Difference between revisions of "Law of demand"

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==Levels of operation of the law==
 
==Levels of operation of the law==
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===For individuals and households===
  
 
Conceptually, the law of demand arises from two fundamental causes: first, the limited purchasing power of an individual or household, and second, the fact that the nature of preferences of the individual or household, i.e., the nature of the utility function that the individual or household is trying to maximize. The law of demand operates at multiple levels.
 
Conceptually, the law of demand arises from two fundamental causes: first, the limited purchasing power of an individual or household, and second, the fact that the nature of preferences of the individual or household, i.e., the nature of the utility function that the individual or household is trying to maximize. The law of demand operates at multiple levels.
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* ''For a given household and a given commodity'': The demand of a particular household for a particular commodity is expected to increase, or at least stay constant, as the price of the commodity falls. This relies on the assumption that the marginal benefit from every additional unit of the commodity is decreasing. There are two effects responsible for the law of demand: [[income effect]], which states that the higher the price, the less the household can spend on the good with the limited income it has, and the [[substitution effect]], which predicts that an increase in price makes the household substitute away from the good towards [[subsitute goods]]. {{further|[[Law of demand for individual buyers follows from diminishing marginal utility]], [[Income effect explains law of demand]], [[substitution effect explains law of demand]]}}
 
* ''For a given household and a given commodity'': The demand of a particular household for a particular commodity is expected to increase, or at least stay constant, as the price of the commodity falls. This relies on the assumption that the marginal benefit from every additional unit of the commodity is decreasing. There are two effects responsible for the law of demand: [[income effect]], which states that the higher the price, the less the household can spend on the good with the limited income it has, and the [[substitution effect]], which predicts that an increase in price makes the household substitute away from the good towards [[subsitute goods]]. {{further|[[Law of demand for individual buyers follows from diminishing marginal utility]], [[Income effect explains law of demand]], [[substitution effect explains law of demand]]}}
 
* ''For an aggregate of households and a given commodity'': The demand over an aggregate of households for a particular commodity is expected to increase, or at least stay constant, as the price of the commodity falls. This may happen because the consumption of individual households increases steadily, as well as because the number of households purchasing the commodity also increases steadily, as the price falls to the reservation price. The second effect is due to differences in [[reservation price]]s across households. Note that this effect is operational even when there is essentially no scope for a single individual or household to buy more than one unit of the commodity. {{further|[[Law of demand for multiple buyers following from differences in reservation prices]]}}
 
* ''For an aggregate of households and a given commodity'': The demand over an aggregate of households for a particular commodity is expected to increase, or at least stay constant, as the price of the commodity falls. This may happen because the consumption of individual households increases steadily, as well as because the number of households purchasing the commodity also increases steadily, as the price falls to the reservation price. The second effect is due to differences in [[reservation price]]s across households. Note that this effect is operational even when there is essentially no scope for a single individual or household to buy more than one unit of the commodity. {{further|[[Law of demand for multiple buyers following from differences in reservation prices]]}}
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===For firms in their demand for inputs to production===
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The law of demand also applies for firms that buy inputs to their production process (i.e., [[factor of production|factors of production]]) from other firms. When the price of an input into the production process of a firm increases, the demand of the firm for that input is likely to decrease. The firm typically does either one or both of the following: alter its production process to use less of that input and more of various substitutes, and/or scale back the quantity of its production.
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Note that, as discussed in the apparent counterexamples, if the prices of substitute inputs increases ''more'', demand for the given input might increase even as the price increases.
  
 
==Causation versus correlation: superfical counterexamples==
 
==Causation versus correlation: superfical counterexamples==

Revision as of 13:02, 1 August 2010

Statement

The law of demand states the following equivalent things:

  • The price-elasticity of demand for a good is negative, or at best, non-positive.
  • ceteris paribus, as the price of a good increases, the demand for it decreases (or at best, remains the same).
  • ceteris paribus, as the price of a good decreases, the demand for it increases (or at best, remains the same).
  • The demand curve for a good is downward-sloping.

Goods satisfying the law of demand are termed ordinary goods. Examples of goods that (appear to) fail the law of demand are Veblen goods and Giffen goods.

Levels of operation of the law

For individuals and households

Conceptually, the law of demand arises from two fundamental causes: first, the limited purchasing power of an individual or household, and second, the fact that the nature of preferences of the individual or household, i.e., the nature of the utility function that the individual or household is trying to maximize. The law of demand operates at multiple levels.

  • For a given household and a given commodity: The demand of a particular household for a particular commodity is expected to increase, or at least stay constant, as the price of the commodity falls. This relies on the assumption that the marginal benefit from every additional unit of the commodity is decreasing. There are two effects responsible for the law of demand: income effect, which states that the higher the price, the less the household can spend on the good with the limited income it has, and the substitution effect, which predicts that an increase in price makes the household substitute away from the good towards subsitute goods. Further information: Law of demand for individual buyers follows from diminishing marginal utility, Income effect explains law of demand, substitution effect explains law of demand
  • For an aggregate of households and a given commodity: The demand over an aggregate of households for a particular commodity is expected to increase, or at least stay constant, as the price of the commodity falls. This may happen because the consumption of individual households increases steadily, as well as because the number of households purchasing the commodity also increases steadily, as the price falls to the reservation price. The second effect is due to differences in reservation prices across households. Note that this effect is operational even when there is essentially no scope for a single individual or household to buy more than one unit of the commodity. Further information: Law of demand for multiple buyers following from differences in reservation prices

For firms in their demand for inputs to production

The law of demand also applies for firms that buy inputs to their production process (i.e., factors of production) from other firms. When the price of an input into the production process of a firm increases, the demand of the firm for that input is likely to decrease. The firm typically does either one or both of the following: alter its production process to use less of that input and more of various substitutes, and/or scale back the quantity of its production.

Note that, as discussed in the apparent counterexamples, if the prices of substitute inputs increases more, demand for the given input might increase even as the price increases.

Causation versus correlation: superfical counterexamples

It is important to understand that the law of demand discusses the effect of a change in price on the demand for the good. Thus, it does not predict that an increase in price is always accompanied by a decrease in demand. Rather, it says that, ceteris paribus, an increase in price is responsible for a decrease in demand.

Independent shifts of the demand curve

To understand how the causation and correlation issue can be confused, consider a shift in the demand curve due to a change in one of the other determinants of demand (i.e., an exogenous parameter in the interaction between demand and price). If the shift is outward, i.e., if demand increases for every given price, this causes a tendency for the market price (the price at which the market clears) to rise. This does not contradict the law of demand, because the change in demand was due to exogenous factors.

What matters are relative prices -- effects of inflation and simultaneous changes in prices of substitutes

The analysis of the relation between demand and price is carried out in terms of real prices, i.e., prices relative to the prices of similar goods and the household income. An across-the-board inflation, that affects all prices uniformly, and also affects income (though wage rises) and savings (through interest) in the same proportion, should not in principle lead to a decrease in demand.

However, non-uniform inflation can lead to an increase in demand even with an increase in price, if the inflation is responsible for a greater increase in the price of substitutes. Similarly, an increase in the price of factors of production used for a certain good may lead to an increase in its price, but if it leads to a greater increase in the price of substitute goods, there may be either an increase or a decrease in demand. What happens depends on the interplay between the income effect and the substitution effect.

For instance, an increase in fuel prices may lead to an increase in train fares but a greater increase in the cost of car fuel. Thus, people may start traveling more by train even though train fares have increased.

Apparent counterexamples

The crucial thing about the law of demand that fails for these apparent counterexamples is the ceteris paribus condition. In other words, for the various goods and services that appear to violate the law of demand, the typical explanation is that a change in price is indirectly responsible for a change in one of the other determinants of demand.

Giffen goods

Further information: Giffen good

A Giffen good is an inferior good for which the price-elasticity of demand is positive, even though the desirability of possessing the good decreases with an increase in price. The increase in demand is explained by the fact that the good consumes a sizable fraction of the consumer's income and hence, the income effect forces the consumer to shift away from higher-quality, more expensive alternatives towards consuming even more of the good.

The explanation for the Giffen effect is that an increase in price in this case leads to a decrease in effective income (which is one of the exogenous determinants of demand), which, combined with the inferior good nature, increases demand.

Empirical evidence for the existence of Giffen goods is weak.

Veblen goods

Further information: Veblen good

A Veblen good is a good where an increase in price leads to an increase in the desirability of possessing the good, thus leading to an increase in demand. (This effect may operate only for certain buyers and within certain price ranges).

The typical explanation for this effect is conspicuous consumption -- consumption done primarily for the purpose of displaying income or wealth. The larger the price, the better the consumption of the good may be as a way of showcasing income and wealth.

The explanation for the Veblen effect is that price itself in this case influences the preferences of the household. Preferences are an exogenous determinant of demand.