Difference between revisions of "Law of demand"

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(What matters are relative prices -- effects of inflation and simultaneous changes in prices of substitutes)
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The analysis of the relation between quantity demanded 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.
 
The analysis of the relation between quantity demanded 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]].
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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 substitutes for those factors of production, 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.
 
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.

Revision as of 14:34, 7 May 2011

Statement

Demand curve with negative linear relation of demand and price

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

Note that the term demand is typically used, not for the quantity demanded at a particular price, but the entire demand behavior across the entire price range, though it may also be used in the sense of quantity demanded at a particular price.

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.

On the right are some examples of demand curves satisfying the law of demand.

Demand curve with inverse proportionality relation of demand and price

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 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 quantity demanded for 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 substitute 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 quantity demanded 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 follows 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

An expansion of the demand curve leads to an increase in the market price and an increase in equilibrium quantity demanded/supplied, but this simultaneous increase of price and quantity demanded does not violate the law of demand.

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 (also called an expansion of the demand curve), 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. Similarly, if the shift is inward (also called a contraction of the demand curve), there is a tendency for the market price to fall.

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 quantity demanded 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 substitutes for those factors of production, 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.

Expectations of future prices

In some cases, buyers may view a rise of price as evidence indicative of an even greater future rise of price for that good. This may be supported by further evidence. If present purchase of that good can substitute for later purchase of the good, then this may actually increase present demand for the good. This happens in particular for durable goods where the inconvenience of not having the good for a short period of time is not that great. It can also happen for non-durable goods if the satisfaction of consuming them is durable -- for instance, a holiday trip today might substitute for a holiday trip six months from now.

Similarly, buyers may view a drop in price as evidence indicative of further price drops in the future, and hence delay the purchase of a good or service.

Psychology

The law of demand is typically derived or justified with the assumption of rational behavior. However, this is one of the most robust laws in the sense that it is substantially valid under highly imperfect conditions and highly irrational behavior. In other words, households and firms exhibit behavior consistent with the law of demand even if they fail to meet the conditions of rationality. Some reasons are given below.

Hard constraints

The law of demand for an individual or household arises, as discussed earlier, from a combination of a finite budget (the income effect) and diminishing marginal utility, often combined with the presence of close substitutes (the substitution effect). In many cases, these constraints are soft constraints, in the sense that an individual or household could in principle spend more on a given good or service by cutting down on other goods or services -- the individual or household is not literally out of money.

However, in other cases, the constraints are hard constraints -- the individual or household actually runs out of money, curtailing its demand for a particular good. For those who are either too poor or who have too little discipline to adhere to soft constraints on spending money, the hard constraints still impose a discipline that leads them to behave roughly according to the law of demand. Thus, for instance, a poor family literally living on a subsistence income, that spends all its money on food and shelter, finds that when the price of a staple food goes down, it literally has more money to spend on that staple good (the income effect).

Hard constraints also operate for the purchase of single items that cost a huge amount of upfront money, such as refrigerators, cars, and houses. This is particularly so if loans or deferred payment options are not easily available.

Subconscious behavior

In many cases, changes in behavior based on the law of demand are subconscious and not based on any conscious calculation. In other words, humans may have natural instincts that lead them to buy more of something when it is cheaper. Such instincts may have both evolutionary and cultural roots. Note that such instinctive behavior may be prone to abuse -- for instance, it may respond more to perceived price differentials (without taking into account hidden costs) than actual price differentials. Fill this in later

References

Journal references

Online articles explaining the law of demand

Article Author Location Comment
Demand David Henderson Concise Encyclopedia of Economics, available online as part of the Library of Economics and Liberty Encyclopedia article explaining the law of demand with real world examples and without mathematical jargon
Demand, High School Economics Topics -- Library of Economics and Liberty Explains: "Supplementary resources by topic. Demand is one of 51 key economics concepts identified by the National Council on Economic Education (NCEE) for high school classes."
The law of demand -- Shmoop Description of the law of demand in simple English with very little mathematical jargon, suitable for school students learning the subject. Other complementary material on the website as well.

General-purpose economics textbook references

These are texts intended for use in undergraduate/graduate economics teaching.

Book Pages Chapter/section More comments Link
Price theory and applications by Steven E. Landsburg, 10-digit ISBN 0324579934, 13-digit ISBN 978-0324579932More info 1-4 Section 1.1 (Demand) Google Books
Principles of Economics by N. Gregory Mankiw, 10-digit ISBN 0324589972, 13-digit ISBN 978-0324589979More info 67-69 Part of Chapter 3 Google Books
Economics by Paul Krugman and Robin Wells, 10-digit ISBN 0716771586, 13-digit ISBN 978-0716771586More info 64-65 Google Books
Price theory and applications: decisions, markets, and information by Jack Hirshleifer, Amihai Glazer, David HirshleiferMore info 29 Google Books