Explain the law of demand. When price decreases demand increases, why?

Law of Demand: Explanation and Reasoning for Inverse Relationship Between Price and Demand

Definition of the Law of Demand

The law of demand is a fundamental economic principle that states:

"Other things being equal, when the price of a good or service falls, the quantity demanded of that good or service rises, and vice versa."

In simpler terms, there is an inverse relationship between price and quantity demanded, assuming all other factors (like income, tastes, and expectations) remain constant. This relationship is graphically represented by a downward-sloping demand curve, as shown in the figure above.

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Why Does Demand Increase When Price Decreases?

The inverse relationship between price and quantity demanded can be explained through the following five key reasons:

1. Income Effect (Purchasing Power Paradox)

• When the price of a good falls, consumers can buy more of it with the same income.
• Example: If the price of rice drops from ₹50/kg to ₹40/kg, a consumer who previously bought 1 kg can now buy 1.25 kg with the same ₹50.
• Result: Consumers feel richer and demand more of the good.

2. Substitution Effect

• When a good becomes cheaper relative to substitutes, consumers switch from the more expensive alternative to the now cheaper good.
• Example: If the price of bus rides falls, people will take buses instead of taxis, increasing the demand for bus rides.
• Result: Consumers substitute expensive goods with cheaper ones, increasing demand for the latter.

3. Law of Diminishing Marginal Utility

• The marginal utility (additional satisfaction) of consuming a good decreases with each additional unit consumed.
• Example: The first glass of cold drink gives high satisfaction, but the second glass gives less, and the third gives even less.
• Implication: If prices fall, consumers are willing to buy more units because the additional satisfaction from extra units is still positive, even if decreasing.

4. Speculative Demand (Future Expectations)

• If consumers expect prices to rise further in the future, they may buy more now to avoid paying higher prices later.
• Example: If the price of gold is falling today but expected to rise next month, people may increase purchases now to take advantage of the lower price.
• Result: Current demand increases due to fear of future scarcity or higher prices.

5. Normal Goods and Income Constraint

• For normal goods (goods whose demand increases with income), a price decrease makes them more affordable, allowing consumers to buy more.
• Example: If the price of smartphones falls, more people (including those with lower incomes) can afford them, increasing overall demand.
• Exception: For inferior goods (e.g., cheap noodles), demand may fall when price falls (due to income effect), but this is rare and not the general case.

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Exceptions to the Law of Demand (When Demand Does Not Increase with Price Decrease)

While the law of demand generally holds, there are five exceptions where demand may not increase when price falls:

Note: These exceptions are rare and do not invalidate the general law of demand.

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Mathematical Representation of the Law of Demand

The law of demand can be expressed using the demand function: $$Q_d=f(P)$$ Where:

• $Q_d$ = Quantity demanded
• $P$ = Price of the good
• $f(P)$ = A function showing that as $P$ decreases, $Q_d$ increases.

Example: If the demand function is $Q_d=100-2P$, then:

• When $P=20$, $Q_d=100-2(20)=60$ units.
• When $P=10$, $Q_d=100-2(10)=80$ units. Observation: As price falls from ₹20 to ₹10, quantity demanded rises from 60 to 80 units, confirming the law.

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Real-World Example: Smartphone Market

Consider the iPhone market:

• In 2015, the price of an iPhone 6 was ₹50,000.
• In 2020, the price of an iPhone 11 dropped to ₹60,000 (adjusted for inflation, it was cheaper).
• Result: Sales increased because:
  1. More people could afford it (income effect).
  2. Older models became cheaper, encouraging upgrades (substitution effect).
  3. New features made it more attractive (utility effect).

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Conclusion

The law of demand is a fundamental economic principle that explains why lower prices lead to higher demand (and vice versa). This relationship is driven by:

1. Income effect (more purchasing power).
2. Substitution effect (switching to cheaper alternatives).
3. Diminishing marginal utility (willingness to buy more at lower prices).
4. Speculative behavior (fear of future price hikes).
5. Normal goods affordability (more people can buy them).

While exceptions exist (like Giffen and Veblen goods), the law holds true for most goods and services in the real world. Understanding this principle is crucial for consumers, businesses, and policymakers in making informed economic decisions.