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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 In most contexts, the concept of good denotes the conduct that should be preferred when posed with a choice between possible actions. Good is generally considered to be the opposite of evil and is of interest in the study of ethics, morality, ph ...
increases (↑), quantity demanded will decrease (↓); conversely, as the price of a good decreases (↓), quantity demanded will increase (↑)".
Alfred Marshall Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist, and was one of the most influential economists of his time. His book '' Principles of Economics'' (1890) was the dominant economic textbook in England for many years. I ...
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 In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity (the ''y''-axis) and the quantity of that commodity that is demanded at that price (the ''x''-axis). Demand curves can be used either for ...
, 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 The law of supply is a fundamental principle of economic theory which states that, keeping other factors constant, an increase in price results in an increase in quantity supplied. In other words, there is a direct relationship between price and ...
to determine the efficient allocation of resources in an economy through the equilibrium price and quantity. It is important to note that 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 In economics and consumer theory, a Giffen good is a product that people consume more of as the price rises and vice versa—violating the basic law of demand in microeconomics. For any other sort of good, as the price of the good rises, the ...
and perfectly inelastic goods.


Overview

Economist Alfred Marshall provided the graphical illustration of the law of demand. This graphical illustration is still used today to define and explain a variety of other concepts and theories in economics. A simple explanation of the law of demand is that all else equal, at a higher price, consumer will demand less quantity of a good and vice versa. The law of demand applies to a variety of organisational and business situations. Price determination, government policy formation etc are examples. 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. An important concept to apprehend from the law of demand is the difference between demand and quantity demanded. Demand refers to the
demand curve In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity (the ''y''-axis) and the quantity of that commodity that is demanded at that price (the ''x''-axis). Demand curves can be used either for ...
. 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.


History

The famous law of demand was first stated by Charles Davenant (1656-1714) in his essay, "Probable Methods of Making People Gainers in the Balance of Trade (1699)". 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 Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist, and was one of the most influential economists of his time. His book '' Principles of Economics'' (1890) was the dominant economic textbook in England for many years. I ...
documented the graphical illustration of the law of demand. In ''Principles of Economics'' (1890), Alfred Marshall reconciled the demand and supply into a single analytical framework. The formulation of the demand curve was provided by the utility theory while supply curve was determined by the cost. This idea of demand and supply curve is what we still use today to develop the market equilibrium and to support a variety of other economic theories and concepts. Due to general agreement with the observation, economists have come to accept the validity of the law under most situations. Economist also see Alfred Marshall as the pioneer of the standard demand and supply diagrams and their use in economic analysis including welfare applications and consumer surplus.


Mathematical description

Consider the function \ Q_x = f(P_x ; \mathbf Y), where Q_x is the quantity demanded of good ''x'', f is the
demand function In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity (the ''y''-axis) and the quantity of that commodity that is demanded at that price (the ''x''-axis). Demand curves can be used either for t ...
, P_x is the price of the good and \mathbf Y is the list of parameters other than the price. The law of demand states that \frac < 0. Here \partial/\partial P_x is the partial derivative operator. The above equation, when plotted with quantity demanded (Q_x) on the ''x''-axis and price (P_x) on the y-axis, gives the
demand curve In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity (the ''y''-axis) and the quantity of that commodity that is demanded at that price (the ''x''-axis). Demand curves can be used either for ...
, which is also known as the demand schedule. The demand curve is downward sloping illustrating the inverse relationship between quantity demanded and price. Therefore, a downward sloping demand curve embeds the law of demand. In a more specific manner: :Qdx = f(P_x, I, P_y, T) Which is a functional relationship where the quantity demanded by the consumer Qdx depends on the price of the good P_x, the monetary income of the consumer I, the prices of other goods P_y, and the taste of the consumer T. Another common way to express the law of demand without imposing a functional form is the following: :(p'-p)(x'-x)\leq 0 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 p_j'-p_j=0 \; \forall j\neq i), the law of demand is clearly violated, as we have both p_i'-p_i>0 (as price increased) and q_i'-q_i>0 (as we consider a Giffen good), so that (p'-p)(x'-x)=(p_i'-p_i)(x_i'-x_i)>0.


Demand versus quantity demanded

It is very important to apprehend the difference between demand and quantity demanded as they are used to mean different things in the economic jargon. On the one hand, demand refers to the
demand curve In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity (the ''y''-axis) and the quantity of that commodity that is demanded at that price (the ''x''-axis). Demand curves can be used either for ...
. Changes in demand are depicted graphically by a shift in the demand curve to the left or right. Changes in the demand curve are usually caused by 5 major factors, namely: number of buyers, consumer income, tastes or preferences, price of related goods and future expectations. On the other hand, quantity demanded refers to a specific point located on the demand curve which corresponds to a specific price. Therefore, quantity demanded represents the exact quantity of a good or service demanded by a consumer at a particular price, conditional on the other determinants. A change in quantity demanded can be indicated by a movement along the existing demand curve that is caused only by a change in price. For instance, let's take the example of a housing market. An increase or decrease in price of housing will not shift the demand curve rather it will cause a movement along the demand curve for housing i.e. change in quantity demanded. But if we look at mortgage rates (a factor other than price), even if housing prices remain unchanged, an increased mortgage rate leads to a lower willingness to buy at all prices, shifting the demand curve to the left. Consumers will buy less, even though the price is the same. On the other hand, lower mortgage rate leads to a higher willingness to buy at all prices, and eventually shifting the demand curve to the right. Consumers will now buy more, even though the price has not changed at all. Such variation in demand can be explained by demand elasticity.


Demand elasticity

The elasticity of demand refers to the sensitivity of a goods demand as compared to the fluctuation of other economic factors, such as price, income, etc. The law of demand explains that the relationship between Demand and Price is directly inverse. However, the demand for some goods are more receptive to a change in price than others. There are four major elasticities of demand, these being the price elasticity of demand, income elasticity of demand, cross elasticity of demand, and advertising elasticity of demand.


Price elasticity of demand

The variation in demand with regards to a change in price is known as the price elasticity of demand. The formula to solve for the coefficient of price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in Price. :E_ = \frac An elastic demand is one in which the elasticity is greater than one, and thus a change in price has substantial effect on the demand of that good. A good is inelastic if the change in price does not directly cause a fluctuation in demand, and therefore an inelastic demand is one in which elasticity is less than one. A good is unitary elastic if the elasticity is equal to one.


Cross elasticity of demand

The
cross elasticity of demand In economics, the cross elasticity of demand or cross-price elasticity of demand measures the percentage change of the quantity demanded for a good to the percentage change in the price of another good, ceteris paribus. In real life, the quantity d ...
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. :\text = \frac The Cross elasticity of demand, also commonly referred to as the Cross-price elasticity of demand, allows companies to establish competitive prices against
substitute good In microeconomics, two goods are substitutes if the products could be used for the same purpose by the consumers. That is, a consumer perceives both goods as similar or comparable, so that having more of one good causes the consumer to desire less ...
s and
complementary good In economics, a complementary good is a good whose appeal increases with the popularity of its complement. Technically, it displays a negative cross elasticity of demand and that demand for it increases when the price of another good decreases. ...
s. 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 In economics, the income elasticity of demand is the responsivenesses of the quantity demanded for a good to a change in consumer income. It is measured as the ratio of the percentage change in quantity demanded to the percentage change in incom ...
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. :\epsilon_d = \frac 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 In economics, a normal good is a type of a good which experiences an increase in demand due to an increase in income, unlike inferior goods, for which the opposite is observed. When there is an increase in a person's income, for example due to a ...
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. :AED = \frac = \frac 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.


Exceptions to the law of demand

The elasticity of demand follows the law of demand and its definition. However, there are goods and specific situations that defy the law of demand. Generally, the amount demanded of a good increases with a decrease in price of the good and vice versa. In some cases this may not be true. There are certain goods which do not follow the law of demand. These include
Giffen goods In economics and consumer theory, a Giffen good is a product that people consume more of as the price rises and vice versa—violating the basic law of demand in microeconomics. For any other sort of good, as the price of the good rises, the ...
,
Veblen goods A Veblen good is a type of luxury good for which the demand increases as the price increases, in apparent (but not actual) contradiction of the law of demand, resulting in an upward-sloping demand curve. The higher prices of Veblen goods may mak ...
, basic or necessary goods and expectations of future price changes. Further exception and details are given in the sections below:


Giffen goods

Initially proposed by
Sir Robert Giffen Sir Robert Giffen (22 July 1837 – 12 April 1910) was a Scottish statistician and economist. Life Giffen was born at Strathaven, Lanarkshire. He entered a solicitor's office in Glasgow, and while in that city attended courses at the univ ...
, economists disagree on the existence of Giffen goods in the market. A Giffen good describes an inferior good that, as the price increases, demand for the product increases. As an example, during the Great Famine of Ireland of the 19th century, potatoes were considered a Giffen good. Potatoes were the largest staple in the Irish diet, so as the price rose it had a large impact on income. People responded by cutting out on
luxury good In economics, a luxury good (or upmarket good) is a good for which demand increases more than what is proportional as income rises, so that expenditures on the good become a greater proportion of overall spending. Luxury goods are in contrast to ...
s such as meat and vegetables, and instead bought more potatoes. Therefore, as the price of potatoes increased, so did the quantity demanded.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 The Slutsky equation (or Slutsky identity) in economics, named after Eugen Slutsky, relates changes in Marshallian (uncompensated) demand to changes in Hicksian (compensated) demand, which is known as such since it compensates to maintain a fixed ...
for a change in a good's own price: : \frac = \frac - \fracx_i 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. Similarly, if the household expects the price of the commodity to decrease, it may postpone its purchases. Thus, some argue that the law of demand is violated in such cases. In this case, the demand curve does not slope down from left to right; instead, it presents a backward slope from the top right to down left. This curve is known as an exceptional demand curve.


Basic or necessary goods

The goods which people need no matter how high the price is are basic or necessary goods. Medicines covered by insurance are a good example. An increase or decrease in the price of such a good does not affect its quantity demanded.


Certain scenarios in stock trading

Stock buyers acting in accord with the
hot-hand fallacy The "hot hand" (also known as the "hot hand phenomenon" or "hot hand fallacy") is a phenomenon, previously considered a cognitive social bias, that a person who experiences a successful outcome has a greater chance of success in further attempts. ...
will increase buying when stock prices are trending upward. 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. Likewise, demand among short traders during a
short squeeze In the stock market, a short squeeze is a rapid increase in the price of a stock owing primarily to an excess of short selling of a stock rather than underlying fundamentals. A short squeeze occurs when there is a lack of supply and an excess ...
can increase as price increases.


Misconception of Veblen goods as an exception

Unlike
Giffen goods In economics and consumer theory, a Giffen good is a product that people consume more of as the price rises and vice versa—violating the basic law of demand in microeconomics. For any other sort of good, as the price of the good rises, the ...
, which are inferior items,
Veblen goods A Veblen good is a type of luxury good for which the demand increases as the price increases, in apparent (but not actual) contradiction of the law of demand, resulting in an upward-sloping demand curve. The higher prices of Veblen goods may mak ...
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. Veblen goods appear to go against the law of demand because of their exclusivity appeal, in the sense that if a price of a luxurious and expensive product is increased, it may attract the status-conscious group more, since it will be further out of reach for an average consumer. Thorstein Veblen referred to this sort of consumption as the purchase of goods that do not exhibit additional utility or functionality but offer status and reveal socioeconomic position. In simple words, these goods are not bought for their satisfaction but for their "snob appeal" or "ostentation". Accordingly, all these factors also lead to an upward sloping demand curve for Veblen goods along a certain price range. However, despite appearing to break the law of demand, the upward-sloping demand curve for a Veblen good does not actually violate the law. This is because the social value of the good is itself dependent on the price; in other words, the good itself changes as the price changes.Becker, G. S. & Murphy, K. M. (2000). This is illustrated when looking at the derivative of societal demand for a social good (goods whose value depends on others' consumption of it) with respect to price: : \frac = \frac or : \left(\frac\right) \left(1 - \frac \sum \frac\right) = \frac \sum \frac In other words, the rise in price increases the societal demand for the good, and because an individual demands less of this good the more others have, the entire left-hand side is positive, meaning the right-hand side is positive. The RHS means that in general, people will demand more of the social good the higher price goes (though not necessarily every individual will do so). Because of the price itself leading to a change in the social good's value, as opposed to a pure price effect leading to an increase in demand, this does not constitute a law of demand violation.


See also

* Revealed preference *
Aggregation problem An ''aggregate'' in economics is a summary measure. It replaces a vector that is composed of many real numbers by a single real number, or a scalar. Consequently there occur various problems that are inherent in the formulations that use aggregat ...
* Representative agent *
Methodological individualism In the social sciences, methodological individualism is the principle that subjective individual motivation explains social phenomena, rather than class or group dynamics which are illusory or artificial and therefore cannot truly explain marke ...
* Demand (economics) *
Price–performance ratio In economics, engineering, business management and marketing the price–performance ratio is often written as cost–performance, cost–benefit or capability/price (C/P), refers to a product's ability to deliver performance, of any sort, for i ...
* Second law of demand (
price elasticity A good's price elasticity of demand (E_d, PED) is a measure of how sensitive the quantity demanded is to its price. When the price rises, quantity demanded falls for almost any good, but it falls more for some than for others. The price elastici ...
over time) * Third Law of Demand Alchian–Allen effect * Supply and demand *
Law of supply The law of supply is a fundamental principle of economic theory which states that, keeping other factors constant, an increase in price results in an increase in quantity supplied. In other words, there is a direct relationship between price and ...


References

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