Principles of Economics/Demand Laws
Demand is represented by a schedule or curve showing the various amounts of a good, resource, or service that consumers are willing and able to purchase at a series of possible prices, other things equal. It reflects the relationship between the possible price of a product and the quantity of product that the consumer would be willing and able to purchase at each price.
The Law of Demand is as follows: All else equal, as price falls, the quantity demanded of a product will rise whereas as the price rises, the quantity demanded of a product will fall. In other words, price and quantity have an inverse relationship. This can be gathered by common sense, if the price of a product is high, people will be less inclined to buy the product than they would if the price of the product was low. Conversely, if the price of a product is low, people will be more likely to purchase the product and more likely to purchase a higher quantity of the product than they would if the price of the product was high.
Income effect[edit | edit source]
The income effect is a change in demand that results from a change in the income of consumers. Based on a buyer's income, for any price changes related to a product, there will either be an increase or a decrease in demand. Either way, an increase in income results in a higher purchasing power.
Substitution effect[edit | edit source]
As the price of Good A falls, buyers have an incentive to substitute Good B for Good A because of the increase in purchasing power. For example, if the price of apples falls relative to the price of oranges, the purchasing power of consumers increase for apples, causing them to substitute apples for oranges.
Normal and inferior goods[edit | edit source]
Normal goods are those goods that consumers demand more of as income increases. Inferior goods are those goods that consumers demand less of as income increases, often because they are lower-quality substitutes for normal goods. As buyers gain purchasing power, they shift toward buying normal goods and away from inferior goods.
In situations where the prices of inferior goods rise but the substitute normal good does not, as long as the price of the inferior good is less than the price of the substitute normal good, the income effect is dominant to the substitution effect. For example, imagine if a pepperoni pizza is a normal relative substitute good to cheeseburgers. Let the price of cheeseburgers be $6.53, and let the price of a normal pepperoni pizza be $12.14. If the price of cheeseburgers increased to $8.45, and the income of consumers did NOT increase, although the substitution effect would be in favor of the pepperoni pizza, demand will only slightly decrease. This is due to two reasons:
- The cheeseburger is an inferior good to the pepperoni pizza. The pepperoni pizza is the "premium item" compared to the cheeseburger. Although consumers want the cheeseburger, the pepperoni pizza is still far from their grasp. As long as the real income of consumers does not increase, cheeseburgers are still the item of choice.
- Although the increase in price will have decreased the quantity demanded of cheeseburgers, it is not going to change that much because the purchasing power of consumers has not changed despite the price increase.
Diminishing returns[edit | edit source]
The law of demand is also subject to the Law of Diminishing Marginal Utility which states that in any specific period of time, each buyer of a product will derive less utility from each successive unit of the good consumed. This means that as the price of Good A falls, the quantity demanded of Good A will rise at a decreasing rate.
Imagine you want to go to Paris and visit the Eiffel Tower. You have to purchase a plane ticket, a hotel room, and a ticket to get in the eiffel tower. After paying for all the expenses, you felt a calm synergy and bond between the history and the "beauty" of the tower. To maximize your opportunity cost, you decide to go in the eiffel tower again, for a second time. However, you feel that you gain less happiness from going there the second time. Going on there the third time really starts to feel old. This situation represents a diminishing marginal utility. Despite not having to pay for the other times, you start to lose utils for every visit to the Eiffel Tower.
Check your Understanding[edit | edit source]