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

Law of Demand

The law of demand is a fundamental principle in economics that states that, other things being equal (ceteris paribus), when the price of a good or service falls, the quantity demanded of that good or service rises, and vice versa. In other words, there is an inverse relationship between price and quantity demanded.

This law is based on human psychology and economic behavior. When consumers observe that the price of a product has decreased, they tend to buy more of it. Conversely, if the price increases, they reduce their purchases. 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 law of demand operates due to several key factors:

1. Income Effect

• When the price of a good falls, the real purchasing power of consumers increases.
• With the same income, consumers can now buy more units of the product.
• For example, if the price of rice drops from Rs. 100/kg to Rs. 80/kg, a consumer who previously bought 5 kg can now afford 6 kg with the same income.

2. Substitution Effect

• If the price of a product decreases, consumers tend to substitute it for more expensive alternatives.
• For instance, if the price of tea falls, consumers may switch from coffee to tea, increasing tea demand.
• This effect is stronger when close substitutes are available.

3. Law of Diminishing Marginal Utility

• The marginal utility (additional satisfaction) of consuming a good decreases with each additional unit consumed.
• When prices fall, consumers are willing to buy more because the additional satisfaction from consuming extra units is still positive, even if it is decreasing.
• For example, the first cup of coffee gives high satisfaction, but the fifth cup gives less. If the price drops, consumers may still buy the fifth cup because it still provides some utility.

4. Expectations of Future Price Changes

• If consumers expect the price of a good to rise in the future, they may increase current demand to avoid paying a higher price later.
• For example, if people believe that the price of smartphones will increase next month, they may buy more now at the current lower price.

5. Availability of Complementary Goods

• Some goods are complements (used together), such as cars and petrol.
• If the price of petrol falls, the demand for cars may increase because petrol becomes more affordable, making car ownership more attractive.

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Exceptions to the Law of Demand

While the law of demand generally holds true, there are some exceptions where demand may not increase when price decreases:

1. Giffen Goods – Inferior goods where demand increases when price rises (e.g., cheap staple foods like rice in poor households).
2. Veblen Goods – Luxury goods where higher prices increase demand due to prestige (e.g., Rolex watches, designer clothes).
3. Speculative Demand – When consumers buy goods expecting future price hikes (e.g., land, gold).
4. Habitual Goods – Consumers may stick to a brand regardless of price changes (e.g., loyal customers of a specific cigarette brand).
5. Unique or Rare Goods – Some goods (e.g., rare paintings, antiques) may see increased demand at higher prices due to exclusivity.

However, these exceptions are rare and do not invalidate the general principle of the law of demand.

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Practical Example

Suppose the price of a mobile phone decreases from Rs. 20,000 to Rs. 15,000.

• Income Effect: Consumers can now buy more phones with the same income.
• Substitution Effect: If another brand’s phone is more expensive, consumers switch to this cheaper option.
• Marginal Utility: Even if the 6th or 7th phone provides less satisfaction, the lower price makes it worthwhile.

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Conclusion

The law of demand explains why consumers buy more of a good when its price falls. This behavior is driven by economic rationality, substitution effects, and changes in purchasing power. While exceptions exist, the law remains a cornerstone of microeconomic theory, guiding pricing strategies for businesses and policy decisions for governments. Understanding this principle helps in analyzing market equilibrium, elasticity of demand, and consumer behavior in various economic scenarios.