1.4 - Demand

The law of demand

The law of demand describes a fundamental principle in economics that explains how consumers respond to changes in the price of a good or service. This law forms the basis for understanding buyer behavior in competitive markets, where many buyers and sellers interact without any single participant controlling the price.

According to the law of demand, there is an inverse relationship between the price of a good or service and the quantity demanded. This means that as the price increases, the quantity demanded decreases, and as the price decreases, the quantity demanded increases. This relationship holds assuming all other factors remain constant, a condition known as ceteris paribus (Latin for "all other things being equal").

This inverse relationship occurs because higher prices make a good less attractive to buyers, who may seek cheaper alternatives or reduce their purchases. Lower prices, on the other hand, encourage more consumption by making the good more affordable.

The demand curve and its characteristics

A demand curve is a graphical representation of the law of demand, showing the relationship between the price of a good and the quantity demanded at various price levels. It helps visualize how changes in price affect consumer choices in a competitive market.

Key features of the demand curve

• Downward-sloping shape - The curve slopes downward from left to right, illustrating the inverse relationship: higher prices correspond to lower quantities demanded, and lower prices to higher quantities.
• Axes - The vertical axis represents price (P), while the horizontal axis represents the quantity demanded.
• Individual vs. market demand - An individual demand curve shows one consumer's quantity demanded at different prices. The market demand curve sums up the quantities demanded by all consumers in the market at each price level.

Graphical representation of the demand curve

The diagram below shows the demand curve D, with price on the vertical axis and quantity demanded on the horizontal axis. At the higher price P₁ buyers want the smaller quantity Q₁, and at the lower price P₂ they want the larger quantity Q₂. The curve assumes ceteris paribus, so only the price is changing.

Movements along the demand curve occur due to price changes alone. The arrow traces a price fall from P₁ to P₂, moving down and to the right along D, which is an increase in quantity demanded. A price rise moves the other way, up and to the left, which is a decrease in quantity demanded.

Price and quantity demanded

The relationship between price and quantity demanded is central to the law of demand and explains why consumers adjust their buying behavior. This connection highlights how price acts as a signal in competitive markets, influencing resource allocation.

When the price of a good rises, consumers demand less of it because their purchasing power decreases, so they can afford fewer units with the same budget. This leads to a contraction in quantity demanded. Conversely, when the price falls, consumers can buy more with the same income, resulting in an expansion in quantity demanded.

Factors underlying this relationship

• Income effect - A price change affects consumers' real income (purchasing power). A lower price increases real income, allowing buyers to purchase more of the good.
• Substitution effect - When a good's price rises, consumers switch to cheaper substitutes, reducing the quantity demanded of the original good. A price drop makes the good relatively cheaper than alternatives, increasing its quantity demanded.

These effects combine to create the inverse relationship, ensuring that demand responds predictably to price signals in the market.

Determinants of demand and shifts

Determinants of demand are factors other than the price of the good itself that influence how much consumers want to buy. Unlike price changes, which cause movements along the demand curve, changes in these determinants cause the entire demand curve to shift. A rightward shift indicates an increase in demand (more quantity demanded at every price), while a leftward shift shows a decrease in demand (less quantity demanded at every price).

Key determinants of demand

• Consumer income - An increase in income often leads to higher demand for normal goods (goods for which demand rises as income increases), shifting the curve rightward. For inferior goods (goods for which demand falls as income rises, like generic brands), higher income shifts the curve leftward.
• Prices of related goods - For substitutes (goods that can replace each other, like coffee and tea), a price increase in one boosts demand for the other, shifting its curve rightward. For complements (goods used together, like smartphones and apps), a price drop in one increases demand for the other.
• Consumer tastes and preferences - Changes in trends, advertising, or cultural shifts can increase demand (rightward shift) if a good becomes more popular, or decrease it (leftward shift) if preferences move away.
• Expectations - If consumers expect future price increases or shortages, current demand rises, shifting the curve rightward. Expectations of price drops reduce current demand.
• Number of buyers - An increase in the number of consumers in the market (e.g., due to population growth) shifts the demand curve rightward, while a decrease shifts it leftward.

Graphical representation of demand shifts

Consider a market demand curve. If consumer income rises, the new curve shifts rightward, showing higher quantity demanded at each price.

The diagram below shows both directions. Demand starts at D₁. An increase shifts it right to D₂, so more is demanded at every price; a decrease shifts it left to D₃, so less is demanded at every price. These shifts demonstrate how external factors alter overall demand, affecting market outcomes in competitive settings.