Definition of the law of demand: basic economics

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 daily transactions.

The law of demand states that the quantity purchased varies inversely with the price. In other words, the higher the price, the lower the quantity demanded. This happens because of the decrease in marginal utility. That is, consumers use the first units of an economic good they buy to meet their most urgent needs first, and use each additional unit of the good to successively serve less valuable purposes. .

Key points to remember

  • 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, where consumers use economic goods to meet their most urgent needs first.
  • A market demand curve expresses the sum of the quantities demanded at each price for all consumers in the market.
  • Price changes can be reflected in movement along a demand curve, but by themselves do not increase or decrease demand.
  • The shape and magnitude of demand changes in response to changes in consumer preferences, income or related economic goods, NOT changes in prices.

Understanding the law of demand

Economics involves the study of how people use limited means to meet unlimited needs. The law of demand focuses on these unlimited needs. Naturally, people prioritize the most urgent wants and needs over the less urgent in their economic behavior, and this affects how people choose from the limited means at their disposal. For any economic good, the first unit of that good that a consumer gets hold of will tend to be used to meet the consumer’s most urgent need and that good can satisfy.

For example, consider a castaway on a desert island who gets a pack of six bottles of fresh water washed up on the shore. The first bottle will be used to satisfy the castaway’s most urgent need, probably drinking water to avoid dying of thirst. The second bottle could be used for bathing to prevent illness, an urgent but less immediate need. The third bottle could be used for a less urgent need, like boiling fish to have a hot meal, and up to the last bottle, which the castaway uses for a relatively low priority, like watering a small potted plant for him. keep company. the Island.

In our example, because each additional bottle of water is used for a desire or a need less and less valued by our castaway, we can say that the castaway values ​​each additional bottle less than the previous one. Likewise, when consumers buy goods in the market, each additional unit of a given good or service that they buy will have a less valued use than the previous one, so we can say that they value less and less. minus each additional unit. Because they value less for each additional unit of the good, they are willing to pay less for it. Thus, the more units a good consumer buys, the less he is willing to pay in terms of price.

By adding up all the units of a good that consumers are willing to buy at a given price, we can describe a market demand curve, which is always sloping downward, like the one shown in the graph 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 for the good, and at lower prices, they demand more.

Image by Julie Bang © Investopedia 2019

Demand vs quantity demanded

In economic thought, it is important to understand the difference between the phenomenon of demand and the quantity demanded. In the graph, the term “demand” refers to the green line drawn by A, B and C. It expresses the relationship between the urgency of consumer needs and the number of units of the economic good at hand. A change in demand means a shift in the position or shape of this curve; it reflects a change in the underlying pattern of consumers’ wants and needs relative to the means available to satisfy them.

On the other hand, the term “quantity demanded” refers to a point along the horizontal axis. Changes in the quantity demanded strictly reflect changes in price, without implying a change in the pattern of consumer preferences. Changes in quantity demanded simply mean movement along the demand curve itself due to a change in price. These two ideas are often confused, but it is a common mistake; rising (or falling) prices do not decrease (or increase) demand, they change the quantity demanded.

Factors affecting demand

So what is the demand changing? The shape and position of the demand curve can be affected by several factors. Increased income tends to increase the demand for normal economic goods, as people are willing to spend more. The availability of close substitutes that compete with a given economic good will tend to reduce the demand for that good, as they can satisfy the same kinds of consumer wants and needs. Conversely, the availability of closely complementary goods will tend to increase the demand for an economic good, as using two goods together can be even more valuable to consumers than using them separately, such as peanut butter and jelly.

Other factors such as future expectations, changes in background environmental conditions, or change in the real or perceived quality of a good can alter the demand curve, as they alter the pattern of consumers’ preferences for how the good can be used and how urgently it is needed.

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 higher. Likewise, the higher the price of a good, the lower the quantity that will be purchased by consumers.

Why is the law of demand important?

Along with the law of supply, the law of demand helps us understand why the prices of things are where they are and identify opportunities to buy what is perceived to be undervalued (or sell overvalued. ) products, assets or securities. For example, a company may increase its production in response to rising prices that has been spurred by an increase in demand.

Can the law of demand be broken?

Yes, in some cases an increase in demand does not affect prices in the manner intended by the law of demand. For example, so-called Veblen goods are things whose demand increases as their price increases, as they are seen as status symbols. Likewise, the demand for Giffen products (which, unlike Veblen products, are not luxury items) increases when the price increases and decreases when the price decreases. Examples of Giffen products can include bread, rice, and wheat. These tend to be common necessities and essentials with few good substitutes at the same price points. So people can start hoarding toilet paper even as its price increases.

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