What is the Law of Demand?
The law of demand is one of the most fundamental concepts in economics. It works with the law of supply to explain how market economies allocate resources and determine the prices of goods and services that we observe in everyday transactions. The law of demand states that quantity purchased varies inversely with price. In other words, the higher the price, the lower the quantity demanded. This occurs because of diminishing marginal utility. That is, consumers use the first units of an economic good they purchase to serve their most urgent needs first, and use each additional unit of the good to serve successively lower valued ends.
- The law of demand is a fundamental principle of economics which states that at a higher price consumers will demand a lower quantity of a good.
- Demand is derived from the law of diminishing marginal utility, the fact that consumers use economic goods to satisfy their most urgent needs first.
- A market demand curve expresses the sum of quantity demanded at each price across all consumers in the market.
- Changes in price can be reflected in movement along a demand curve, but do not by themselves increase or decrease demand.
- The shape and magnitude of demand shifts in response to changes in consumer preferences, incomes, or related economic goods, NOT to changes in price.
Law of Demand
Understanding the Law of Demand
Economics involves the study of how people use limited means to satisfy unlimited wants. The law of demand focuses on those unlimited wants. Naturally, people prioritize more urgent wants and needs over less urgent ones in their economic behavior, and this carries over into how people choose among the limited means available to them. For any economic good, the first unit of that good that a consumer gets their hands on will tend to be put to use to satisfy the most urgent need the consumer has that that good can satisfy.
For example, consider a castaway on a desert island who obtains a six pack of bottled, fresh water washed up on shore. The first bottle will be used to satisfy the castaway's most urgently felt need, most likely drinking water to avoid dying of thirst. The second bottle might be used for bathing to stave off disease, an urgent but less immediate need. The third bottle could be used for a less urgent need such as boiling some fish to have a hot meal, and on down to the last bottle, which the castaway uses for a relatively low priority like watering a small potted plant to keep him company on the island.
In our example, because each additional bottle of water is used for a successively less highly valued want or need by our castaway, we can say that the castaway values each additional bottle less than the one before. Similarly, when consumers purchase goods on the market each additional unit of any given good or service that they buy will be put to a less valued use than the one before, so we can say that they value each additional unit less and less. Because they value each additional unit of the good less, they are willing to pay less for it. So the more units of a good consumers buy, the less they are willing to pay in terms of the price.
By adding up all the units of a good that consumers are willing to buy at any given price we can describe a market demand curve, which is always downward-sloping, like the one shown in the chart below. Each point on the curve (A, B, C) reflects the quantity demanded (Q) at a given price (P). At point A, for example, the quantity demanded is low (Q1) and the price is high (P1). At higher prices, consumers demand less of the good, and at lower prices, they demand more.
Demand vs Quantity Demanded
In economic thinking, it is important to understand the difference between the phenomenon of demand and the quantity demanded. In the chart, the term "demand" refers to the green line plotted through A, B, and C. It expresses the relationship between the urgency of consumer wants and the number of units of the economic good at hand. A change in demand means a shift of the position or shape of this curve; it reflects a change in the underlying pattern of consumer wants and needs vis-a-vis the means available to satisfy them.
On the other hand, the term "quantity demanded" refers to a point along with horizontal axis. Changes in the quantity demanded strictly reflect changes in the price, without implying any change in the pattern of consumer preferences. Changes in quantity demanded just mean movement along the demand curve itself because of a change in price. These two ideas are often conflated, but this is a common error; rising (or falling) in prices do not decrease (or increase) demand, they change the quantity demanded.
Factors Affecting Demand
So what does change demand? The shape and position of the demand curve can be impacted by several factors. Rising incomes tend to increase demand for normal economic goods, as people are willing to spend more. The availability of close substitute products that compete with a given economic good will tend to reduce demand for that good, since they can satisfy the same kinds of consumer wants and needs. Conversely, the availability of closely complementary goods will tend to increase demand for an economic good, because the use of two goods together can be even more valuable to consumers than using them separately, like peanut butter and jelly.
Other factors such as future expectations, changes in background environmental conditions, or change in the actual or perceived quality of a good can change the demand curve, because they alter the pattern of consumer preferences for how the good can be used and how urgently it is needed.
Frequently Asked Questions
What is a simple explanation of the Law of Demand?
The Law of Demand tells us that if more people want to buy something, given a limited supply, the price of that thing will be bid higher -- and vice-versa.
Why is the Law of Demand important?
Together with the Law of Supply, the Law of Demand helps us understand why things are priced at the level that they are, and to identify opportunities to buy what are perceived to be underpriced (or sell overpriced) products, assets, or securities. For instance, a firm may boost production in response to rising prices that have been spurred by a surge in demand.
Can the Law of Demand be broken?
Yes, in certain cases an increase in demand does not affect prices in ways predicted by the Law of Demand. For instance, so-called Veblen goods are things whose demand increases as its price rises, as these are perceived as status symbols. Similarly demand for Giffen goods (which in contrast to Veblen goods are not luxury items) rises when the price rises and falls when the price falls. Examples of Giffen goods can include bread, rice, and wheat. These are commonly necessities and essential items with few good substitutes at the same price levels. Thus, people may start to hoard toilet paper even as its price goes up.