| CONTENTS Rationale of the law of demand: Price effect of a fall in price: Utility maximizing behaviour of consumer: Arrival of new customers: Different uses: |
Rationale of the law of demand:
We know that the demand curve slopes downwards. There is an inverse relationship between quantity demanded and its price. i.e, as price decreases, quantity demanded increases and as price increases, quantity demanded decreases. But what is the rationale between price and quantity? Different explanations given by different economists for the operation of the law of demand.
Point to be noted: meaning of rationale: a set of reasons or logical basis for a course of action or belief.
Let us consider the points related to Rationale of the law of demand:
| Price effect of a fall in priceUtility maximizing behavior of consumersArrival of new consumersDifferent uses |
Explanation of these points one by one as below:
- Price effect of a fall in price:
Hicks and Allen have explained the law in terms of substitution effect and income effect. Let us first understand substitution effect:
For easy understanding, let us consider an example:
| Let us take the example of coke and Pepsi as substitute products. For example : PepsicokePepsiPrice, ↓ Quantity demand, ↓Quantity demand, ↑ |
Explanation: As Pepsi and coke are substitutes, as the price of substitutes changes, it becomes cheaper than other commodities. As you can observe in our example, the price of substitute product Pepsi decreases and subsequently the quantity demanded for coke decreases as Pepsi becomes cheaper than coke. This is called the substitution effect.
Substitution effect will be stronger when:
- Goods are closer substitutes
- There is lower cost of switching to the substitute good
- There is lower inconvenience while switching to the substitute good.
Income effect: The increase in demand on account of the increase in real income, known as income effect. When the price of the commodity decreases, the same quantity can be purchased with lesser money or more quantity with the same money as a result, as a result the consumer’s real income or purchasing power increases. However, there is one exception, i.e., inferior goods.
Note: purchasing power means the financial ability to buy products or services.
These are goods for which quantity demanded in high quantities up to a certain level, and after that it decreases. Ex. say your salary is RS. 10,000/- per month. So you purchase cheap rice, say for EG. kolam rice. Now you get a promotion and your income increases and the price for kolam rice reduces, still you will shift to basmati rice as now it is within your purchasing power even at a higher price.
- Utility maximizing behavior of consumer:
A consumer is in equilibrium, i.e., maximize his satisfaction when the marginal utility of its commodity is equal to its price. According to Marshall, consumers have diminishing utility for each additional unit of a commodity and would be willing to buy only for that additional unit. A rational consumer will not pay more for lesser satisfaction, and will be induced to buy only when the price decreases.
- Arrival of new customers:
When the price of the commodity falls, more consumers can buy it as those consumers who could not afford it earlier can now buy. This raises the number of consumers for a commodity at lower prices, and the demand for the commodity increases.
- Different uses:
Many commodities have multiple uses. When the price of such commodities are high they will be put to limited uses only and consequently if the price of such commodities fall, the demand will increase.
| Example: if the price of electricity reduces, we can buy more electric products. |
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Authored by: Kamaishi Singhvi
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