Law of Demand

Definition

The law of demand is an economic principle that states that as the price of a good or service increases, the quantity demanded of that good or service decreases, and vice versa. This inverse relationship between price and quantity demanded is a fundamental concept in microeconomics that helps explain consumer behavior.

5 Must Know Facts For Your Next Test

1. The law of demand is based on the principle of diminishing marginal utility, which explains why consumers demand less of a good as its price rises.
2. The law of demand applies to normal goods, where the quantity demanded increases as income increases, and to inferior goods, where the quantity demanded decreases as income increases.
3. The law of demand assumes that all other factors affecting demand, such as consumer income, prices of related goods, and consumer preferences, remain constant.
4. The law of demand is a fundamental assumption in microeconomic analysis, as it allows economists to predict how consumers will respond to changes in prices.
5. Exceptions to the law of demand, such as Giffen goods and Veblen goods, are rare and occur when the income effect outweighs the substitution effect.

Review Questions

• Explain how the law of demand relates to the concept of diminishing marginal utility.
  • The law of demand is closely tied to the principle of diminishing marginal utility. As consumers purchase more units of a good, the additional satisfaction or utility they derive from each successive unit decreases. This means that as the price of a good rises, consumers will demand less of it, as the marginal utility of the good becomes lower relative to its higher price. The inverse relationship between price and quantity demanded, as described by the law of demand, is a direct result of the diminishing marginal utility experienced by consumers.
• Describe the role of the substitution effect in the law of demand.
  • The substitution effect is a key factor in explaining the law of demand. When the price of a good increases, consumers will substitute away from that good and towards relatively cheaper alternatives. This shift in consumption patterns leads to a decrease in the quantity demanded of the good, as described by the law of demand. The substitution effect occurs because consumers aim to maximize their utility by choosing the best combination of goods given their budget constraints. As the relative price of a good changes, consumers will adjust their consumption to maintain the optimal balance of goods and services.
• Analyze the exceptions to the law of demand and explain how they challenge the fundamental assumptions of the law.
  • While the law of demand generally holds true for most goods and services, there are rare exceptions that challenge its underlying assumptions. Giffen goods and Veblen goods are examples of these exceptions, where the quantity demanded increases as the price increases. This occurs because the income effect, which describes the change in consumption due to a change in real purchasing power, outweighs the substitution effect. For Giffen goods, the income effect is so strong that consumers are willing to purchase more of the good as its price rises, as it represents a larger portion of their limited budget. For Veblen goods, the increase in price may be perceived as an indicator of higher quality or prestige, leading to an increase in demand. These exceptions highlight the importance of considering the complex interplay of factors that influence consumer behavior, beyond the simplistic assumptions of the law of demand.

Related terms

Demand Curve: A graphical representation of the law of demand, showing the relationship between the price of a good and the quantity demanded of that good.

Diminishing Marginal Utility: The principle that as a consumer consumes more of a good, the additional satisfaction or utility derived from each successive unit of that good decreases.

Substitution Effect: The change in quantity demanded of a good due to a change in its price, holding the consumer's real income constant.