Law of Demand

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Law of Demand?

The law of demand is the concept of economics. The prices of the goods or services and their quantity demanded are inversely related when the other factors remain constant. In other words, when the price of any product increases, then its demand will fall, and when its price decreases, its demand will increase in the market.

Law of-Demand

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This happens because of the concept of the diminishing marginal utility which states marginal utilityMarginal UtilityA customer's marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. It could be calculated by dividing the additional utility by the amount of additional units.read more of the goods or service declines when there is an increase in its available supply, i.e., the consumer uses first units of good purchased to serve their need which they think is most urgent over the less urgent demands in their behavior.

Key Takeaways

  1. The law of demand states that the price and demand of goods and services are interrelated in a reverse proportional relationship.
  2. When the price increases, the demand for that product declines, and vice versa. It happens due to the law of diminishing utility of a product. 
  3. The law of demand doesn’t hold during wars, the Giffen paradox, ignorance effect, demonstration effect, etc.
  4. During financial and taxation decisions, the law of demand is very important since the tax price directly affects the demand for the product. 

Law of Demand Explained

Law of demand is a principle of economics which states that a rise in price would be met with a decrease in the quantity demanded of the product. This law was first stated by Charles Davenant in 1699.

The economic law of demand works with the law of supply to determine and explain how the resources are being allocated in the market economies and how the prices of the goods and services reused in the day-to-day work are determined.

When other things in the market are being equal then the per unit quantity demanded of the product will be greater when there is a reduction in the prices of that commodity whereas per unit quantity demanded of the product will be less when there is an increase in the prices of that commodity. There are certain exceptions to the law of demand and there are certain assumptions of the law of demand. In the case of exceptional situations, the law of demand will not work.

Similarly, if there is any change in the assumption then also the law of demand will not work. However, the limitations or the exceptions of the law of demand do not falsify general law which must operate.

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Examples

Let us understand law of demand and supply and their interrelated nature with the help of a couple of examples.

Example #1

XYZ ltd. which is selling only one type of goods in the market. Following is the demand schedule of the company showing how much quantity will be demanded of that product at a special price during that day. Explain the relationship between the price and quantity demanded when all the assumptions of the law of demand holds.

Price per Unit ($)$100$250$500$750$1,000
Quantity Demanded5035251710

According to the law of demand in economics, when the price of any product increases, its demand will fall, and when its price decreases, its demand will increase in the market. In the present case, we can see that when the prices per unit of the quantity of the product sold by company XYZ increase from $ 100 to $ 250, then the quantity demandedQuantity DemandedQuantity demanded is the quantity of a particular commodity at a particular price. It changes with change in price and does not rely on market equilibrium.read more product decreases from 50 units to 35 units. When the prices per unit of the quantity of the product sold by company XYZ increase from $ 250 to $ 5000, then the quantity demanded of the product decreases from 35 units to 25 units and so on.

This shows that commodity prices and their demand are inversely related. Thus, with the increase in the price per unit of the quantity, the demand for its quantity is decreasing, so this is an example of the concept of the law of demand.

Example #2

In March 2023, Arizona saw a steep rise in gasoline prices every week. Arizonians began paying over $4 a gallon or approximately $65 for a 16-gallon refueling.

The national average for gasoline at the beginning or March 2023 was around $3.45. Therefore, Arizona with $4 a gallon was only second to California where the per-gallon prices went up to $4.92.

American Automobile Association (AAA) cited a rise in demand and a decrease in supplies due to the Russia-Ukraine war led to the hike in prices. They also made it clear that if the demand keeps rising at this rate, the prices are bound to hike even further.

Important Points

Let us understand the importance of the law of demand assumptions and their effect on the market through the explanation below.

  • When there is a lot of change in the quantity demanded with the change in the price then it is called the elastic demand whereas when there is no much change in the quantity demanded with the change in the prices then it is called the inelastic demand.
  • There are certain exceptions of the law of demand which include war, depression, demonstration effect, Giffen paradox, speculation, ignorance effect, and necessities of life.
  • Along with the exceptions, there are certain assumptions of the law of demand without which the concept of law of demand would not hold true. These assumptions are
    • No change in consumer’s tastes and preferences.
    • No change in the prices of the other products.
    • No change in the size of the population.
    • No expectation for the change in the prices in the future.
    • Consumer income remains constant.
    • No substitute for the product is there.
    • Consumer habits should remain the same and should not change.

Benefits & Limitations

Despite being one of the fundamental principles upon which the micro and macroeconomic factors are analyzed and calculated, there are a handful of benefits and limitations of the law of demand and supply which would be clear through the discussion below.

Benefits

There are several benefits of the law of demand, providing the opportunity for the traders, consumers, and other related parties. Some of the advantages are as follows:

  • It helps the party selling the different goods fix the prices of their sold commodities. It will let them know that if they increase or decrease the demand prices and its corresponding effect on the quantity that its customers will demand.
  • The study of the law of demand in economics is of great importance to the finance minister of every country as the change in the rate of tax will change the prices of the different commodities, thereby affecting their demand in the market.

Limitations

The different limitations and drawbacks of the law of demand in economics include the following:

  • They do not hold true in every situation. In events such as war, depression, demonstration effect, Giffen paradox, speculation, ignorance effect, and necessities of life. For example, if there is an anticipation of war, citizens will start buying their required stocks and store them for use at the time of war, even if the prices of those goods keep on increasing. Thus, this is the exception of the law of demand as even with the increase in prices of the goods, demand for and for those goods will not decrease in a war situation.
  • There are law of demand assumptions. If any assumptions do not hold, then the law of demand will not be applicable in those cases.

Frequently Asked Questions (FAQs)

Who gave the law of demand?

Sir Alfred Marshall gave the law of demand’s graphical illustration. However, the law of demand was first stated by Mr. Charles Devanant.

What factors affect the demand of a product?

Several variables affect whether a good’s demand rises or falls. It comprises the cost of the product, the perceived quality, the amount spent on promotion, the income and confidence of the buyer, as well as shifts in consumer preferences and fashion.

Why is the law of demand important?

Along with the rule of supply, the law of demand enables us to comprehend why prices are established at their levels and to spot opportunities to buy perceived bargains (or to sell overpriced items) in goods, services, or securities. For instance, a business may increase production due to increased pricing brought on by a spike in demand.

This has guide to what is the law of demand. Here we explain its examples, benefits, limitations, and importance in detail. You can learn more about economics from the following articles –

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