The Law of Demand

The quantity demanded for an economic product varies inversely with its price. – Therefore, the higher the price, the less the quantity demanded. – The lower the price, the greater the quantity demanded. This is evident from both the demand schedule (numbers move in opposite directions) and the demand curve (downward slope). The law of demand is fundamental to understanding consumers’ behavior when it comes to prices.

Why is there an inverse relation between price and quantity demanded? 1. Diminishing marginal utility 2. The income effect 3. The substitution effect

1. Diminishing Marginal Utility Marginal Utility: the extra usefulness or satisfaction derived from acquiring one more unit of a product. Example: lemonade on a hot day – Your enjoyment of each glass is usually less than the previous one. – This illustrates the principle of DIMINISHING MARGINAL UTILITY: When consuming consecutive units of a product, marginal utility will decrease. (You will enjoy each unit less than the one before.)

1. Diminishing Marginal Utility, cont. Because of diminishing marginal utility, the first glass of lemonade might be worth $5, the second might be worth $2, the third might be worth $.50, etc. – At $5, you would only buy one glass. – At $2, you would buy two glasses, but no more. – At $.50, you would buy three glasses, but no more. Therefore, lower prices lead to a greater quantity demanded, and vice-versa. (Inverse relation)

2. The Income Effect A lower price means a person’s income goes further toward buying that product, so many people will buy more than before. A higher price means a person’s income goes less far toward buying that product, so many people will buy less than before. Therefore, lower prices leads to a greater quantity demanded, and vice-versa. (Inverse relation)

3. The Substitution Effect When the price of a product drops, people who were buying a substitute might now switch to that product. When the price of a product rises, people might now stop buying that product in favor of a substitute. Therefore, lower prices leads to a greater quantity demanded, and vice-versa. (Inverse relation)