What is the law of price demand?

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The inverse relationship between the quantity of the good demanded and its price

The law of demand states that the quantity demanded of a good shows an inverse relationship with the price of a good when other factors are held constant (cetris peribus). It means that as the price increases, demand decreases.

The law of demand is a fundamental principle in macroeconomics. It is used together with the law of supply to determine the efficient allocation of resources in an economy and find the optimal price and quantity of goods.

Figure 1. Demand Curve Approximation

Graphical Representation of the Law of Demand

The law of demand is usually represented as a graph. The graphical representation of the law of demand is a curve that establishes the relationship between the quantity demanded and the price of a good.

The shape of the demand curve can vary among different types of goods. Most frequently, the demand curve shows a concave shape. However, in many economics textbooks, we can also see the demand curve as a straight line.

The demand curve is drawn against the quantity demanded on the x-axis and the price on the y-axis. The definition of the law of demand indicates that the demand curve is downward sloping.

It is important to distinguish the difference between the demand and the quantity demanded. The quantity demanded is the number of goods that the consumers are willing to buy at a given price point. On the other hand, the demand represents all the available relationships between the good’s prices and the quantity demanded.

Exceptions to the Law of Demand

Unlike the laws of mathematics or physics, the laws of economics are not universal. For example, the law of demand comes with a few exceptions. Some goods do not show an inverse relationship between the price and the quantity. Therefore, the demand curve for these goods is upward-sloping.

1. Giffen goods

These are inferior goods that lack close substitutes that represent a large portion of the consumer’s income. Scottish economist Sir Robert Giffen proposed the existence of such goods in the 19th century. Giffen goods violate the law of demand because the prices of these goods increase with the increase in the quantity demanded. However, Giffen goods remain mostly a theoretical concept as there is limited empirical evidence of their existence in the real world.

2. Veblen goods

Certain types of luxury goods violate the law of demand. Veblen goods are named after American economist Thorstein Veblen. Generally, they are luxury goods that indicate the economic and social status of the owner. Therefore, consumers are willing to consume Veblen goods even more when the price increases. Some examples of Veblen goods include luxury cars, expensive wines, and designer clothes.

The Law of Demand in the Real World

The law of demand comes with important applications in the real world. It is an economic principle that guides the actions of politicians and policymakers. The law of demand is quintessential for the fiscal and monetary policies that are undertaken by governments around the world. The policies generally intend to increase or decrease demand to influence the country’s economy.

Additional Resources

Thank you for reading CFI’s guide to the Law of Demand. To keep learning and advancing your career, the following CFI resources will be helpful:

What is the law of supply? 

The law of supply says that suppliers will produce more of a good if it sells at higher prices. This makes sense, as higher prices mean increased revenue. Suppliers are willing to deliver more products and services when paid more for doing so. 

The law of supply can be graphed via the supply curve, which shows the correlation between the price of a good or service and the quantity supplied for a given period.

What is the law of demand?

The law of demand says that there will be demand for a higher quantity of a particular product as its price reduces. This is because consumers can afford to buy more if prices are lower. 

Conversely, the higher the price, the lower the demand. This is because the opportunity cost of purchasing a particular good increases with the price. The law of demand can be graphed via the demand curve, which shows the correlation between the price of a good or service and the quantity demanded in a given period.

How does the law of supply and demand work?

The law of supply and demand says that the price and quantity of a particular good will be determined by the point at which the supply curve and demand curve intersect. At this point, consumers are willing to buy the same quantity of goods as sellers are willing to produce. This is the equilibrium quantity. 

At this point, the market-clearing price is known as the ‘equilibrium price’. Suppliers can sell all the units they wish to supply at the equilibrium price, and buyers can buy all the units they want.

What factors impact demand?

Numerous factors can impact the level of demand for different goods and services. This shifts the demand curve, changing market equilibrium. Total demand depends on the quantity of a product consumers are willing and able to purchase at a particular price. 

Consumer preference impacts demand – if we do not want or need something, we are unlikely to buy it. Consumer preference can be influenced by advertising and publicity, brand awareness, and perceived value.

Our ability to buy products is a function of our income and expenses. Therefore, as personal incomes increase, we see demand increase. Excess demand will result in an upward shift in prices. 

The price of related and complementary goods can also impact demand. If you are a buyer shopping for a new car, you may compare similar models from different manufacturers. The price of one model will affect how much you are willing to pay for another. 

When goods are complementary, a change in the price or demand for one affects the other. For example, a decrease in the price of video game consoles may increase consumer demand for video games. This, in turn, can cause a price increase. 

Factors impacting supply 

The supply level is impacted by factors that encourage or discourage production. The availability of workers, weather, technology, and government subsidies can all cause a shift in the supply curve. 

Where the price of inputs or the cost of production falls, producers can supply more goods at a lower price. Similarly, improvements in productivity and investments in capacity can increase supply. 

Supply can be constrained by factors such as bad weather, which can cause agricultural yields to fall, and higher taxes, which increase the cost of goods. A supply shock is an unexpected event that suddenly changes the supply of a product. Issues in the supply chain can impact producers, causing the market price of a good to rise. 

Why is the law of supply and demand important?  

By understanding the law of supply and demand, we can better understand the factors impacting the price and availability of resources. This can help us predict future demand and future supply. We can determine the quantity of goods producers will need to supply at a given price. 

The law of supply and demand also applies to the share market. The price of an ASX share is the equilibrium price of the supply curve and demand curve at the time the share is sold. 

Share prices fluctuate as a result of changes in supply and demand. When a company reports good news, the share price can shift upwards. Sellers may demand a higher price for their shares, and buyers may be more willing to pay that price. Conversely, if there is a deterioration in a company’s outlook, a downward price change can occur. Buyers may offer less for shares, and the equilibrium point shifts down.