Question

What is law of demand? Explain why there exists a negative relationship between the price of a product and its quantity demanded? Note: discuss the three reasons why the law holds. (Income, substitution effects and law of diminishing marginal utility)

Answer 1

The Law of Demand says that price of a commodity is inversely related to the quantity demanded of that commodity. It says that when price of a commodity falls, the quantity demanded of that commodity rises and when the price of the commodity rises then the quantity demanded of that commodity falls.

The reasons for this inverse relation of price and quantity demanded of a commodity are :

Or,

The Law of Demand holds due to the following reasons :

i) Income Effect : Income Effect explains the change in quantity demanded of a commodity due to a change in the real income of the consumer. When price of a commodity rises, the real income/purchasing power of the income falls and he/she can only buy lesser of the commodity at that increased price with the same income. On the other hand, when price of the commodity falls, the real income rises and the demand for commodity also rises as the consumer can now purchase more of that commodity at the new price at the same income.

ii) Substitution Effect : Substitution effect happens when the demand for a commodity changes due to change in price of a closely related good. When the price of a commodity falls, it becomes relatively cheaper than other similar commodities while other similar commodities become relatively expensive. Hence, more consumers now wat to purchase this commodity which has become relatively cheaper. Hence, the demand for this commodity rises when price falls. In the opposite way, when price of a commodity rises, other similar commodities become relatively cheaper and consumers move to consuming other commodities. Hence, demand falls.

iii) Law of Diminishing Marginal Utility : When a consumer consumes a commodity, he o she gets some satisfaction out of consuming the commodity. This satisfaction is called Utility. When a person consumes a commodity, he or she gets some utility and the total utility that the person wants to get decreases with each additional unit if commodity that is consumed. Hence, the value of each additional commodity is lower for the consumer than the previous unit. Hence, he or she will only demand another unit of the commodity at a lower price so that the utility derived from this additional unit is equal to the price that the consumer pays. Therefore, only at lower prices will a consumer demand more of the commodity.