Law of Demand

Law of Demand:

This law is also known as the First Law of Purchase. It indicates the relation between the price of a commodity and its quantity demanded in the market. The law may be stated as follows: Under the same conditions of demand, the quantity of a commodity bought tends to vary inversely with its price. At a higher price, less of the commodity would be purchased and at a lower price more of it would be bought, provided the conditions of demand remain unchanged. It should, however, be remembered that the law of demand is only indicative and not a quantitative statement. It indicates only the direction in which the demand will change, whether it will change upwards or downwards. It says nothing about the magnitude of the upward or downward change. For example, if the price of butter changes from $8 to $10 per kg., we could say with the help of this law that the demand for butter will decline. But the law will not tell us the actual amount by which the demand for butter will decline consequent upon the rise in price. There is no mathematical relationship between the change in price and the change in the quantity demanded of the commodity.

While stating the law of demand, we have used the phrases “under the same conditions of demand” and “provided the conditions of demand remain unchanged” to cover the assumptions on which the law is based. We must now state these assumptions explicitly: we assume-

• that people’s incomes remain unchanged.
• that people’s tastes remain unchanged.
• that the prices of other related goods remain the same.
• that no substitutes for the commodity in question are available.
• that the people do not have expectations of further changes in the price of the commodity.
• that the commodity in question is not one which has a “prestige value” such as diamonds, etc.

The law of demand will operate only if the above things remain unchanged. A change in any one of them will render the law inoperative in the market.

Why does the Law of Demand Operate?

There are four reasons for the operation of the law-

Firstly, the law of demand operates because the law of diminishing marginal utility comes into force when a consumer buys additional quantities of a particular commodity. Even though an average consumer does not calculate exactly the marginal utility, he is nevertheless influenced by the fact that additional expenditure on a given commodity brings him less satisfaction as he buys additional quantities of it. This is bound to limit his purchases of the commodity unless its price is also correspondingly reduced. Thus, a seller will have to lower the price in order to induce the consumer to increase his purchases of the commodity.

Secondly, the law of demand operates on account of the working of the principle of different uses. As is well-known, some commodities have several uses, some of which are more important than others. If the price of the commodity is high, its use will be restricted to the purpose that the consumer considers to be the most important. The effective demand of the commodity will, therefore, be small; but if the price declines, the consumer will employ it in less important uses. Consequently, the effective demand of the commodity will rise. For example, if the price of mustard oil is very high, it will be used only as a cooking medium. If its price falls, it will be used even as hair oil.

Thirdly, the law of demand operates due to the working of the principle of different desires. People have different requirements, tastes, and temperaments. This fact contributes to the working of the law of demand. For example, some people are passionately fond of movies, others enjoy them only to a moderate degree, while still others find them extremely monotonous. The first category of persons will be prepared to pay any price rather than go without the movies; hence if the number of seats is limited, they can be sold to the first category at very high prices. But the second category of movie-goers will not be prepared to pay so much for the seats; hence if the movie owners desire to tap their demand, they must be prepared to lower down the admission rates to a reasonable level.

Fourthly, the law of demand operates on account of the working of the principle of different incomes. The fact that members of a community have different personal incomes also reinforces the law of demand. The rich man on account of his higher purchasing power can offer for a commodity a higher price than a poor man even though his desire for the commodity is not as urgent as that of the poor man. Thus, if the supply of the commodity is small, the whole of it can be sold to rich people who can afford to pay a high price for it. But if the supply is large and some of it has to be sold to consumers of small means, then the price will have to be lowered to a reasonable level to attract them.

Working of the Law of Demand:

The working of the law of demand can also be explained in terms of the two effects- the Income Effect and the Substitution Effect.

(1) Income Effect- A fall in the price of a commodity results in a rise in the consumer’s real income. He can, therefore, purchase more of it. On the contrary, a rise in the price of a commodity amounts to a fall in his real income. He is, therefore, forced to purchase less of it. Let us suppose that the price of sugar falls down. After having bought his usual quantity, the consumer is still left with some money, a part of which he is likely to spend on buying additional quantities of sugar. The consequent increase in his demand for sugar can be attributed to the income effect. Generally speaking, a consumer does not spend a very large part of his income on any single commodity. As such, the income effect is not very strong. If, however, the commodity in question is an important one, and the consumer spends a large part of his income on its purchase, the income effect, in that case, will be quite strong

(2) Substitution Effect- Again, the fall in the price of a commodity unaccompanied by a fall in the prices of its substitutes, making it more attractive to the consumers who now substitute it for the latter, leading to an extension in its demand. The extension in the demand of the commodity in question can be attributed to this substitution effect. Conversely, a rise in the price of the commodity, while the price of its substitutes remains constant, will make it unattractive to the consumers, who will now demand less of it. They will now use other commodities (whose prices have not risen) in place of the commodity in question. Consequently, there will be a contraction in its demand which can be attributed to the substitution effect.

Normally, the income effect is weaker than the substitution effect. As stated above, a consumer ordinarily spends a very small part of his income on one particular commodity. A fall in the price of the commodity will not, therefore, increase his real income in any substantial measure. The extension in the demand for the commodity consequent upon the income effect will, therefore be only of a small degree. The substitution effect, on the contrary, is stronger than the income effect because the consumer will always substitute the inexpensive for the expensive commodity. Furthermore, the income effect is positive only in the case of a superior commodity. If the price of such a commodity falls, the consumer’s real income increases and he will buy more of the commodity in question. But the income effect is negative in the case of an inferior commodity. If the price of such a commodity falls, the consumer’s real income increases and he buys less of the commodity in question. He spends the increased real income on superior goods. The substitution effect, on the other hand, is always positive, because a consumer always substitutes the more expensive by the less expensive commodity. In the case of a superior commodity, the income effect and the substitution effect are both positive. Hence, a fall in its price will always be accompanied by an extension in its demand. But in the case of an inferior commodity, the income effect is negative though the substitution effect is positive. The weak income effect is more than offset by the strong substitution effect. The net result, of course, is positive. In other words, the demand for the inferior commodity will extend with a fall and contract with a rise in price.

Exceptions to the Law of Demand:

The law of demand is a general statement. There are said to be a few exceptions to this general statement which may be set forth below.

(1) The Giffen Paradox- The ‘Giffen’ good (or an inferior commodity) is often considered an exception to the law of demand. A fall in its price tends to reduce, and a rise in its price tends to extend its demand. For example, take the case of a poor man who spends a major portion of his money income on an inferior commodity like bajra and is, therefore, able to spend only a small part of it on other commodities. Now suppose that the price of bajra rises, but the prices of other commodities remain the same. His money income also remains unchanged. He would now be worse off than before. His real income would have fallen. He would find that the monthly sum of money which he allotted to bajara buys less than before owing to the rise in the price of that grain. If he bought other commodities in their usual quantities and spent the same amount of money on bajara as before, he would be faced with starvation. He would, therefore, readjust his expenditure, cutting down on other items, in order not merely to maintain, but actually to increase the quantity of bajara he bought per month. Conversely, if the price of bajra falls down, his real income will increase by a substantial measure. He will, therefore, spend now on better quality or superior commodities. Consequently, his demand for bajara may actually contract with a fall in its price. We, thus, find that he buys more of bajara when its price rises and buy less of it when its price falls.

This strange phenomenon (obviously an exception to the law of demand) was first observed by Sir Robert Giffen and has been named after him as Giffen Paradox. Sir Giffen discovered that faced with an increase in the price of bread, the working-class families of Britain were compelled to curtail their consumption of meat in order to be able to spend more on bread.

It should, however, be remembered that, from the point of view of the entire market demand for a particular commodity, the Giffen Paradox may not have much significance. The reason being that a commodity that is ‘inferior’ for some people may be quite ‘normal’ for others. Its total demand may, therefore, extend with a fall and contract with a rise in its price.

(2) “Status Symbol” Commodity- A commodity is sometimes bought not because it has any intrinsic worth, but because its possession confers a social distinction on the holder. For example, diamonds and precious stones are bought largely by the richer classes for the prestige they confer upon the possessor. If the prices of diamonds were to fall down so that even the poorer classes could have them in plenty, they would no longer confer any prestige or social distinction and the richer classes may stop buying them altogether. But, except in very rare cases, a fall in the price of a ‘status symbol’ commodity may not lead to a decline in its total demand, which may even extend because several people who could not afford it earlier, may start buying it now when it’s pricing has fallen. The market demand for a ‘status symbol’ commodity may not thus be considered an exception to the law of demand.

(3) “Highly Priced” Commodity- The law of demand may not apply to a commodity whose quality is judged by the consumer by its high price. The producers of several goods, such as creams, powders, lipsticks, and other cosmetics have discovered through experience that their sales of these goods often go up when they increase their prices. The ignorant consumers consider those products superior which are sold at higher prices. As such, they buy more of these products at higher than at lower prices. Professor Benham has mentioned the case of a book of photographs that was published before the First World War at Tennis 10s-6d. Very few copies of the book were sold. The same book was re-issued after the War at a price of £3-3s. It sold very well at a higher price. Such cases are, however, rare.

(4) Speculation- If the price of a commodity is increasing and it is expected to increase still further, the consumer will buy more of the commodity at the higher price than they did at the lower price. Thus an increase in price may not be accompanied by a decrease in its demand, negativing the law of demand itself. In another sense, however, the phenomenon of increased quantity bought at a higher price, when further price increases are expected, may be considered a confirmation of the law of demand, namely, the consumers buying more at the higher price only to be able to buy less when the price rises still higher,

It is evident from the above discussion that the exceptions of the law of demand are not of much significance from the quantitative point of view. Despite these exceptions, the law of demand is a valid generalization for most of the commodities sold in the market. On the whole, it is not untrue to say that, other things remaining the same, more of a commodity is bought at a lower than at a higher price, though some consumers may not behave in this generalized fashion on certain occasions.