Law of Demand: Higher the price, the smaller the quantity demanded

Law of Demand


The law of demand is one of Alfred Marshall’s many contributions to economic theory. The demand varies inversely with price. The lower the price, the larger the quantity demanded. Similarly, the higher the price, the smaller the quantity demanded. This inverse relationship between price and quantity demanded is often called the Law of Demand. This law may be stated as – “Other things being equal, the higher the price of a commodity, the smaller is the quantity demanded and lower the price, the larger the quantity demanded.”

This law is based on The Law of Diminishing Marginal Utility. According to this law, when a man consumes more and more of a commodity, the utility from latter units declines. Hence, at a given time in given market, people will not buy more of a commodity unless its price becomes lower. The lower price induces the persons already buying to buy more and other persons to start buying.

The law of demand is based on several assumptions:
  1. Taste and preference of the consumer remain constant.
  2. Prices of substitutes and complements remain constant.
  3. Consumer’s income is fixed and constant.
  4. The size of the population is unchanged.
  5. There is no change in distribution of income and wealth.
Demand Schedule
Price ($)
Quantity
12
10
8
6
4
2
2
3
5
7
10
14

A demand schedule shows the relationship between two variables, price and quantity. To be more precise, it indicates the quantity demanded by the consumer at each price. As shown in the demand schedule, when price per unit is $12, the quantity demanded is 2 units, when price falls to $10, $8, $6 and $4 per unit, the quantity demanded increases to 3, 5, 7 and 10 units respectively.

This law can also be illustrated with the help of a diagram known as demand curve. When the demand schedule is displayed geometrically, it is called demand curve. The demand curve also shows the price-quantity relation as the demand schedule.

Law of Demand

In figure, OX axis represents quantity demanded and OY axis represent price. DD is the demand curve. The demand curve has been constructed on the basis of the demand schedule. It shows that when price is $12 per unit, the quantity demanded is 2 units. When the price falls to $10, the quantity demanded increases to 3 units. When the price further falls to $8, the quantity demanded increases to 5 units and so on.

The slope of a demand curve is negative. It always slopes downwards from left to right. It implies that when the price of a commodity falls, the quantity demanded of that commodity increases.

Causes of Demand Curve Sloping Downwards

The demand curve slopes downwards to the right due to the following reasons:
  1. Law of Diminishing Marginal utility: According to this law, as a consumer consumes more and more of a commodity, the marginal utility of the commodity goes on declining. Hence, people demand more only when the price falls.
  2. Income effect: When the price of a commodity falls, there is an increase in the real income or purchasing power of people. Hence, they are able to buy more of that commodity.
  3. Substitution effect: When the price of a commodity falls, it becomes cheaper than other commodities. So people buy more of this goods or substitute this goods for other.
  4. New consumers: When the price of a good fall, new consumers who did not buy before due to inability to buy also buy. So, the demand for the commodity increases. As for example, the transistors made in Khasa of China has decreased considerably. As a result of this, many people have started to buy transistors.
  5. Put to less important uses: When a commodity becomes cheaper, people are inclined to put them to less important uses. Hence, the demand increases when the price of a commodity falls.

Exceptions to the Law of Demand

There are several limitations to the law of demand, which are as follows:
  1. Judged by price: This exception is associated with the name of T. Veblen and his doctrine of conspicuous consumption. If consumers measure the commodity entirely by its price, they will buy less of the commodity when the price falls, and more when the price rises. As for example, the demand for diamond for personal use or premium priced beer. The demand for diamond by rich falls when price decrease.
  2. Giffen Goods: The other exception is associated with the name of Robert Giffen. According to him, a rise in the price of bread causes to buy more bread, not less. Because, the wage earners subsist on the diet mainly on bread. When its price rises, they have to spend more money for a given quantity of bread. So, to maintain their intake of food, they buy more bread at higher price. According to Watson and Getz, these two exceptions to the law of demand are quite important.
  3. Price exception: To quote Watson and Getz again, the other exceptions to the law of demand are only apparent not real. When the consumers expect the price to fall even further, they do not buy more even if the price is lower. Likewise, when the consumer expect further rise in price, they buy more even if the price is higher.
  4. Articles sold under two brand name: The article may be sold under two brand names at the same time. The consumers buy more of the higher-priced brand than the lower-priced brand even though the articles are more or less identical. But the consumers think that the two brands are different. The two brands are taken as two different commodities.
  5. If shortage is feared: If people feel that the commodity is going to be scarce in future, they buy more of it even if the price is high. As for example, when people feel that cooking gas or kerosene is going to be of short supply in future, they buy more even if price is high.
  6. Out of fashion: If the commodity goes out of fashion, people do not buy more even if the price falls, as for example, people do not buy bell-bottom pants or pointed shoes these days even if their prices are lower relatively. Because, their use has gone out of fashion.
  7. Customs and tradition: The law of demand may not hold goods due to customs and traditions. As for example, the demand for clothes, goat increase during Dashain festival even if the prices are too much higher.
  8. Change in season: The law of demand may not hold good due to the change in season. The demand for umbrella does not rise even if price falls during winter season. Likewise, the demand for ice cream, Coca-Cola does not rise during winter even if price is substantially reduced.
  9. Necessaries of life: The necessaries of life are the things that the people cannot do without. Hence, even if the price of rice increases, the demand does not decrease.
  10. Change in income: If the income of people increase, they do not reduce demand for the commodities even if the price rise. On the contrary, if their income decreases, they reduce the demand even if the price of commodities falls.

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Derivation of Market Demand Curve and Shift in Demand Curve

Derivation of Market Demand Curve


An individual demand curve shows the demand of only an individual. But it is necessary to have the knowledge of total demand of all the consumers in market to explain the market behavior. The market demand schedule is derived from individual demand schedule by summing up the demand of all consumers at a particular price. The market demand schedule is prepared after deriving the total demand at different prices. This schedule when converted into a figure is called market demand curve. According to R. G. Lipsey –“the market demand curve is the horizontal sum of the demand curves of all the households in the market.”

The market demand curve shows the relationship of total quantity demanded with price. The price of other commodities, total household income, distribution of income and taste of consumers are assumed to be constant.


The quantity of sugar demanded by three consumers and the total market demand at different prices has been presented in the table below:

Individual and Market Demand Schedule
Price ($ per kilo)
Demand of A (Kilo per month)
Demand of B (Kilo per month)
Demand of C (Kilo per month)
Market Demand (Kilo per month)
2
4
6
8
10
12
40
30
24
18
14
10
45
35
30
20
15
13
18
16
13
12
11
8
103
81
67
50
40
31

A market demand curve is derived by the horizontal summation of the demand curves of all individuals in the market. The market demand curve has been presented in the figure below. It is derived on the basis of the above table.

Market Demand Curve

In the figure, DM is the market demand curve. The market demand curve is derived by summing up the individual demand curves. The market demand curve of a commodity can be derived by joining the points of quantity demanded at different prices.


Shift in Demand Curve

At first, it is necessary to distinguish between shifts in the demand curve and movement along a given demand curve.

Shift in Demand Curve

The distinction between these two kinds of demand change is very important. According to David Begg and others, “Movement along the demand curve represents consumer adjustment to changes in the market price. Shifts in demand, by contrast, represent adjustment to outside factors (other prices, income, tastes) and lead in turn to changes in equilibrium price and quantity”. The change in quantity demanded may occur only due to the change in the price of the commodity concerned. This makes a consumer move from one point of same demand curve. The change in quantity demanded due to the reasons other than price of the commodity causes shift in the entire demand curve.

In the figure, when demand curve is D, price is OP, the quantity demanded is OQ. Now suppose that the demand for the commodity increases. As a result of this, the demand curve shifts to the right in the form of D1. The quantity demanded increases from OQ to OQ1 at the same price. Likewise, if the demand falls, demand curve shifts to the left in the form of D2. The quantity demanded decreases from OQ to OQ2 at the same price. The change in demand leads to the change in equilibrium point. Hence, the shift in the demand curve changes the equilibrium price and quantity in the market. This can be shown only by using supply curve.

In general, when price of a commodity increases, less is demanded. But if demand increases, people buy more even if price rises. If the demand has increased due to increase in income, people buy more even at higher price. According to Watson and Getz, “A demand curve is like a still picture. Behind the price-quantity relation are always the tastes of buyers, their incomes, and the prices of substitute and complementary commodities. When they change, the demand curve changes, shifting to the right or to the left. Demand curves are thus in constant motion, motion picture would be far better than still photographs”.

Factors Causing the Shift in Demand Curve


The changes in demand causes shift in the demand curve. The changes in demand are caused by changes in income, tastes and prices of related goods such as substitutes and complements. The causes of changes in demand has been shown in the following table.

Causes of Change in Demand
Demand Increase
Demand Decrease
1. Consumer desires become stronger
2. Consumer incomes rise
3. Price of substitutes rise
4. Price of complements fall
1. Consumer desires become weaker
2. Consumer incomes fall
3. Price of substitutes fall
4. Price of complements rise.

The factors causing the shift in demand curve are as follows:

1. Price of related goods: The demand for a commodity and the price of related goods have two types of relationships. A fall in the price of a commodity may increase or decrease the demand for other commodity. If the fall in the price of one goods leads to the fall in the demand for other commodity, those goods are called substitutes. As for example, when price of coffee falls, the demand for tea falls. When price of coffee falls, consumers buy more of coffee and buy less of its substitute, tea. In case of substitutes, the demand for a commodity varies directly with the price of substitutes.

If the fall in price of a commodity leads to the rise in demand for other commodity, those goods are called complements. Because if the price of a commodity falls, more of it is consumed and the complementary goods is also consumed more. This kind of relationship exists in the goods that should be consumed together. As for example, pen and ink, car and petrol, shoe and shoelaces.

2. Consumer Incomes: The quantity demanded of a commodity changes with the change in consumer incomes. In general, when income increases, people demand more of a commodity. If the demand increases with the increase in income, such goods are called normal goods. On the contrary if the demand decreases with the increase in income, such goods are called inferior goods. Most goods are normal goods. The inferior goods are typically cheap. As consumer incomes rise, they spend less in cheaper goods like inferior quality rice.

3. Consumer tastes and fashion: The tastes and fashion of consumers change from time to time. If the consumer taste for a particular commodity increases, the demand for that commodity increases. On the other hand, if the taste decreases for that commodity, the demand for that commodity decreases. As for example, the taste for kurta-paijama among Nepalese women has increased these days, which has increases the demand for them. Likewise, the fashion for mini-skirts has reduced the demand for textile materials.

In past, the tastes and fashion were shaped by convenience, custom, and social attitudes. But they can be changed by advertisement and increase in knowledge.

4. Technological progress: The new commodities produced due to technological progress reduce the demand for old commodities. As for example, the demand for piano has declined and that of radio, television has increased. The supply of electricity has reduced the demand for kerosene mantles.

5. Change in size and composition of population: The increase in population increase the demand for goods and services. The scarcity of water at Kathmandu, and appreciable rise in price of food grains is due to high growth of population. Likewise, the change in composition of population also changes the demand for goods. The increase in female population leads to increase in demand for saris, lipsticks, and ornaments.

6. Change in distribution of income: The change in distribution of income in favor of the poor people increases the demand for many things. If the distribution of income is concentrated on rich, the demand for luxuries will be high.

7. Taxation policy: If the taxes are levied deliberately to reduce the demand for commodity, the demand will fall. Since few years back wines, beers and tobacco have been heavily taxed so as to reduce consumption. Similarly, high import taxes are levied on luxury goods such as motorcar, television, and video deck simply to reduce demand.

8. Change in real income: The increase in quantity of money increases the price level. This reduces the real income of people. Consequently people buy less due to fall in purchasing power. The increase in real income may have little effect on necessaries like foodstuffs. But it may considerably increase the demand for luxuries and semi-luxuries.

9. Expectations: If the people feel future shortage of commodity or rise in price, the demand will increase at present.

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|| Demand || Theory of Demand: desire, willingness and ability to pay for a commodity

Meaning of Demand


Demand is not the same as desire or need. Demand for a commodity means desire, willingness and ability to pay. For example, a poor man's desire and willingness to pay for a car is not demand since he does not have ability to pay. Similarly, a person's ability to pay for a car is not demand since he does not have willingness and desire to buy a car. The demand for any commodity is the desire for that commodity baked by willingness and ability to pay. Thus, demand means effective demand, in the sense of being able and willing to buy. Only this affects the volume of sales. 

According to Fredric Benham, "The demand for anything, at a given price is the amount of it which will be bought per unit of time at that price."

In the words of Pappas and Brigham, "The term demand is defined as the number of units of particular goods or service that consumers are willing to purchase during a specific period and under a given set of conditions."

According to Milton H. Spencer, "Demand is the quantity that will be purchased of particular commodity at various prices, at a given time and place."

Thus, demand is always defined with reference to a particular time and given values of variables on which it depends. Two things should be noted in the definition:

First, demand always means demand per unit of time. The time period might be a month or year. We must specify the period for which the commodity is being demanded. The statement that demand for ghee in Kathmandu is 1000kg at Rs. 50 per kg, has no significance unless we state clearly the period for which this quantity is being demanded.

Second, the condition on which the things is demanded should be specified. The conditions would include the price of the good in question, price and availability of competitive goods, expectations of price changes, income, tastes and preference, advertising expenditures and so on. The demand for the product depends on all these factors. For example, the term demand has no significance unless it is related to price. The statement that the weekly demand for ghee in Kathmandu is 1000kg is meaningless unless we specify the price at which the quantity is being demanded by the customers of Kathmandu. The demand may be fairly small if the price is high.

Derivation of Individual and Market Demand Curve

The process of derivation of individual and market demand curve has been explained as follows:

Derivation of Individual Demand Curve


The individual demand schedule is a schedule of prices of commodity and the demand for the commodity made by an individual. Similarly, individual demand curve is the schedule of different quantities of goods demanded by an individual at different prices. The demand schedule shows the relationship between the prices of the commodity and the quantity demanded. The individual demand (for sugar) schedule has been presented in table below:

Individual Demand Schedule
Price ($ Per kg)Quantity Demanded (kg per month)
2
4
6
8
10
12
14 
10
7
5
3
2

As shown in the table, the quantity demanded of sugar at price $2 per kg is 14 kg, at $4 is 10kg, at $6 is 7kg, and so on. It shows that the quantity demanded increase with fall in price.

The individual demand curve is derived on the basis of this demand schedule. The individual demand curve DD has been derived in the following figure on the basis of above table.


In the given figure, OY axis represents price of sugar and OX axis represents quantity demanded DD is the demand curve. It shows that the quantity demanded is 14kg at price $2, 10kg at $4, 7kg at $6, 5kg at $8 and so on. In this way, the demand curve shows the relationship between price of the commodity and quantity demanded. According to R. G. Lipsey, "The demand curve for a commodity shows the relation between its price and a quantity a household wishes to purchase per period of time."

The demand curve has the following characteristics:
  • Traditionally, the price level is shown along the vertical axis and the quantity demanded is shown along the horizontal axis.
  • The demand curve may show the demand of an individual or the group of consumers in the market.
  • The demand curve assumes that there is no change in the value of other relevant variables. This means that the prices of other goods, income of the consumers and taste of consumers are assumed to be constant.
  • In general, the demand curve has negative slope, or the demand curve slopes downwards. This means that people demand more at lower prices.

The law of demand implies this. But there are two exceptions to this:
a) The situation of snob appeal – as for example, the expensive jewelry are demanded more at higher prices, but demanded less at lower prices due to the fall in snob appeal. 

b) The situation in which consumers judge quality by price – as for example, if the consumers do not have ability to judge the quality of the products directly, they use price as the quality. Hence, demand may fall when price falls.

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Market Economy : Concept, Features and Functions of Market Economy

Concept of Market Economy

The resources are limited in the society. Hence, throughout history, every society has faced the fundamental economic problem of deciding what to produce, and for whom. According to R.G. Lipsey and C. Harbury, "the term economic system refers to a distinctive set of social and institutional arrangements within which answers are provided by determining how resources are allocated."

In the 20th century, two competing economic systems were used for the solution of these problems: command economies directed by a centralized government and market economies based on private enterprise. The market economies are prevalent in North America, Western Europe and Japan. The command economies were prevalent in the former Soviet Union, Eastern Europe and parts of Asia over the past half-century.

At present in the last decade of 20th century, the command economy has been found to be a failure. It has "failed to sustain economic growth, to achieve a measure of prosperity, or even to provide economic security for its citizens."

The market economies are, by nature, decentralized, flexible, practical and changeable. The central fact about market economies is that there is no center. The 'invisible hand' works in the private market place. The market economies are based on the principle of individual freedom: freedom as a consumer to choose among competing products and services, freedom as a producer to start or expand business and share its risks and rewards, freedom to choose a job, join a labor union or change employers.

According to R.G. Lipsey and C. Harbury, "In a type of economic system all decisions about resource allocation are made without any central direction but, instead, as a result of innumerable independent decisions taken by individual producers and consumers: such a system is known as a market economy."

Functioning of Market Economy

The functioning of a market economy may be described as follows: 

Production


Decision in command economies the economic planners, production experts and political officials establish production levels of goods and designate which factories will produce them. The central planning committees establish the prices of the products and wages for the workers who produce them. It is the set of central decisions that determines the quantity, variety and prices of products. Due to this, there either shortages or surpluses of the products in the economy. The planning authorities are unable to make efficient decisions when number of people, products increase and the production technologies change rapidly.

The phenomenon of command economies does not happen in the market economy. In a market economy, government ministry, or planners do not decide the quantity, quality, and design of the products. Anyone individual or company, can decide and sell products. This leads to direct competition between different firms producing the products. Competition is the heart of market economies. Due to competition there are different products available to the consumers. 

Pricing Decision


Another key point about market economies is that the planning committee does not fix the prices of products. The sellers are free to raise or lower prices according to changing market conditions. When products become scarce, the price usually rises. The price increase accomplishes two things at the same time. 

The price rise makes the product more expensive compared to other products. Hence, some consumers will choose fewer of them. 

The higher price goes directly to the producers and sellers. Hence the higher price increases the profits of the firms enabling them to produce and sell more goods. Attracted by high price, other firms will also begin to make the popular product. 

Incentives


The higher prices give every consumer and producer incentive to respond. Because, they are allowed to reap the benefits of their own decisions while also bearing the associated risks and costs. For example, the consumers willing to pay the higher prices can get the popular product. But they have to give up more money and other goods and services to do so.

On the production side, the firms making popular products can sell them at competitive prices and earn profits. The producers who make unwanted products or produce inefficiently incur losses. Eventually, they must either learn to produce efficiently or will go out of business. In sum, the economic incentives work in a market economy. 

Efficient Resource Allocation


The consumers, producers and workers all work in their own self-interest in open and competitive markets. They use their economic resources in ways that have the greatest value to the national economy. They are useful in satisfying more of people's wants. The first person to point out this fact in a systematic way was the great classical economist Adam Smith. He published his famous book 'An Enquiry Into The Nature and Causes of Wealth of Nations,’ in 1776. He was first to describe how an economy based on a system of market could promote economic efficiency and individual freedom.

Smith described the feature of market economics in these words, "People are led as if by an invisible hand" to work and behave in ways that use resources efficiently, in terms of producing things that other people want and are willing to pay for, even though that may have been "no part of their original intentions". In market economies, with a decentralized system of private markets, resources are efficiently allocated to satisfy consumer demands.

Despite many benefits of market economy, it provides no magic solutions. "The market economies are by no means immune to issues such as inflation, unemployment, pollution, poverty and barriers to international trade". Hence, the government will have to play a critical role in helping correct problems that cannot be fully solved by a system of private markets.

Features of Market Economy


Two major types of economic system are command and market economies. In command economies, resources are allocated by decisions taken by central planners. In market economies, the allocation of resources is determined by decentralized decisions coordinated through the price mechanism.

The basic features of market economy are as follows:
  1. Decentralized decision-taking: In a market economy, decisions relating to basic economic issues are decentralized. But they are coordinated. The main coordinating device is the set of market-determined prices. 
  2. Freedom of enterprise: People are free to choose nay occupation or take up any business according to self-interest. 
  3. Profit motive: The economic activities are undertaken with the aim of earning profit. People themselves borne the risk and return of business. 
  4. Consumer's sovereignty: The consumer is the king in the sense that they have complete freedom in making choice of the products. 
  5. Price mechanism: The price mechanism guides producers and consumers in making production and consumption decisions. The price system is the coordinator of decisions. Every day millions of people independently make millions of decisions relating to consumption and production. Most of these decisions are not motivated by a desire to contribute to the social good, but by the consideration of self-interest. The price system coordinates these decentralized decisions. Due to this the whole system is sensitive to whishes of the individuals who compose it. Price is a signaling device, which give signals about scarcities and surpluses. 
  6. Perfect competition: There is perfect competition in the market between producers, consumers and consumers and producers. 
  7. Specialization in production: There is specialization in production. It is accompanied by freedom to exchange what is produced among individuals. 
  8. Market-determined prices: The most remarkable feature of the market economy is that it requires no planning authority to allocate resources. The key to the whole process is to be found in the role of prices. The prices perform the crucial function of providing signals that help to determine the allocation of resources. 
  9. Lack of conscious direction: The market economy fulfills its function of coordinating decisions without any one having to understand how it works. For example, a farmer need not know how many people eat rice and where they live. He needs to know only the cost of production and price of rice. By responding to such public signals as the costs and prices of what he buys and sells, the farmer helps the whole economy fit together, to produce what people want, and to provide it where and when they want it. 
  10. Laissez-faire: There is what is called laissez-faire in the market economy. This French expression describes the belief that the market economy would perform most efficiently if left free from government intervention. Adam Smith opined that the 'hidden hand' of market forces should be allowed to govern the economy.

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