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IB DP Economics Study Notes

2.1.1 Law of Demand

The Law of Demand is an essential cornerstone in microeconomics, elucidating the relationship between the price of a commodity and the quantity that consumers are willing to purchase.

Definition

The Law of Demand postulates that, ceteris paribus (all other factors being constant), as the price of a product or service augments, the quantity demanded by consumers diminishes. Conversely, as the price drops, the quantity demanded surges.

Law of demand graph

A law of demand graph illustrating the inverse relationship between the price and quantity demanded.

Image courtesy of study.com

This inverse relationship between price and quantity demanded arises from two primary effects:

  • Substitution Effect: When the price of a commodity escalates, similar goods become relatively more affordable. This price disparity prompts consumers to swap the pricier item with a more economical alternative. For instance, if the price of beef rises, consumers might opt for chicken, assuming it's cheaper.
  • Income Effect: An elevation in the price of a commodity effectively curtails the purchasing power of a consumer's income. This reduction compels them to curtail their consumption of that particular good. For example, if the price of cinema tickets increases, individuals might decide to watch fewer films in theatres, choosing home entertainment instead.
A image comparing substitution effect and income effect of a price change

Image courtesy of economicshelp

Determinants of Demand

While price is a pivotal factor moulding demand, several other determinants can instigate shifts in the demand curve. These determinants encompass:

1. Income: The correlation between consumers' income and demand is quite pronounced. As income swells, consumers typically procure more of most commodities, provided the good is categorised as a normal good. However, for inferior goods, a surge in income might precipitate a decline in demand. For instance, as individuals' income grows, they might prefer dining at upscale restaurants over fast-food outlets.

2. Tastes and Preferences: Fluctuations in consumer predilections can usher in an augmentation or reduction in demand. A surge in health consciousness, for example, might bolster the demand for organic foods while diminishing the demand for processed snacks.

3. Price of Related Goods: The demand for a particular good can be swayed by the price trajectory of related goods, which can be categorised as either substitutes or complements.

  • Substitutes: A hike in the price of coffee might amplify the demand for tea, a substitute.
  • Complements: Conversely, if the price of printers rises, the demand for printer ink might wane, given that they are complementary products.

4. Expectations: Anticipations about future prices can significantly influence current demand. If consumers foresee a future price escalation for a product, they might be inclined to make a purchase now, thereby amplifying current demand.

5. Number of Buyers: An influx of consumers into the market, perhaps propelled by demographic shifts or other socio-economic factors, can amplify the market demand for a commodity or service.

6. External Factors: Unforeseen events such as natural calamities, pandemics, or geopolitical upheavals can significantly recalibrate consumer confidence and purchasing patterns, thereby recalibrating demand. For instance, a global health crisis might suppress the demand for travel and tourism services.

Movement vs. Shift

Distinguishing between a movement along the demand curve and a shift in the demand curve is paramount:

1. Movement Along the Demand Curve: This transpires exclusively due to alterations in the price of the commodity in question. For instance, a reduction in the price of a bestselling novel will lead to an upward movement along the demand curve, culminating in a heightened quantity demanded.

Graph of movement along the demand curve

A graph illustrating the movement along the same demand curve from one point to the other.

Image courtesy of geeksforgeeks

2. Shift in the Demand Curve: This phenomenon is triggered by modifications in any of the determinants of demand other than the product's own price. A sudden cultural trend promoting veganism, for instance, might escalate the demand for plant-based products, leading to a rightward shift in the demand curve. On the flip side, a widespread negative publicity campaign against sugary drinks might induce a leftward shift in the demand curve for such beverages.

Graph of shift in the demand curve

A graph illustrating the shifts in the demand curve.

Image courtesy of geeksforgeeks

To encapsulate, the Law of Demand is a bedrock principle in economics that delineates the inverse correlation between price and quantity demanded. While price remains a cardinal factor sculpting this relationship, a plethora of other determinants can induce the entire demand curve to shift. Grasping the distinction between a mere movement along the curve and an actual shift in the curve is indispensable for a nuanced comprehension of market dynamics.

FAQ

Yes, the Law of Demand can be applied to labour markets, where workers supply labour and firms demand it. In this context, the "price" of labour is the wage rate. Generally, as wages increase (all else being equal), the quantity of labour demanded by firms decreases, and vice versa. Higher wages might make it more expensive for firms to hire or retain employees, leading them to reduce the number of hours offered or hire fewer workers. Conversely, if wages decrease, labour becomes cheaper for firms, potentially increasing the quantity of labour demanded.

Consumer expectations play a pivotal role in shaping current demand. If consumers anticipate that the price of a particular good will escalate in the near future, they might be inclined to purchase more of it now to avoid paying a higher price later. This phenomenon can lead to a surge in current demand. Conversely, if consumers expect prices to drop in the future, they might defer their purchases, leading to a decrease in current demand. For instance, if there's a rumour about an upcoming sale on electronics, consumers might hold off on buying until the sale begins.

Changes in the number of buyers can significantly impact market demand. If more consumers enter the market, perhaps due to demographic shifts like population growth, urbanisation, or increased market awareness, the aggregate demand for a product or service will likely increase. Conversely, if the number of buyers diminishes, perhaps due to migration, changing consumer preferences, or a decline in a particular age group, the overall demand for certain products might wane. For instance, a city experiencing a surge in its young population might see increased demand for educational services or tech gadgets.

The Law of Demand is visually represented by the downward-sloping demand curve on a graph. The curve illustrates the inverse relationship between price (on the vertical axis) and quantity demanded (on the horizontal axis). As you move down the curve from left to right, the price decreases and the quantity demanded increases, and vice versa. Each point on the demand curve reflects a specific price-quantity combination. The downward slope reaffirms the principle that, all else being equal, as the price of a good or service rises, the quantity demanded falls, and as the price falls, the quantity demanded rises.

The Law of Demand is a general principle that describes the typical behaviour of consumers in response to price changes. However, there are exceptions known as "Giffen goods" and "Veblen goods." A Giffen good is an inferior product that sees an increase in quantity demanded as its price rises, contrary to the Law of Demand. This anomaly occurs because the income effect, which dictates that people will buy less of a good as it becomes more expensive and reduces their real income, outweighs the substitution effect. Veblen goods, on the other hand, are luxury items where higher prices can increase demand because the high price itself becomes a status symbol, like luxury cars or designer brands.

Practice Questions

Explain the difference between the substitution effect and the income effect in the context of the Law of Demand.

The substitution effect and the income effect are two primary reasons behind the inverse relationship between price and quantity demanded, as described by the Law of Demand. The substitution effect refers to the change in consumption patterns when the price of a good rises, making other similar goods relatively cheaper. Consumers, therefore, substitute the more expensive good with a cheaper alternative. On the other hand, the income effect occurs when a rise in the price of a good effectively reduces the real income or purchasing power of consumers, leading them to buy less of that good. In essence, while the substitution effect focuses on the relative price attractiveness of other goods, the income effect centres on the diminished purchasing power due to price changes.

Distinguish between a movement along the demand curve and a shift in the demand curve. Provide an example for each.

A movement along the demand curve and a shift in the demand curve are two distinct phenomena in the context of demand. A movement along the demand curve is solely caused by a change in the price of the good itself. For instance, if the price of apples decreases, there will be an upward movement along the demand curve, leading to an increase in the quantity demanded. In contrast, a shift in the demand curve is instigated by changes in any of the determinants of demand other than the good's own price. For example, if there's a widespread health trend promoting the consumption of fruits, the demand for apples might increase, leading to a rightward shift in the demand curve.

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Written by: Dave
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Cambridge University - BA Hons Economics

Dave is a Cambridge Economics graduate with over 8 years of tutoring expertise in Economics & Business Studies. He crafts resources for A-Level, IB, & GCSE and excels at enhancing students' understanding & confidence in these subjects.

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