Meaning of the Law of Demand
Law of demand states “while other things do not change, there is an inverse relationship between the price of a commodity and the quantity demanded at a specified time.” In simple terms, people tend to purchase more of goods or services when their prices decrease and tend to purchase less when the prices increase. However, the law of demand is valid only when the assumption “other things remaining the same” is fulfilled.
Assumptions of the Law of Demand
By the phrase “other things remaining the same”, law of demand assumes the following:
- Consumer’s income, tastes and preferences are constant.
- Prices of substitutes and complements do not change.
- There are no new substitutes for the goods under consideration.
- People do not speculate on prices. It means that if price of the commodity in question falls, people will not wait for further decline in prices.
- The commodity under consideration does not have prestige value.
The law of demand will not work as expected if any one of the aforementioned assumptions is violated.
Basis for the Law of Demand
The foundation for law of demand is law of diminishing marginal utility. Marshall derived law of demand from law of diminishing marginal utility. Law of diminishing marginal utility states that utility derived from additional units of a commodity keeps declining. For example, when you eat the first apple, you get more satisfaction from it. Here satisfaction means utility. At the same time, when you start eating more apples, the utility you derive from every additional unit becomes less and less. This occurs because you reach the saturation level.
From this diminishing marginal utility concept, you can derive law of demand. Let us consider the same apple example. Since the first apple gives more utility, you do not bother about the price of it. Hence, you tend to buy an apple even at a high price. However, additional units of apple give you less and less utility. Hence, you do not want to buy apples at a high price anymore. Now the seller has to lower the price of apples to increase the demand. When the price is declined, you start buying more apples again. In this manner, law of diminishing marginal utility paves a path to law of demand.
There is a direct relationship between marginal utility and price of a commodity. Further, there is an inverse relationship between quantity demanded and price of a commodity. Let us look at figure 1. From figure 1(a), we understand that OM1 quantity of goods gives MU1 marginal utility. Now MU1 = P1. From figure 1(b), we understand that at OP1 price, the consumer demands OM1 quantity. Similarly, OM2 quantity of goods gives MU2 marginal utility. Now MU2 = P2. At price OP2, the consumer purchases OM2. Further, at OM3 quantity, the marginal utility is MU3. MU3 = P3. At price P3, the consumer purchases OM3 quantity. Because of diminishing utility, the marginal utility curve slopes downwards from left to right (in figure 1(a)). Therefore, the demand curve based on marginal utility also slopes downwards from left to right (in figure 1(b)).
Exceptions to the Law of Demand
In general, people tend to buy more when the price declines. Also demand decreases when the price starts moving upwards. This causes the demand curve slope downwards from left to right. However, there are some exceptions to this rule. Because of these exceptional cases, demand curve takes unusual shape, which does not obey the law of demand. In the exceptional cases, demand curve slopes upwards from left to right. This means that demand decreases when there is a fall in price and demand increases when there is a rise in price. This type of demand curve is known as an exceptional demand curve or positively sloped demand curve.
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For example, have a look at figure 2. In figure 2, DD represents a demand curve, which slopes upwards from left to right. The diagram shows that that when the price rises from OP1 to OP2, the quantity demanded also increases from OQ1 to OQ2 and vice versa. Conspicuously, such positively sloped demand curves violate the basic law of demand.
1. Giffen Paradox
Sir Robert Giffen observed consumption pattern of low-paid British wage earners early in 19th century. He found that an increase in the price of bread caused wage earners to buy more of it. The wage earners supported themselves by consuming bread only. When the price of bread increased, they spent more money on a given quantity of bread by restricting other expenses. Marshall was unable to explain this scenario and called it ‘Giffen Paradox’.
2. Veblen Goods
Another exception is based on the doctrine of conspicuous consumption attributed by Thorstein Veblen. People purchase certain goods for ostentation or showy purposes. Such goods are known as Veblen goods. Since these goods are used to impress others, people may not buy when the price falls. In other words, demand decreases when the price falls.
Speculation on prices is a also cause for upward sloping demand curve. A typical example for this scenario is stock market trading. When a price of a share rises, people tend to buy the share more on the expectation that the price will rise further. Similarly, when the price falls, people tend to sell the share expecting that the price will fall further.
© 2013 Sundaram Ponnusamy
Shreedhar on March 08, 2014:
Thanks for this side