Law of demand

thumb|The demand curve, shown in blue, is sloping downwards from left to right because price and quantity demanded are inversely related. This relationship is contingent on certain conditions remaining constant. The supply curve, shown in orange, intersects with the demand curve at price (Pe) = 80 and quantity (Qe)= 120. Pe = 80 is the equilibrium price at which quantity demanded is equal to the quantity supplied. Similarly, Qe = 120 is the equilibrium quantity at which the quantity demanded and supplied are at the equilibrium price. Therefore, the intersection of the demand and supply curves provide us with the efficient allocation of goods in an economy.|365x365px

In microeconomics, the law of demand is a fundamental principle which states that there is an inverse relationship between price and quantity demanded. In other words, "conditional on all else being equal, as the price of a good increases (↑), quantity demanded will decrease (↓); conversely, as the price of a good decreases (↓), quantity demanded will increase (↑)". Alfred Marshall worded this as: "When we say that a person's demand for anything increases, we mean that he will buy more of it than he would before at the same price, and that he will buy as much of it as before at a higher price". The law of demand, however, only makes a qualitative statement in the sense that it describes the direction of change in the amount of quantity demanded but not the magnitude of change.

The law of demand is represented by a graph called the demand curve, with quantity demanded on the x-axis and price on the y-axis. Demand curves are downward sloping by definition of the law of demand. The law of demand also works together with the law of supply to determine the efficient allocation of resources in an economy through the equilibrium price and quantity.

The relationship between price and quantity demanded holds true so long as it is complied with the ceteris paribus condition "all else remain equal" quantity demanded varies inversely with price when income and the prices of other goods remain constant. If all else are not held equal, the law of demand may not necessarily hold. In the real world, there are many determinants of demand other than price, such as the prices of other goods, the consumer's income, preferences etc. There are also exceptions to the law of demand such as Giffen goods and perfectly inelastic goods.

Overview

Economist Alfred Marshall provided the graphical illustration of the law of demand. Together with the law of supply, the law of demand provides to us the equilibrium price and quantity. Moreover, the law of demand and supply explains why goods are priced at the level that they are. They also help us identify opportunities to buy what are perceived to be underpriced (or sell overpriced) goods or assets.

Law of Demand is relied heavily upon by managerial economics, which is a branch of economics that applies microeconomic analysis to managerial decision-making, to make informed decisions on pricing, production, and marketing strategies. In this context, understanding the alternative factors that influence the Law of Demand becomes crucial for managers and decision-makers.

Income effect: The income effect is the change in the quantity demanded of a good or service as a result of changes in consumers' purchasing power. When prices increase, the purchasing power of consumers decreases, leading to a decline in the quantity demanded. Conversely, a decrease in prices will increase purchasing power and lead to an increase in the quantity demanded.
Substitution effect: The substitution effect is the change in the quantity demanded of a good or service due to a change in the relative prices of substitute goods. When the price of a good increases, consumers may shift their consumption to relatively cheaper substitute goods, causing the demand for the original good to decrease.
Price expectations: Consumer expectations about future prices can influence their current demand for goods or services. If consumers expect prices to rise in the future, they may increase their current consumption to avoid higher prices later. Conversely, if they expect prices to fall, they may delay consumption, causing a decline in the quantity demanded.
Market size and demographics: The size of the market and its demographics can also influence the Law of Demand. Changes in population size, age distribution, and income levels can affect the overall demand for goods or services, thus impacting the relationship between price and quantity demanded.

Demand refers to the demand curve. A change in demand is indicated by a shift in the demand curve. Quantity demanded, on the other hand refers to a specific point on the demand curve which corresponds to a specific price. A change in quantity demanded therefore refers to a movement along the existing demand curve. However, there are some exceptions to the law of demand. For instance, if the price of cigarettes goes up, its demand does not decrease. The exceptions to the law of demand typically suit the Giffen commodities and Veblen goods which is further explained below.

The four main types of elasticity of demand are price elasticity of demand, cross elasticity of demand, income elasticity of demand, and advertising elasticity of demand. However, there were instances of its understanding and use much earlier when Gregory King (1648-1712) made a demonstration of the law of demand. He represented a relationship between the price of wheat and the harvest where the results suggested that if the harvest falls by 50%, the price would rise by 500%. This demonstration illustrated the law of demand as well as its elasticity.

Skipping forward to 1890, economist Alfred Marshall documented the graphical illustration of the law of demand.

:<math>(p'-p)(x'-x)\leq 0</math>

This formula states that, for all possible prices p' and p, and corresponding demands x' and x, prices and demand must move in opposite directions, i.e. as price increases, demand must decrease and vice versa. Note that demands are demand bundles, not individual demands. Demand for a single good can still increase even though its price also increased, if there is another good whose price increased and which is sufficiently substituted away from. If good i is a Giffen good whose price increases while other goods' prices are held fixed (so that <math display="inline">p_j'-p_j=0 \; \forall j\neq i</math>), the law of demand is clearly violated, as we have both <math display="inline">p_i'-p_i>0</math> (as price increased) and <math display="inline">q_i'-q_i>0</math> (as we consider a Giffen good), so that <math display="inline">(p'-p)(x'-x)=(p_i'-p_i)(x_i'-x_i)>0</math>.

Demand versus supply

On the one hand, demand refers to the demand curve. Changes in supply are depicted graphically by a shift in the supply curve to the left or right.

Cross elasticity of demand

The cross elasticity of demand is an economic concept that measures the relative change in demand of a good when another good varies in price. The formula to solve for the coefficient of cross elasticity of demand is calculated by dividing the percentage change in quantity demanded of good A by the percentage change in price of good B.

:<math>\text{Cross-price Elasticity Of Demand}

= \frac{\%\text{ change in quantity demanded of good A{\%\text{ change in price of good B</math>

The Cross elasticity of demand, also commonly referred to as the Cross-price elasticity of demand, allows companies to establish competitive prices against substitute goods and complementary goods. The metric figure produced by the equation thus determines the strength of both the relationship and competition between the two goods.

Income elasticity of demand

Income elasticity of demand is an economic measurement tool developed to measure the sensitivity of a goods quantity demanded when there is a change in the real income of a consumer. To calculate the income elasticity of demand, the percentage change in quantity demanded is divided by the percentage change in the consumers income.

:<math>\epsilon_d = \frac{\%\ \mbox{change in quantity demanded{\%\ \mbox{change in income</math>

The Income elasticity of demand allows businesses to analyse and further predict the impact of business cycles on total sales. The Income elastitcty of demand thus allows goods to be broadly categorised as Normal goods and Inferior goods. A positive measurement suggests that the good is a normal good, and a negative measurement suggests an inferior good. The Income elasticity of demand effectively represents a consumers idea as to whether a good is a luxury or a necessity.

Advertising elasticity of demand

Advertising elasticity of demand measures the effectiveness of an advertising campaign as to generate new sales. To calculate the Advertising elasticity of demand, the percentage change in quantity demanded is divided by the percentage change in advertising expenditures.

:<math>AED = \frac{\%\ \mbox{change in quantity demanded{\%\ \mbox{change in spending on advertising = \frac{\Delta Q_d/Q_d}{\Delta A/A} </math>

A business utilises the advertising elasticity of demand to measure the effectiveness of advertising on generating new sales. A positive elasticity indicates success for the advertisement as demand for the goods has increased. However, this measurement is also subject to the availability of substitutes, consumer behaviours and price points of the good being advertised. This results in an upward sloping demand curve contrary to the fundamental law of demand.

Giffen goods violate the law of demand due to the income effect dominating the substitution effect. This can be illustrated with the Slutsky equation for a change in a good's own price:

:<math>

\frac{\partial x_i}{\partial p_i} = \frac{\partial h_i}{\partial p_i} - \frac{\partial x_i}{\partial m}x_i

</math>

The first term on the right-hand side is the substitution effect, which is always negative. The second term on the right side is the income effect, which can be positive or negative. For inferior goods, this is negative, so subtracting this means adding its positive absolute value. The non-derivative component of the income effect is a measure of a consumer's existing demand for the good, meaning that if a consumer spends a large amount of his income on an inferior good, then a price increase could cause the income effect to dominate the substitution effect. This leads to a positive partial derivative of the good's demand with regards to its price, which violates the law of demand.

Expectation of change in the price of commodity

If an increase in the price of a commodity causes households to expect the price of a commodity to increase further, they may start purchasing a greater amount of the commodity even at the presently increased price. Other rationales for buying a high-priced stock are that previous buyers who bid up the price are proof of the issue's quality, or conversely, that an issue's low price may be evidence of viability problems.

Veblen goods

thumb|Named after the American economist [[Thorstein Veblen, Veblen goods are luxury items. They are perceived as status symbols and include diamonds and luxury cars.]]

Unlike Giffen goods, which are inferior items, Veblen goods are generally high quality goods. The demand for Veblen goods increases with the increase in price. Examples of Veblen goods are mostly luxurious items such as diamond, gold, precious stones, world-famous paintings, antiques etc. In simple words, these goods are not bought for their satisfaction but for their "snob appeal" or "ostentation".