good, and this decreases demand for the good or service, hence the downward facing curve.

Endogenous and Exogenous Factors

Within a demand model, the price and quantity are the endogenous variables and are essentially what the demand model attempts to explain (inside the model). Exogenous variables, on the other hand, are those variables outside of the model that are taken as fixed (constant) but can affect demand. The purpose of the model is not only as an illustration of the relationship between price and quantity demanded within the model (when keeping exogenous variables fixed), but also to demonstrate how exogenous variables can affect the demand curve. As a result, we can say that the Law of Demand holds true when outside factors are kept constant.

Types of exogenous variables that can SHIFT the demand curve to consider are consumer income, preferences and the availability and prices of other goods. It is important to understand that a rise in the price of a good or service will see movement along the demand curve. When an exogenous factor is not fixed, this can cause a shift in the demand curve, either left or right.

Consumer Income:

A rise in income can witness an increase in the quantity demanded of a good or service on the back of consumers having more purchasing power. This would cause a shift to the RIGHT of the demand curve as the quantity demanded would increase for each price level.

Preferences:

Using the example for jeans above, let’s imagine preferences for lower-end jeans changed as a new brand of slightly more expensive jeans was now more fashionable. In this case, as demand for the lower-end jeans has decreased, a shift to the LEFT in the demand curve would be observed.

Availability of Other Goods:

If close substitutes become readily available at lower prices, the quantity demanded for the original good is likely to decrease, hence a shift to the RIGHT in the demand curve.

Exceptions

Like all things in life, there are exceptions to the Law of Demand.

Veblen Goods is a good example of one such exception. These represent goods associated with conspicuous consumption, where consumers purchase goods to signal their social status or, more precisely, demonstrate what their economic condition is. So, when the price of Veblen goods increases, it becomes more desirable and thus tends to increase the quantity demanded for that good rather than decrease demand.

Another example is Giffen Goods; these are goods—often low-priced inferior goods—in which a higher price can cause increased demand, and this is usually seen due to the higher price outweighing the substitution effect.

Final Take

It's important to remember that the Law of Demand is a fundamental principle and may not hold true in every circumstance. Factors such as income levels, consumer preferences, and availability of substitutes can also influence demand. However, the Law of Demand remains a foundational concept in understanding consumer behaviour and market dynamics.