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What is the Law of Demand?

definition

The law of demand describes the inverse relationship between the price of a good and a consumer’s willingness to pay for it. The higher the price, the lower the demand, and vice versa.

🤔 Understanding the law of demand

The law of demand states that as the price of a good goes up, the amount of it purchased goes down, and vice versa. The relationship between a good’s price and the quantity sold is often illustrated by a line graph sloping downward (aka the demand curve). The inverse relationship between price and sales was first documented in 1892 by economist Alfred Marshall, and it’s since become regarded as a fundamental principle in microeconomics. The law of demand, along with the law of supply, describes the foundation of all economic activity.

example

If you were in the business of selling umbrellas, the number of umbrellas you sell would change with the price you set. The lower the price, the more umbrellas you’d sell. If a customer is on the fence about buying an umbrella, for example, you might need to set a very low price to entice them into purchasing. The price of your product and the number you sell are in an inverse relationship — As price goes down, sales go up. This is how the law of demand works in theory.

In the real world, other factors can change the relationship between price and sales. For example, if all of a sudden it starts raining, the demand for your umbrellas would change. Without changing the price at all, you’re likely to increase sales. Or, you could increase the price of your product without losing customers. When some outside force, other than the price, changes how customers feel about the value of your product, that is a change in demand.

Takeaway

The law of demand is like gravity…

Like the law of gravity, the law of demand has been proven over and over through centuries of observation and study. The idea that sales volume falls as price rises is as true as the old saying about gravity: What goes up must come down.

Tell me more...

What makes the law of demand work?
What factors affect demand?
What are the assumptions of the law of demand?
What are the exceptions to the law of demand?
How is demand different from quantity demanded?

What makes the law of demand work?

Two essential concepts help explain how the law of demand works. The first idea is known as diminishing marginal utility. That’s an economist’s way of describing how the more you consume something, the less value it brings. Think about buying your first TV. Having zero TVs in your living room, adding one makes a big difference. By comparison, going from one to two TVs adds a smaller value to your life. As a result, you may be willing to pay less and less for each additional TV you buy.

The second idea has to do with different tastes and preferences. For any given product, each person may have a different price they’re willing to pay. If you’re selling a product, you have to offer a better deal to get the next sale. For example, let’s say there are ten people in line at your coffee shop, each person willing to pay $1 more than the next for a latte. If you priced one latte at $10, you’d get one customer willing to pay the price. If you lowered the price of a latte to $9, you’d get two customers (the person willing to pay $10 plus the person willing to pay $9). And so on. What these ten people are willing to pay for your product makes up the demand for your lattes.

As a business, figuring out the price that will make you the most profit can be tricky, as the demand for a product can fluctuate for a variety of reasons.

What factors affect demand?

Demand describes how much someone is willing to pay for something, assuming all other factors are equal. (Economists use the Latin phrase, ceteris paribus, which means "all else equal.") But a change in price isn’t the only thing that affects how much people will buy. When demand for a good changes, there are additional factors at play. Here are a few examples:

  • Income: People tend to spend more money when they have more money. As a consumer’s income goes up, their demand for a good does, too.
  • Personal preference: If you don’t like pineapple on your pizza, you’ll be willing to pay a lot less for it than someone that does like pineapple. Of course, tastes can change over time — If your taste for pineapple pizza changes, so will your demand for it.
  • The availability of comparable or substitute goods: If two cans of sparkling water are sold at the same price, you might choose to buy the flavor you prefer. But if the prices are different, you might pick the one with the lower price.
  • The price of complementary goods: Likewise, the prices of things that go together tend to move together. These are called complementary goods. If the cost of peanut butter goes up, you might buy less of it. And with less peanut butter, you might buy less jelly. When you have complementary goods, if the price rises on one, the price often falls on the other (due to lower demand).

What are the assumptions of the law of demand?

The law of demand assumes that rational people are self-interested. In other words, people will do things to make themselves happy, and that could mean anything between buying new shoes to rescuing a lost dog. Economists generally assume that when a consumer is looking to buy something, they weigh how much time and money they have, then choose the good that will bring them the most satisfaction or happiness.

What are the exceptions to the law of demand?

There are three general exceptions to the law of demand.

  • Inferior goods: These are goods that you only tend to buy when your income is low. Although the law of demand applies to inferior products, the usual reaction to income is the opposite to that of a normal good. Let’s say you won the lottery, for example. With your new income, you might be more willing to eat out at a restaurant instead of making a bologna sandwich (the inferior good).
  • The Giffen good: In certain situations, increasing the price of a good can increase the consumption of it. Think about the Irish potato famine. The story goes like this: when the price of potatoes went up, people had to reevaluate how to use their limited budget. Under the previous price, a family might have purchased 10 potatoes and a pound of beef. But with the higher price of potatoes, a family had to choose between 8 potatoes and a pound of beef, or 16 potatoes and no beef. Beef was treated like a luxury item while potatoes became a necessity.
  • Asymmetric information: In other words, the seller knows something the buyer doesn’t. Take a used car, for example. If a seller wants to get rid of the car and only recoup what they paid, they may set the asking price below market value. The law of demand suggests that a lower price will attract more potential buyers. But in this case, a buyer might interpret the low cost as a sign that something is wrong with the car. The inability to distinguish between a good deal and a defective product can thus contradict the law of demand.
  • Veblen goods: Sometimes, a seller can inflate the price of a good to make it seem more valuable than it actually is. A buyer might interpret the higher price as a signal of higher value and be willing to purchase it. In this case, increasing the price can lead to an increase in sales, contrary to the law of demand.

How is demand different from quantity demanded?

There’s an important difference between movements along the demand curve and shifts of the demand curve itself. Remember, demand is the relationship between a customer’s willingness to pay for something and the price at which it is offered, assuming other factors are constant. So, if you reduce the price of your product, you don’t necessarily change the demand for it. However, according to the law of demand, you’ll see a change in the number of customers willing to buy your good — That is, the quantity demanded.

In the real world, other factors can change a consumer’s underlying willingness to pay for a good, be it a pay raise, a maturing palette, a news story, or a change in the price of close substitutes or complementary goods. - That’s a change in demand.

Mistaking a change in quantity demanded for a shift in demand may lead a business into trouble. For example, let’s say a company selling e-readers decides to advertise a sale. At the discounted price, the number of sales go up and the e-readers sell out. The company looks at these sales numbers and decides to increase its inventory of e-readers, thinking that the demand for e-readers has gone up. But the company may be misinterpreting the situation. If it turns out that demand hasn’t changed, the company may end up having to put the e-readers on sale again and may lose money.

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