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Law of Demand: Definition, History, How it Works, Calculation          

Law of Demand: Definition, History, How it Works, Calculations, and Demand Elasticity

Law of Demand: Definition, History, How it Works, Calculations, and Demand Elasticity

The law of demand states that the quantity of a good or service that a consumer will purchase is inversely related to its price. Law of demand is in other words is when price increases, the quantity demanded decreases, and vice versa. This occurs because of diminishing marginal utility, which states that consumers use the first units of an economic good they purchase to satisfy their most urgent needs first, then use each additional unit to serve successively lower-valued ends. The law of demand helps in determining the demand elasticity which is a measure to find the influence of price change in the quantity demanded by the consumers. 

The concept of the law of demand can be traced back to the 18th century when economists such as Adam Smith and David Ricardo first began to study and write about the principles of supply and demand. The law of demand was formalized and popularized in the 19th century by economist Alfred Marshall, who is considered to be one of the founders of modern economics.

What is the law of demand?

The law of demand is an economic principle that states that consumer demand for a good rise when prices fall and declines when prices rise. The law of demand dictates that when the price for a good or service increases, the quantity demanded of that good or service decreases; and conversely, when the price of a good or service decreases, the quantity demanded of that good or service increases.

This principle is based on the concept of diminishing marginal utility, which states that consumers use the first units of an economic good they purchase to satisfy their most urgent needs first, then use each additional unit to serve successively lower-valued ends.

The law of demand is an important concept in economic theory, as it helps explain how prices and quantities are determined in a market economy. It is one of the most fundamental laws of economics and is studied in depth in microeconomics. The law of demand explains why people are willing to pay more for goods and services when the demand for them increases and less when the demand for them decreases. It also explains why companies will adjust their prices accordingly to attract more customers.

The law of demand has a wide range of applications. It is used to analyze the effects of changes in the economy on the demand for certain goods and services. It is also used to evaluate the effects of government policies on the economy, such as taxes and subsidies. It can also be used to examine the effects of changes in consumer preferences on the demand for certain goods and services. 

The law of demand is also used to predict the pricing and quantity of goods and services in a market. Economists can accurately predict how changes in the price of a good or service affect its demand and quantity by understanding the law of demand. This knowledge can be used to develop market strategies that maximize profits and optimize prices. 

Finally, the law of demand is also used to determine the demand elasticity of a good or service. Demand elasticity is the measure of how much the quantity demanded of a good or service changes in response to a change in its price.

A good with a high demand elasticity is said to be elastic, meaning that its quantity demanded changes significantly in response to a change in its price. A good with a low demand elasticity is said to be inelastic, meaning that its quantity demanded does not change significantly in response to a change in its price.

What is the History of the Law of Demand?

The earliest evidence of law of demand or at least the concept was seen when Gregory King made a demonstration in the 17th century. The law of demand, as such, was first put forth by Charles Devenant through the years 1656 and 1714. This was first quoted in his essay on the “Probable Methods of Making People Gainers in the Balance of Trade (1699)”. 

Sir James Steuart’s Inquiry into the Principles of Political Economy, published in 1796, is the first known printed use of the term “supply and demand.” Steuart noted that when supply levels were higher than demand, prices significantly decreased, lowering the profits realized by merchants. Merchants could not afford to pay workers, when they made less money, resulting in high unemployment.

Adam Smith dealt extensively with the topic in his 1776 epic economic work, The Wealth of Nations. Smith explained the concept of supply and demand as an “invisible hand” that naturally guides the economy. The invisible hand is the automatic pricing and distribution mechanisms in the economy according to Smith. Smith described a society in which bakers and butchers provide products that individuals need and want, providing a supply that meets demand and developing an economy that benefits everyone.

Alfred Marshall’s Principles of Economics developed a supply-and-demand curve that is still used to demonstrate the point at which the market is in equilibrium in 1890. Marshall’s most important contribution to microeconomics was his introduction of the concept of price elasticity of demand, which examines how price changes affect demand.

Other scholars across the world also contributed to its development, though these theorists are the figures frequently mentioned when discussing the origin of the law of supply and demand. For example, Islamic scholar Ibn Taymiyyah.

What does the law of demand say about the relationship between price and quantity?

The law of demand says that there is an inverse relationship between the price of a product or service and its demand. This means that when the price of something increases, its demand decreases. This happens because an increase in price means a decrease in the purchasing power of the people. This happens the other way around too. A decrease in price would mean an increase in the demand. Because people are encouraged to buy the product or service. 

How does the Law of Demand work?

The law of demand states that the higher the price of a good or service, the lower the quantity that consumers will demand, and vice versa. This relationship is often referred to as the inverse relationship between price and quantity demanded. The law of demand is a guiding economic principle and helps to explain how market economies allocate resources and determine the prices of goods and services that we observe in everyday transactions.

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The law of demand is based on the concept of diminishing marginal utility, which states that consumers use the first units of an economic good they purchase to satisfy their most urgent needs first, then use each additional unit to serve successively lower-valued ends. The more of a good that consumers buy, the less they are willing to pay in terms of the price. This inverse relationship between price and quantity demanded is represented by a downward-sloping demand curve on a graph. 

The law of demand is closely related to the law of supply. The law of supply states that the quantity of a good or service that suppliers are willing and able to supply is directly related to its price. Suppliers are able to increase their profits by supplying more of that good or service when the price of a good or service increases. This relationship is often referred to as the direct relationship between price and quantity supplied.

The law of demand and the law of supply are the two most fundamental principles of economics and are studied in depth in microeconomics. These two laws together explain how prices and quantities of goods and services are determined in a market economy. Economists can accurately predict how changes in the price of a good or service will affect its demand and supply by understanding the law of demand and the law of supply, and thus it’s price. This knowledge can be used to develop market strategies that maximize profits and optimize prices.

The law of demand is important because it helps to explain how prices and quantities are determined in a market economy. It is also used to predict the pricing and quantity of goods and services in a market and to determine the demand elasticity of a good or service. The law of demand is closely related to the law of supply, and together they form the cornerstone of economics.

Does the Law of Supply affect the stocks in the Stock Market?

Yes, the law of supply does affect stock prices in the stock market. The law of supply states that as the price of a good or service increases, the quantity supplied of that good or service will also increase, ceteris paribus (all other things being equal). This means that when the price of a stock increases, the quantity of stock supplied by the company will also increase, which leads to a decrease in stock prices.

It is important to note that the relationship between stock prices and the law of supply is not always straightforward. The law of supply assumes that all other factors, such as production costs, government regulations, and market conditions, remain constant. These factors, in reality,  change and affect the relationship between stock prices and the law of supply.

Additionally, looking at the law of demand is also important when analyzing stock prices in the stock market. The law of demand states that as the price of a good or service increases, the quantity demanded of that good or service will decrease. This means that when the price of a stock increases, the quantity of stock demanded by investors will decrease, which can lead to a decrease in stock prices.

How do the Law of Demand relate to the Law of Supply?

The law of demand and the law of supply are closely related economic principles that work together to determine the price and quantity of goods and services in a market. The law of demand states that as the price of a good or service increases, the quantity demanded of that good or service will decrease, ceteris paribus (all other things being equal). The law of supply states that as the price of a good or service increases, the quantity supplied of that good or service will also increase, ceteris paribus.

Both laws coexist and complement each other in determining the market price and quantity of a good or service. The law of demand describes how consumers behave in response to changes in price, while the law of supply describes how producers behave in response to changes in price. The law of demand and supply interact to establish the market price and quantity of a good or service.

The point at which the quantity demanded equals the quantity supplied is called the “equilibrium price and quantity”. The market at this point is said to be in equilibrium and there is no excess supply or excess demand. The equilibrium price and quantity are determined by the intersection of the supply and demand curves. Any changes in the market, such as changes in consumer preferences, production costs, or government policies, will shift the supply and demand curves and cause the equilibrium price and quantity to change.

In summary, the law of demand and the law of supply are closely related economic principles that work together to determine the price and quantity of goods and services in a market. The interaction between the law of demand and the law of supply leads to the establishment of the equilibrium price and quantity, which is the point at which the market is in balance and there is no excess supply or excess demand.

How to calculate the Law of Demand?

The law of demand can be mathematically represented by the demand curve, which is a graphical representation of the relationship between the price of a good or service and the quantity demanded. The demand curve is typically downward sloping, which reflects the inverse relationship between price and quantity demanded as stated by the law of demand.

The formula for calculating the demand curve is:

Qd = a – bP

Where:

Qd = Quantity demanded

P = Price

a = the point where the demand curve intersects the y-axis (the quantity demanded when the price is zero)

b = the slope of the demand curve (the change in quantity demanded for a given change in price)

The above is the basic formula for calculating the law of demand, however, this formula can be expanded to include other factors that can affect demand such as income, population, and price of substitutes.

For example, consider a coconut farmer in India. The farmer’s demand curve for coconuts can be represented by the following equation:

Qd = a – bP + cY – dPs

Where:

Qd = Quantity demanded of coconuts

P = Price of coconuts

Y = Income of consumers

Ps = Price of substitutes (such as palm oil)

a, b, c, d = parameters that reflect the impact of each variable on demand

Suppose, the farmer wants to find out how many coconuts he can sell at a price of Rs.20 and with an average income of Rs.10000 and Rs.30 being the price of substitute palm oil.

Qd = a – (20b) + (10000c) – (30*d)

The farmer can estimate the quantity of coconuts he can sell at a given price, income and price of substitute by using this formula. He can make informed decisions about how much to produce and at what price to sell his coconuts to maximize his profits with this information.

How to understand the Law of Demand curve?

A demand curve is a graphical representation of the relationship between the price of a commodity or service and the quantity of that good or service that consumers are willing to pay for it. There is an inverse relationship between price and quantity demanded according to the law of demand. This is reflected by the fact that the curve often slopes in a downward direction.

The demand curve is a tool that is used to gain an understanding of how customers will react to changes in the cost of a product or service. The demand curve is a graph that illustrates the quantity of a product or service that customers are willing and able to purchase at a variety of pricing points for that product or service.

Understanding how changes in other parameters, such as changes in consumer income or changes in the price of substitutes, might alter the quantity of a good or service that is wanted can also be accomplished with the help of the demand curve. In addition, the demand curve can be used to make predictions about how changes in market conditions, such as shifts in the preferences of consumers or shifts in the policies of governments, might have an effect on the price and quantity of a product or service that is sold on the market.

What are the different Demand Elasticities?

Demand elasticity is an economic measure of the sensitivity of the quantity demanded of a good or service to a change in its price. It is the ratio of the proportionate change in quantity demanded to the proportionate change in price. Demand elasticity is important because it helps to determine the impact of a change in price on the quantity demanded of a good or service. There are several types of demand elasticities, including price elasticity of demand, income elasticity of demand, cross-price elasticity of demand, and elasticity of demand over time. 

  1. Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of the quantity demanded of a good or service to a change in its price. A price elasticity of demand greater than 1 indicates that the quantity demanded is very responsive to changes in price, while an elasticity of demand less than 1 indicates that the quantity demanded is not very responsive to changes in price.

The formula for calculating price elasticity of demand is:

%ΔQd / %ΔP = Elasticity of demand

Where:

%ΔQd = Percentage change in the quantity demanded

%ΔP = Percentage change in the price

To calculate the price elasticity of demand, you first need to determine the percentage change in the quantity demanded and the percentage change in the price.

To calculate the percentage change in the quantity demanded:

(New quantity demanded – Original quantity demanded) / Original quantity demanded) x 100

To calculate the percentage change in the price:

(New price – Original price) / Original price) x 100

Then divide the percentage change in the quantity demanded by the percentage change in the price to get the elasticity of demand.

For example, consider a coconut farmer in India. The farmer wants to determine the price elasticity of demand for coconuts. He currently sells 1000 coconuts per month at a price of Rs.20 each. He plans to increase the price by 10% to Rs.22. After the price increase, he sells 800 coconuts per month.

To calculate the price elasticity of demand:

%ΔQd = (-200 / 1000) x 100 = -20% (decrease in quantity demanded)

%ΔP = (22 – 20) / 20 x 100 = 10% (increase in price)

Elasticity of demand = %ΔQd / %ΔP = -20 / 10 = -2

The elasticity of demand is -2, which means that the demand for coconuts is elastic. A 10% increase in price leads to a 20% decrease in the quantity demanded. This means that the farmer can expect a significant decrease in sales if he raises the price of coconuts.

  1. Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of the quantity demanded to a change in income. A positive income elasticity of demand indicates that the quantity demanded increases as income increases, while a negative income elasticity of demand indicates that the quantity demanded decreases as income increases. 

The formula for calculating income elasticity of demand is:

%ΔQd / %ΔY = Income Elasticity of Demand

Where:

%ΔQd = Percentage change in the quantity demanded

%ΔY = Percentage change in income

To calculate income elasticity of demand, you first need to determine the percentage change in the quantity demanded and the percentage change in income.

To calculate the percentage change in the quantity demanded:

(New quantity demanded – Original quantity demanded) / Original quantity demanded x 100

To calculate the percentage change in income:

(New income – Original income) / Original income x 100

  1. Cross Elasticity of Demand

The cross-price elasticity of demand measures the responsiveness of the quantity demanded of one good to a change in the price of another. A positive cross-price elasticity of demand indicates that the two goods are substitutes, while a negative cross-price elasticity of demand indicates that the two goods are complements.

The formula for calculating the cross elasticity of demand is:

%ΔQd / %ΔPx = Cross Elasticity of Demand

Where:

%ΔQd = Percentage change in the quantity demanded of the first good or service

%ΔPx = Percentage change in the price of the related good or service

To calculate the cross elasticity of demand, you first need to determine the percentage change in the quantity demanded of the first good or service and the percentage change in the price of the related good or service.

For example, consider a coconut farmer in India. The farmer wants to determine the cross elasticity of demand for coconuts with respect to the price of palm oil. He currently sells 1000 coconuts per month at a price of Rs.20 each. The price of palm oil, a substitute for coconut oil, increases by 15%. After the price increase, he sells 800 coconuts per month.

To calculate the cross elasticity of demand:

%ΔQd = (-200 / 1000) x 100 = -20% (decrease in quantity demanded)

%ΔPx = (15 / 100) = 15% (increase in price of palm oil)

Cross elasticity of demand = %ΔQd / %ΔPx = -20 / 15 = -1.33

The cross elasticity of demand is -1.33, which means that the demand for coconuts is inelastic with respect to the price of palm oil. A 15% increase in the price of palm oil leads to a 13.3% decrease in the quantity demanded of coconuts. This suggests that palm oil is a close substitute of coconut oil and the change in price of palm oil affects the demand of coconut oil.

  1. Advertising Elasticity of Demand

Advertising elasticity of demand (AED) is a measure of a market’s sensitivity to increases or decreases in advertising saturation. It is calculated by dividing the percentage change in the quantity demanded by the percentage change in advertising expenditures. A positive AED indicates that an increase in advertising leads to a rise in demand for the advertised good or service.

Advertising elasticity of demand is a valuable tool for companies to measure the effectiveness of their advertising strategies. It can help a company determine the optimal level of advertising expenditure to maximize profits. AED can also help a company identify the most effective channels for their advertising campaigns and understand the impact of their advertising on sales.

In addition, AED can be used to compare the effectiveness of different types of advertising and to determine the most cost-effective channels for marketing a product or service. AED can also be used to measure the effectiveness of an advertising campaign over time and to identify potential problems or opportunities in the market.

The advertising elasticity of demand formula is:

Advertising Elasticity of Demand = (% Change in Quantity Demanded) / (% Change in Advertising Expenditure)

These are four types of demand elasticity and they are used by businesses and governments alike to quantify the sensitivity of the demand. 

What are some of the factors that affect the Law of Demand?

There are several factors that affect demand, but not the law of demand. It includes availability, price, quality, etc.

1. Availability of substitutes

The availability of substitutes can have a significant impact on demand for a particular product. Substitutes are alternative products that can be used in place of the original product, and their availability can dilute demand for the original product. This is because when substitutes are readily available, customers have more options to choose from and may opt for the substitute product instead of the original product.

For example, let’s consider a brand of coconut oil. If there are no substitutes available for this brand of coconut oil, then demand it will be relatively high as customers have no alternative options. However, the demand for the original brand may decrease if other brands of coconut oil become available in the market, as customers may opt for the substitute brands.

This is because the substitutes may be cheaper, more easily available, or offer similar or better benefits than the original brand. This could lead to the original brand losing its market share and facing a decrease in demand.

2. Price of product

Price is one of the main factors that can affect demand for a product. The relationship between price and demand is known as the law of demand, which states that all other things being equal, the higher the price of a product, the lower the quantity demanded, and vice versa.

Customers perceive it as less affordable and opt for cheaper alternatives when the price of a product is high. This can lead to a decrease in demand for the product.

As an example, consider a brand of coconut oil. Customers may opt for cheaper alternatives, if the price of this brand is high compared to other brands of coconut oil available in the market, leading to a decrease in demand for this brand of coconut oil.

3. Tastes and preferences

The tastes and preferences of customers can have a significant impact on demand for a product. Customers’ preferences and tastes vary widely, and what one customer finds appealing, another does not. For example, some customers prefer organic products while others prefer non-organic products. Some prefer a certain brand or type of product, while others do not.

For example, consider a brand of coconut oil. Some customers may prefer this brand of coconut oil over others because of its taste, texture, or packaging, while others may not. This is because customers have different tastes and preferences, and what one customer may find appealing, another may not. As a result, the demand for a product can be affected by how well it appeals to customers’ tastes and preferences.

4. Number of consumers

The number of consumers in the market can have a significant impact on demand for a product. A larger number of consumers in the market can lead to an increase in demand for a product, while a smaller number of consumers can lead to a decrease in demand.

For example, consider a brand of coconut oil. The demand for a particular brand of coconut oil will be high, if the number of consumers in the market for coconut oil is also high, as more customers will be looking to purchase it. The situation can also be vice versa. 

5. Elasticity vs. inelasticity

Elasticity and inelasticity are measures of how responsive demand for a product is to changes in price. They also affect demand.

Product is elastic means that a change in price has a significant impact on the quantity of the product demanded. A product with elastic demand means that a small change in price can lead to a large change in the quantity of the product demanded.

Changes in these factors can impact consumer behaviour and alter the quantity demanded. Understanding these influences helps businesses and policymakers make informed decisions.

What are the exceptions to the Law of Demand?

The law of demand sometimes does not hold true in certain situations. Four such instances are given below.

Giffen Goods: Giffen goods are goods where an increase in price leads to an increase in the quantity demanded. This is the opposite of the normal relationship between price and demand and is usually seen in basic necessities such as food and shelter.

Veblen Goods: Veblen goods are luxury goods or status symbols, where an increase in price leads to an increase in demand. This is because the higher price is seen as a sign of quality, and people are willing to pay more for them.

Necessities: Necessities are goods or services that people need regardless of the price. Demand for it remains the same even if the price of a necessity increases.

Income Change: Changes in a person’s income can also affect the demand for certain goods. They may be willing to purchase more goods, regardless of the price if the person’s income increases. Conversely, they may be less likely to purchase goods, regardless of the price if a person’s income decreases.

These are rare cases and the law of demand typically stays true in the majority of the situations. 

What happens to the market when the Law of Demand increases?

Prices will increase and the product will experience scarcity when the demand drops. This is because when demand increases, more people are willing to purchase the product, driving up the price. Additionally, supplies become scarce, leading to shortages with more demand for the product. The market will experience higher prices and product scarcity as a result, when demand increases.

An example of how demand affects prices and scarcity for a coconut farmer in India could be as follows:

A coconut farmer in the southern state of Kerala, India, has been selling coconuts at a steady price of INR 10 per coconut for years. However, recently, there has been a surge in demand for coconuts in the market as more people are becoming health-conscious and looking for natural and organic products. The demand for coconuts has risen as a result, and the farmer is receiving more orders for coconuts than he can keep up with.

The farmer realizes that he can raise the price of his coconuts to INR 15 per coconut with the increased demand. More customers are willing to pay the higher price, and the farmer is able to sell all of his coconuts at the new price. However, the farmer is not able to keep up with the orders, and he runs out of coconuts to sell because of the increase in demand. This leads to a scarcity of coconuts in the market, and customers have to wait for more coconuts to be harvested.

We can see how an increase in demand leads to an increase in prices and product scarcity in this scenario. The farmer is able to raise the price of his coconuts due to the increased demand and sales of his stock, creating scarcity in the market.

What happens to the market when the Law of Demand decreases?

One of the most notable effects of lower demand is that prices will typically drop. This is because when there is less demand for a product, businesses will have to lower their prices in order to attract customers and sell their products. Additionally, businesses will not be able to sell all of their products as demand decreases and will have to deal with excess inventory, which can lead to products going to waste.

An example of how demand decreases could affect a coconut farmer in India is as follows:

A coconut farmer in the southern state of Kerala, India, has been selling coconuts at a steady price of INR 15 per coconut for years. However, recently, there has been a decrease in demand for coconuts in the market as more people are looking for other alternative products. The demand for coconuts has decreased as a result, and the farmer is receiving fewer orders for coconuts than he used to.

The farmer realizes that he has to lower the price of his coconuts to INR 10 per coconut with the decreased demand, to attract customers and sell his coconuts. However, the farmer is not able to sell all of his coconuts as the demand continues to decrease, and has to deal with excess inventory. This leads to some of the coconuts going to waste.

Is there an effect in our daily lives when the Law of Demand increases?

Yes, an increase in demand can have an effect on our daily lives. It can lead to an increase in prices, as businesses raise prices to take advantage of the higher demand. This makes the product less affordable for consumers and makes it difficult for them to purchase. Additionally, an increase in demand can lead to product scarcity, making it harder for consumers to find the product they want.

Is there an effect in our daily lives when the Law of Demand decreases?

Yes, a decrease in demand can lead to a decrease in prices, as businesses may lower prices to try and attract more customers. This can make the product more affordable for consumers and make it easier for them to purchase. A decrease in demand can lead to excess inventory and overproduction, leading to products going to waste or being offered with discounts.

What is the difference between Demand and Quantity Demanded?

The fundamental difference between demand and quantity demanded is that while demand simply denotes the willingness and a person’s ability to purchase, quantity demanded represents the amount of an economic good or service desired by consumers at a fixed price.

Demand is inversely related to price, i.e. with the increase in price, the demand for the product or service decreases whereas a decline in the price of the product or service causes a rise in its demand. It can further be represented by a curve that shows the relationship between price and quantity demanded.

Quantity demanded, on the other hand, is a particular point on the demand curve. A change in quantity demanded represents a movement along the current demand curve, while a change in demand will result in a shift of the demand curve.

What is the difference between the Law of Demand and the Law of Supply?

The Law of Demand states that as the price of a good or service increases, the quantity demanded decreases, and as the price decreases, the quantity demanded increases. This law is based on the premise that consumers will be willing to purchase a product or service if it is priced at a lower cost.

The Law of Supply states that as the price of a good or service increases, the quantity supplied increases, and as the price decreases, the quantity supplied decreases. This law is based on the premise that producers will be willing to produce a product or service at a higher cost if it allows them to make a profit.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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