ECON100 CONCEPT OF THE DAY: LAW OF DEMAND
As part of our dual mandate to rebrand the dismal science’s moniker into the ‘decision’ making science as well as to lower the barrier to understand and access economic concepts without a formal economics degree, we’re rolling out a definition of the day (or week) to further these goals. Today’s concept of the day (or week) is: the law of demand.
WTF IS THE LAW OF DEMAND?
The law of demand is the relationship between the price of an item or good and the quantity demanded of that item or good. The relationship is an inverse, or negative relationship meaning the price and quantity demanded for that item or good move in opposite directions. If the price is high, or increasing then the quantity demanded is moving in the opposite direction: decreasing.
Why should we care about the law of demand?
Because the law of demand is immediately recognizable once you take a look at a typical demand curve. The law of demand is what’s behind the typical downward (or negative) slope of the typical demand curve. We say typical because not all demand curves slope downward, but in general and for purposes of standardized testing (AP economics) they do.
The downward slope is explained by two effects: (1) the income effect (2) the substitution effect. The substitution effect refers to the the change in quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods that are substitutes¹. The substitution effect demonstrated why price increases (with all else constant) in red bell peppers cause some consumers to switch to orange (or yellow) bell peppers, leading to a decrease in the quantity demanded of red bell peppers. Similarly, if the price of almond milk falls (with no other changes), it may convince some consumers to buy additional almond milk by switching away from some other type of milk (soy, rice, coconut, etc), resulting in an increase in the quantity demanded for almond milk.
The income effect refers to changes in quantity demanded of a good due to changes in purchasing power from a price change, holding all else equal¹. As the price of a good decreases, more of it can be purchased with the same amount of money. For example, if gas prices were to drop by 50% tomorrow, you would be able to spend the same amount of money and get twice as much gas. Sounds like a dream! However it may seem more like a nightmare if prices were to increase 50% in the opposite direction. Then you would have to pay twice as much for the same amount of gasoline. What a nightmare indeed! In reality, consumers would respond by purchasing fewer units (gallons or liters) of gas. The observation of this scenario would represent the income effect in action.
WHAT DOES THE LAW OF DEMAND MEAN FOR YOU?
Once you understand the law of demand side of a market, you can observe and take note of its role in how some prices in your local economy function. Consumers on the demand side of the market participate in it because the value or benefit of a good sold in that market outweighs the cost of the good from the consumer’s perspective. A close neighbor to the concept of diminishing marginal utility is the law of demand. We will soon tackle the concept of diminishing marginal utility in the future.
Refrences
Hubbard, Glenn, et al. Macroeconomics. Pearson, 2015.
Check out the video below to see if you can identify the income and/or substitution effects as consumers react to changes in food prices.