Law of Demand: Important Facts, Reasons and Exceptions | Micro Economics (2024)

Read this article to learn about the important facts, reasons and exceptions of law of demand!

In our daily life, it is normally observed that decrease in price of a commodity leads to increase in its demand. Such behaviour of consumers has been formulated as ‘Law of Demand’.

Law of demand states the inverse relationship between price and quantity demanded, keeping other factors constant (ceteris paribus). This law is also known as the ‘First Law of Purchase’.

Assumptions of Law of demand:

While stating the law of demand, we use the phrase ‘keeping other factors constant or ceteris paribus’. This phrase is used to cover the following assumptions on which the law is based:

1. Prices of substitute goods do not change.

2. Prices of complementary goods remain constant.

3. Income of the consumer remains the same.

4. There is no expectation of change in price in the future.

5. Tastes and preferences of the consumer remain the same.

Law of demand can be better understood with the help of Table 3.3 and Fig. 3.3:

Table 3.3: Demand Schedule:

Table 3.3 clearly shows that more and more units of commodity are demanded, when price of the commodity falls. As seen in Fig. 3.3, demand curve DD slopes downwards from left to right, indicating an inverse relationship between price and quantity demanded.

Why Other Factors are kept Constant?

The quantity demanded of a commodity depends on many factors, besides price of the given commodity. If we want to understand the separate influence of one factor, it is necessary, that all other factors are kept constant. Therefore, while discussing the ‘Law of Demand’, it is assumed that there is no change in the other factors.

Important Facts about Law of Demand:

1. Inverse Relationship:

It states the inverse relationship between price and quantity demanded. It simply affirms that an increase in price will tend to reduce the quantity demanded and a fall in price will lead to an increase in the quantity demanded.

2. Qualitative, not Quantitative:

It makes a qualitative statement only, i.e. it indicates the direction of change in the amount demanded and does not indicate the magnitude of change.

3. No Proportional Relationship:

It does not establish any proportional relationship between change in price and the resultant change in demand. If the price rises by 10%, quantity demanded may fall by any proportion.

4. One-Sided:

Law of demand is one sided as it only explains the effect of change in price on the quantity demanded. It states nothing about the effect of change in quantity demanded on the price of the commodity.

Derivation of ‘Law of Demand’:

According to the law of demand, demand for a commodity rises with fall in its price and vice-versa, keeping other factors constant. This inverse relationship between price and demand as given by Law of demand, can be derived by: (i) ‘Marginal Utility’ = Price’ Condition; and (ii) Law of Equi-Marginal Utility.

Let us discuss the two in detail:

(i) Marginal utility = Price (Single commodity Equilibrium Condition):

According to single commodity equilibrium condition, consumer purchases that much quantity of a good at which marginal utility (MU) is equal to price.

i. When MU is more than Price:

If price of the good falls, it makes MU greater than price. It encourages the consumer to buy more. It shows that when price of a good falls, its demand rises. The consumer will continue to buy more until MU falls enough to be equal to price again. It shows that when price falls demand rises.

ii. When MU is less than Price:

If price of the good rises, it makes MU less than price. Now consumer will reduce the demand until MU rises till it again becomes equal to price. It means that when price rises demand falls.

So, it can be concluded that there exists an inverse relationship between price and demand.

(ii) Law of Equi-Marginal Utility:

According to this law, a consumer will be at equilibrium when he spends his limited income in such a way that the ratios of marginal utilities and their respective prices are equal and MU falls as consumption increases.

In case of two goods (say, X and Y), equilibrium condition will be stated as:

MU_X / P_X = MU_Y/ P_Y

i. In this equilibrium condition, if the price of commodity X (P_X) falls, then MU_X / P_X > MU_Y/ P_Y. In this case, the consumer is getting more marginal utility per rupee in case of good X as compared to Y. Therefore, he will buy more of X and less of Y. This shows that when price of a good falls, more of it is demanded. The consumer will continue to buy more of X till MU_X / P_X = MU_Y/ P_Y.

ii. Similarly, if price of commodity X (P_X) rises, then MU_X / P_X < MU_Y/ P_Y. Now, consumer is getting more marginal utility per rupee in case of good Y as compared to X. So, he will buy less of X and more of Y. It means, demand of a commodity varies inversely with its price.

It shows that there exists an inverse relationship between price and demand.

Reasons for Law of Demand:

Let us now try to understand, why does the law of demand operate, i.e. why does a consumer buy more at lower price than at a higher price.

The various reasons for operation of Law of Demand are:

1. Law of Diminishing Marginal Utility:

Law of diminishing marginal utility states that as we consume more and more units of a commodity, the utility derived from each successive unit goes on decreasing. So, demand for a commodity depends on its utility.

If the consumer gets more satisfaction, he will pay more. As a result, consumer will not be prepared to pay the same price for additional units of the commodity. The consumer will buy more units of the commodity only when the price falls.

Law of diminishing marginal utility is considered as the basic reason for operation of ‘Law of Demand’.

2. Substitution Effect:

Substitution effect refers to substituting one commodity in place of other when it becomes relatively cheaper. When price of the given commodity falls, it becomes relatively cheaper as compared to its substitute (assuming no change in price of substitute). As a result, demand for the given commodity rises.

For example, if price of given commodity (say, Pepsi) falls, with no change in price of its substitute (say, co*ke), then Pepsi will become relatively cheaper and will be substituted for co*ke, i.e. demand for Pepsi will rise.

3. Income Effect:

Income effect refers to effect on demand when real income of the consumer changes due to change in price of the given commodity. When price of the given commodity falls, it increases the purchasing power (real income) of the consumer. As a result, he can purchase more of the given commodity with the same money income.

For example, suppose Isha buys 4 chocolates @ Rs. 10 each with her pocket money of Rs. 40. If price of chocolate falls to Rs. 8 each, then with the same money income, Isha can buy 5 chocolates due to an increase in her real income.

‘Price Effect’ is the combined effect of Income Effect and Substitution Effect. Symbolically: Price Effect = income Effect + Substitution Effect. For a detailed discussion on Income Effect and Substitution Effect, refer Power Booster.

4. Additional Customers:

When price of a commodity falls, many new consumers, who were not in a position to buy it earlier due to its high price, starts purchasing it. In addition to new customers, old consumers of the commodity start demanding more due to its reduced price.

For example, if price of ice-cream family pack falls from Rs. 100 to Rs. 50 per pack, then many consumers who were not in a position to afford the ice-cream earlier can now buy it with decrease in its price. Moreover, the old customers of ice-cream can now consume more. As a result, its total demand increases.

5. Different Uses:

Some commodities like milk, electricity, etc. have several uses, some of which are more important than the others. When price of such a good (say, milk) increases, its uses get restricted to the most important purpose (say, drinking) and demand for less important uses (like cheese, butter, etc.) gets reduced. However, when the price of such a commodity decreases, the commodity is put to all its uses, whether important or not.

Exceptions to Law of Demand:

As a general rule, demand curve slopes downwards, showing the inverse relationship between price and quantity demanded. However, in certain special circ*mstances, the reverse may occur, i.e. a rise in price may increase the demand. These circ*mstances are known as ‘Exceptions to the Law of Demand’.

Some of the Important Exceptions are:

1. Giffen Goods:

These are special kind of inferior goods on which the consumer spends a large part of his income and their demand rises with an increase in price and demand falls with decrease in price. For example, in our country, it is often seen that when price of coarse cereals like jowar and bajra falls, the consumers have a tendency to spend less on them and shift over to superior cereals like wheat and rice. This phenomenon, popularly known as’ Giffen’s Paradox’ was first observed by Sir Robert Giffen.

2. Status Symbol Goods or Goods of Ostentation:

The exception relates to certain prestige goods which are used as status symbols. For example, diamonds, gold, antique paintings, etc. are bought due to the prestige they confer upon the possessor. These are wanted by the rich persons for prestige and distinction. The higher the price, the higher will be the demand for such goods.

3. Fear of Shortage:

If the consumers expect a shortage or scarcity of a particular commodity in the near future, then they would start buying more and more of that commodity in the current period even if their prices are rising. The consumers demand more due to fear of further rise in prices. For example, during emergencies like war, famines, etc., consumers demand goods even at higher prices due to fear of shortage and general insecurity.

4. Ignorance:

Consumers may buy more of a commodity at a higher price when they are ignorant of the prevailing prices of the commodity in the market.

5. Fashion related goods:

Goods related to fashion do not follow the law of demand and their demand increases even with a rise in their prices. For example, if any particular type of dress is in fashion, then demand for such dress will increase even if its price is rising.

6. Necessities of Life:

Another exception occurs in the use of such commodities, which become necessities of life due to their constant use. For example, commodities like rice, wheat, salt, medicines, etc. are purchased even if their prices increase.

7. Change in Weather:

With change in season/weather, demand for certain commodities also changes, irrespective of any change in their prices. For example, demand for umbrellas increases in rainy season even with an increase in their prices. It must be noted that in normal conditions and considering the given assumptions, ‘Law of Demand’ is universally applicable.