Definition: The Law of Demand explains the downward slope of the demand curve, which posits that as the price falls the quantity demanded increases and as the price rise, the quantity demanded decreases, other things remaining unchanged.
There are several factors that explain why the demand curve slopes downward or why the law of demand showing an inverse relation between the price and quantity is valid?
Reasons for Law of Demand
- Substitution Effect: The Substitution effect is seen when the quantity demanded for one commodity changes due to the change in the price of other closely related commodity. Such as, if the price of the commodity decreases while the price of the other is assumed to remain the same, then the latter becomes dearer and the demand for the cheaper commodity increases.
For example, suppose the price of tea decreases while the price of coffee remains unchanged, then the tea will be substituted for coffee and thus the demand for tea increases. This effect of increase in the demand for tea is called as the substitution effect.
- Income Effect: The income effect explains the change in demand due to the change in the real income of the consumer as a result of the change in the price of the given commodity. Such as, with the fall in the price of a commodity, the real income (purchasing power) of the consumer increases since the consumer can now purchase more units of the commodity with the same amount of money income. Thus, the increase in demand due to the increase in the real income is called as the income effect.
For example, Suppose a boy purchases 5 ice-creams for Rs 50, and if the price of ice-cream falls to Rs 8, now he can purchase 6 ice-creams with the same amount of money income or may decide to buy the same quantity and save the rest of the money, as he is required to spend less.
- Utility-Maximizing Behavior: The consumer theory posits that the consumer buys goods and services to maximize his total utility (satisfaction). We know, that the marginal utility decreases with each additional unit of the commodity and thus, this is one of the reasons for the downward slope of the demand curve, which shows that the demand for the normal goods increases with the fall in the prices.
A person exchanges his money income for the purchase of the commodity so as to maximize his satisfaction. He continues to buy the commodity as long as the marginal utility of money (MUm) is less than the marginal utility of the commodity (MUx).
- Large Number of Consumers: The effect on demand due to the change in the number of consumers as a result of a change in the price also causes the demand curve to slope downwards. Such as, if the price of the commodity falls, then many new consumers who were earlier not able to afford the commodity due to its high price, starts purchasing it. And as a result, the demand for the commodity increases.On the other hand, if the price rises, then few rich people can buy it, and many consumers will withdraw themselves from the market. And as a result, the demand for the commodity decreases.
- Varied Uses of the Product: This is one of the important reasons for the law of demand, which explains that the product has several uses and can be utilized for different purposes. When the price of the commodity rises, then the consumer restricts its usage for the most important purpose. On the other hand, if the commodity becomes cheap then it can be utilized for all kinds of purposes, whether important or not.
For example, if the price of coal increases, then it will be more used in the industries where it is an essential raw material, whereas its demand for less important use such as in household (bonfire) gets reduced.
Thus, these are the important factors that explain the slope of the demand curve and advocates that the law of demand is valid.