Law of Demand - Assumptions, Factors & Exceptions - CA Foundation / CMA Foundation
Law of Demand – Assumptions, Factors & Exceptions – CA Foundation / CMA Foundation
What is Law of Demand
We all know that demand factors influence the market conditions of an economy and determine the costs of products and services. During a competitive market, the market conditions continue to vary until demand=supply, thereby creating equilibrium.
Law of demand
The Law of demand states that all external factors being constant, the quantity demanded of a product decreases as the price increases. Similarly, as the price decreases, the quantity demanded of a product increases.
For example, a consumer may buy two dozen bananas if the worth is INR 50. However, if the worth increases to INR 70, then the same consumer may not get the same quantity (two dozens) since that would cost more to his pocket. Therefore, the demand for bananas got reduced to one dozen.
Therefore, the Law of demand defines an inverse relationship between the price and quantity demanded.
Assumptions for the Law of demand
Income remains unchanged.
The taste, preference and habits of consumers stay unchanged.
Prices of related goods (substitute and complementary goods) remain unchanged
Future prices remain unchanged
Factors affecting Law of demand
1.Price of the good As noted above, the price has an inverse relationship with the quantity demanded. There is an inverse relationship between commodity price and commodity demand.
2.Income of the consumers Consumer income and commodity demand have a direct relationship as when incomes rise, the commodity demand also increases and vice-a-versa.
The income demand relationship varies with the following types of commodities –
Normal Goods – Quantity demanded increases with an increase in income. Thus income effect is positive.
Inferior Goods – Quantity demanded decreases with an increase in income. Thus income effect is negative.
Giffen goods – Quantity demanded increases with a price increase, but it decreases with the rise in income. Thus income effect is negative. Giffen goods are considered an exception also to the Law of demand since price and demand have a direct relationship.
3. Taste and Preference of Consumers
Societal customs, consumer trends, fashion, etc., affect the quantity demanded.
4. Price of Related Goods
There are two kinds of related goods –
The price of the own commodity is dependent on the substitute price. For example, I own a coffee brand. If the price of tea falls, consumers will buy tea more. However, if the price of tea rises, consumers will find relatively cheaper substitutes for tea. Assuming I do not change the price of my coffee, consumers will purchase my coffee brand since it is less expensive than tea.
Therefore, the demand for the commodity will fall if the price of the substitute falls.
Complementary Goods – The increase in the price of one good can cause a decline in the quantity demanded of the other good. For example, if the price of a chair rises, the quantity demanded of the related table will go down. Similarly, if the table price decreases, the quantity demanded of a chair increases.
Therefore, the demand for the quantity will increase if the price of the complement falls.
5. Expectations of Consumers
The quantity demanded gets influenced by the price expectation of a commodity in the future. If consumers expect that prices will increase, the current demand will increase and vice versa.
Exceptions to the Law of demand
Exceptions to the Law of demand consist of the following:
The speculative market of shares
Giffen Goods (Necessary Goods)
Sir Robert Giffen introduced Giffen goods. Hence, the name Giffen goods. These goods are considered necessary for consumers. Therefore, price changes cause a direct relationship between price and the quantity demanded instead of the inverse relationship as stated by the Law of demand,
Irish Potato Famine is considered a classic example of the Giffen goods concept. Potato is a staple within the Irish diet. During the potato famine, when the worth of potatoes increased, people spent less on luxury foods like meat and purchased more potatoes to stay on their diet. Because the price of potatoes increased, the demand for potatoes increased too. Therefore, contradicting the Law of demand.
Veblen Goods got introduced by the American economist Thorstein Veblen. Hence, the name Veblen goods.
Sometimes, consumers believe that a higher-priced product = better quality products while a lower-priced product = poorer quality products. Therefore, the demand for such goods, called Veblen goods, rises with increased prices and decreases with lower prices.
Branded consumer goods are an example of Veblen goods.
Thorstein Veblen also introduced the concept of Conspicuous Consumption. He based this idea on his observations of wealthy people. They would make purchases to project their status and prestige. The theory applies to precious metals and stones like gold, diamonds, and luxury cars, etc. These things are considered prized possessions and status symbols by the wealthy.
The speculative market of shares
In the share market, people tend to buy shares of those companies that have rising share prices. They do so in the hopes of making more money as the share prices continue to increase. On the contrary, they will buy fewer shares if prices begin to fall or continue to fall. Therefore, this causes a contradiction to the Law of demand and is hence, considered an exception.
The bandwagon effect is somewhat similar to the concept of conspicuous consumption. The demand of consumers is heavily dependent on the taste and preference of their social class. For example, there is a boy called Nityam. If Nityam’s social circle considers horse clubs trendy, Nityam will visit the horse club. If the prices for entry at the horse club increase, the people in Nityam’s social circle would go to the club more, meaning Nityam would also go there more often.
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