The classic microeconomics supply and demand model shows price on the vertical axis and quantity on the horizontal axis. Upon the graph is a downward-sloping demand curve where price and quantity demanded are shown to have an inverse relationship (there is usually an upward-sloping supply curve as well).
The model demonstrates that, as goods become more expensive, people tend to demand fewer of them.
Generally speaking, the basis for this inverse relationship is the reasoning of human beings and their resulting behavior.
Key Takeaways
- According to the law of supply and demand, the price of a good is inversely related to the quantity demanded.
- This makes sense for many goods, since the more costly they become, fewer people will be able to afford or want them and demand will subsequently drop.
- Additionally, as prices drop (or rise), consumer purchasing power increases (or decreases) so a greater (or lesser) amount of a commodity can be bought; this represents increased (or decreased) demand.
- Consumer logic and behavior are the reasons why price and quantity are inversely related.
Supply and Demand
The law of supply anddemand, one of the most basic economic laws, ties into almost all economic principles in some way.
In practice, supply and demand move inversely until the market finds an equilibrium price. In many simple markets, this inverse relationship can be seen clearly. For example, if the cost of a shirt doubles, consumers buy fewer of them, all else being equal. If the shirts go on sale, consumers tend to buy more.
However, multiple factors can affect both supply and demand, causing them to increase or decrease in various ways.
There are several practical issues with the simple supply and demand model as depicted in the graph below.
In addition to the theoretical existence of goods that actually rise in demand as the price goes up (known as Giffen and Veblen goods), a basic microeconomics chart like this one cannot possibly contain all of the variables that impact supply and demand.
Nevertheless, it is typically the case that price and quantity are inversely related: the more costly a good becomes, they less people will want it—and vice versa.
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Human Behavior and the Law of Demand
The law of demand is actually a deductive, logical construct. It holds a few observations as true: resources are scarce, there is a cost to acquiring them, and human beings employ resources to achieve meaningful ends.
Cost isn't necessarily represented by only a dollar amount. Cost represents what is given up to acquire something, even if it is time or energy. True cost also implies opportunity costs.
Since human beings reason and act, economists deduce that their actions necessarily reflect value judgments. Broadly speaking, every non-reflex action is taken to obtain or increase value in some sense; otherwise, no action takes place.
As the cost of acquiring a good increases, its relative marginal utility decreases compared to other goods. Even if all relative costs increased by exactly the same proportion at the exact same time, consumers' resources are finite.
Price elasticity of demand concerns the quantity of an item demanded at different price points. A product with high price elasticity has a wide variance of quantity demand at multiple prices. An inelastic product's demand remains consistent despite changes in price.
For example, medications that people need no matter where prices go would have low price elasticity.
The Income and Substitution Effects
Another way of looking at the inverse relationship of price and quantity is the income and substitution effects.
Income Effect
When product prices fall, a consumer's purchasing power increases. That is, their money will now buy a greater quantity of an item than before. The income effect of greater purchasing power and quantity represents greater demand. The opposite result occurs when prices rise and decreases purchasing power.
Substitution Effect
When the price of a particular commodity falls relative to others, consumers may substitute it for another higher priced commodity that they would normally buy but won't due to the expense. This substitution effect increases quantities bought and that represents increased demand.
Why Is the Price-Demand Relationship Important?
It's important because when consumers understand it and can spot it in action, they can take advantage of the swings between higher and lower prices to make purchases of value to them.
What Is the Law of Demand?
It's the economic theory that states that when a commodity's price rises, consumer demand for it falls.
Do Higher Prices Always Lead to Lower Demand?
Not always. If an exciting new product is released at a very high price (or higher price than its predecessor), initial demand can be tremendous. That may continue for quite a while, as in the case of Apple's various iPhone models. In addition, demand for items of necessity, such as bread or medications, can rise even as prices rise because consumers need them no matter what.
The Bottom Line
Consumer logic and behavior, as encapsulated by the law of demand, are behind the inverse relationship of price and quantity demanded. So, with some exceptions, as prices for a commodity or service increase, demand for it decreases and the quantity purchased drops.
