Demand and the Law of Demand

2. The income effect. When the price of a good falls, the buyer's real income rises: the same money now buys more. Part of that increased purchasing power is spent on the good whose price fell. When the price rises, real income falls and less is bought.

3. The substitution effect. When the price of a good falls, it becomes cheaper relative to its substitutes, so buyers switch to it from those substitutes. When tea becomes dearer, some tea drinkers move to coffee.

4. New buyers enter. A high price excludes people who cannot afford it at all. As the price falls, households that were priced out come into the market, so the market quantity rises for a reason that has nothing to do with any existing buyer changing their mind.

5. Multiple uses. Many goods have several uses, some more important than others. Electricity at a high price is used for lighting only; at a low price it is also used for heating water and running an air conditioner. As price falls, the good is put to its less urgent uses as well.

The assumptions: the part students omit

The law holds other things being equal. Six things are being held constant, and naming them is worth marks because each of them, when it changes, shifts the whole curve.

1. The income of the buyer does not change.
2. The tastes and preferences of the buyer do not change.
3. The prices of related goods, substitutes and complements, do not change.
4. The number of buyers in the market does not change.
5. Expectations about future prices do not change.
6. The good does not change in nature, and there is no change in the distribution of income or in the season.

A statement of the law without its assumptions is not a shorter answer, it is a wrong one, because as soon as any of the six moves, price and quantity can perfectly well rise together and the law is not contradicted at all.

Movement along the curve against a shift of the curve

This is the single most examined distinction in the topic and the most commonly muddled.

A movement ALONG the demand curve is caused by a change in the price of the good itself, with all six assumptions holding. It has two names.

• Extension of demand: price falls, quantity demanded rises, and the point moves down the curve to the right.
• Contraction of demand: price rises, quantity demanded falls, and the point moves up the curve to the left.

A SHIFT of the whole demand curve is caused by a change in any factor other than the price of the good itself. It also has two names.

• Increase in demand: the curve shifts to the right, so that more is bought at every price. Caused by a rise in income for a normal good, a taste in the good's favour, a rise in the price of a substitute, a fall in the price of a complement, more buyers, or an expectation that prices will rise.
• Decrease in demand: the curve shifts to the left, so that less is bought at every price.

A worked example: onions in Nashik and a change in the news

The market. At forty rupees a kilogram, Lasalgaon households buy 3,000 quintals a week.

Case one: the price falls to thirty rupees because the new crop has arrived. Households buy 4,200 quintals. This is an extension of demand and a movement down the curve. Nothing has shifted; the same schedule is being read at a different price.

Case two: at the same forty rupees, an announcement is made that exports will be permitted from next month and prices are expected to rise. Households now buy 3,900 quintals at forty rupees, stocking up. This is an increase in demand and a rightward shift of the whole curve, caused by expectations, one of the six things held constant in the law.

Why the distinction matters in practice. If a court or a regulator is asked whether a price rise "caused" a fall in consumption, the answer depends on which of the two happened. If demand shifted at the same time, the observed fall in quantity may understate or overstate the effect of price entirely. This is exactly why the law is stated with its assumptions.

The exceptions to the law of demand

There are situations in which a higher price is accompanied by a larger quantity bought. An examiner asks for them by name.

1. Giffen goods. Named after Sir Robert Giffen, who is said to have observed that when the price of bread rose, the poorest English families bought more of it. The explanation is that bread was so large a share of their budget that a rise in its price made them much poorer in real terms, and they responded by giving up meat, which was dearer per calorie, and eating still more bread. A Giffen good is a strongly inferior good that occupies a large share of a poor household's spending. It is the one genuine exception in theory, because the income effect works against the substitution effect and wins.

2. Veblen goods, or goods of ostentation. Named after Thorstein Veblen, who described conspicuous consumption. Diamonds, luxury watches and some designer goods are bought partly because they are expensive; a fall in price destroys the very quality that was wanted. Here the demand curve can slope upward over a range.

3. Expectation of a further price change. If buyers believe today's rise is the beginning of a much larger rise, they buy more today. This is not really an exception, because the assumption about expectations has been broken.

4. Ignorance of quality, or the price as a signal of quality. Where buyers cannot judge quality, they use price as a proxy and may buy more of the dearer article, believing it better. Common with medicines and with unfamiliar branded goods.

5. Necessities and habitual goods, in a limited sense. Salt, life saving medicine and, for an addicted consumer, tobacco or alcohol, are bought in nearly the same quantity whatever the price. Strictly this is very inelastic demand rather than an upward sloping curve, and a careful answer says so: the curve is steep, not reversed. The distinction is developed in [Elasticity of Demand].

6. Emergencies and speculation. In war, famine or a bank run, buying behaviour is not governed by the ordinary relationship.

A good answer distinguishes the two real exceptions, Giffen and Veblen, where the curve genuinely slopes upward, from the apparent ones, where an assumption has been broken or the curve is merely steep.

What beginners get wrong

"Demand means what people want." No. Without ability and willingness to pay there is no demand.

"The law says price and quantity always move in opposite directions in the real world." No. It says they do so if nothing else changes, and in the real world other things change constantly. Onion prices and onion sales can both rise in a year in which incomes rose faster.

"A rise in demand means a rise in the quantity demanded." These are different. A rise in demand is a shift of the curve; a rise in the quantity demanded is a movement along it caused by a lower price.

"Giffen goods are luxuries." The opposite. A Giffen good is an inferior staple bulking large in a poor household's budget. Veblen goods are the luxuries.

Limits and criticism

It is a qualitative law. It says the direction, not the size. How much quantity changes is the subject of the next chapter and is far more useful for policy.

The assumptions are heroic. Income, tastes and related prices do not stay still while a price moves.

It says nothing about time. The response to a price change is usually much smaller in a week than in a year, because habits and equipment take time to change. A rise in the petrol price changes driving a little at once and vehicle purchases a great deal later.

Aggregation hides diversity. A market demand curve adds a rich household's response to a poor household's, and a policy that relies on the average can miss both.

Quick revision

1. Demand is a want backed by ability and willingness to pay, at a stated price and for a stated period. Desire alone is not demand.
2. Law of demand: other things being equal, quantity demanded varies inversely with price. Fall in price extends demand; rise in price contracts it.
3. Five reasons for the downward slope: diminishing marginal utility, income effect, substitution effect, new buyers entering, and multiple uses of the good.
4. Six assumptions: unchanged income, tastes, prices of related goods, number of buyers, expectations, and nature of the good.
5. Movement along the curve, from the good's own price, is extension or contraction. Shift of the curve, from any other cause, is increase or decrease.
6. Real exceptions: Giffen goods (inferior staple, large budget share, income effect beats substitution effect) and Veblen goods (bought for their price). Apparent exceptions: expectations, price as a quality signal, necessities with very inelastic demand, and emergencies.
7. Market demand is individual demands added horizontally, quantity by quantity at each price.

Test yourself

1. State the law of demand and its assumptions. Other things being equal, the quantity demanded of a commodity varies inversely with its price: a fall in price extends demand and a rise contracts it. The assumptions held constant are the buyer's income, tastes and preferences, the prices of substitutes and complements, the number of buyers, expectations about future prices, and the nature of the good. Stated without those assumptions the law is not a shorter proposition but a false one.

2. Why does the demand curve slope downward? Give five reasons. Because of the law of diminishing marginal utility, so that each further unit is worth less and will only be bought at a lower price; the income effect, since a fall in price raises real income; the substitution effect, since the good becomes cheaper relative to substitutes; the entry of new buyers who were priced out at the higher price; and the extension of the good to less urgent uses as it becomes cheaper.

3. Distinguish an extension of demand from an increase in demand. An extension of demand is a movement down the same demand curve caused by a fall in the price of the good itself, with everything else unchanged. An increase in demand is a rightward shift of the whole curve caused by something other than the good's own price, such as a rise in income, so that a larger quantity is bought at every price including the original one. Confusing the two is the commonest error in this topic.

4. What is a Giffen good? Why is it a genuine exception? A Giffen good is a strongly inferior good that takes up a large part of a poor household's budget, such as a coarse staple grain. When its price rises, the household becomes so much poorer in real terms that it gives up the dearer foods it was also buying and consumes still more of the staple. The negative income effect outweighs the substitution effect, so quantity demanded rises with price and the curve slopes upward over that range. It is genuine because no assumption of the law has been broken.

5. Distinguish a Giffen good from a Veblen good. A Giffen good is an inferior necessity bought by poor households, and the upward slope arises from a powerful negative income effect. A Veblen good is a luxury bought partly because it is expensive, so the demand depends on the price being high and a fall in price reduces its attraction. The first is about poverty; the second is about display.

6. "Salt is an exception to the law of demand." Do you agree? Not strictly. The quantity of salt bought changes very little when its price changes, because it is a necessity that takes a tiny share of the budget and has no substitute. That makes its demand highly inelastic, so the curve is very steep, but it still slopes downward. An exception in the true sense requires an upward sloping curve, which salt does not have. The correct answer distinguishes a steep curve from a reversed one.

7. A market has two buyers. At 20 rupees A buys 5 units and B buys 3; at 15 rupees A buys 8 and B buys 6. Construct the market demand schedule and say what it illustrates. At 20 rupees the market demand is 8 units; at 15 rupees it is 14 units. The schedule is obtained by adding the quantities demanded at each price, which is horizontal summation, and never by adding the prices. It illustrates the law of demand, since the lower price is associated with the larger market quantity.