The demand for goods varies inversely with its ceteris paribus. Thus, as the price of the car goes up, other things remaining same, the demand for the car goes down, and vice versa. This is known as the law of demand. It must be noted here that the law, which describes the inverse relationship between quantity demand and price, includes a rider, that is, other things remaining the same. The other things here refer to all the factors which affect the demand barring its own price. Some people make fun of economists by saying that while most prices are going up, no demand is going down meaning the law of demand does not hold good. However, they forget that the other things have not remained constant.
Several theories have been developed to explain the law of demand. The most convincing one goes through the concepts of price effect, income effect and substitution effect of price change on its own demand. The price effect (PE) refers to the effect of a change in the price of a commodity, ceteris paribus, on the demand for that commodity. This effect is divided into income effect (IE) and substitution effect (SE).
PE= IE + SE
The income effect refers to the effect of a price change on its demand, ceteris paribus, which arises due to the corresponding change in the (real) income of the consumer. For example, suppose the nominal income of the consumer is Rs4,000 per month, price of milk is Rs 5 per litre and currently he buys 60 litres of milk per month. Now, if the price of milk falls to Rs.4, ceteris paribus he would save Rs 60 (60X5 â€“ 60X4) if he continues buying 60 litres of milk. Alternatively, with the earliest milk budget of Rs 300 (60X5), he could now purchase 75 liters of milk instead of earlier 60 litres. Thus a fall in the price of milk is tantamount to an increase in the consumersâ€™ income. Depending on whether milk is a superior or inferior, its demand would increase or decrease. Thus, the income effect could be negative or positive.
The substitution effect stands for the effect of a price change on its demand, ceteris paribus which results due to change in the relative prices of the goods in the consumption basket. For example, if the price of the car goes up, other things (including the prices of other cars) remaining the same, this car under consideration would now become relatively more expensive compared to other cars, than it was before the price change occurred and therefore some people will switch over from this car to other brands of cars, causing a depression for the demand for the car. Thus, an increase in the prices of the car, ceteris paribus, would lead to a decrease in the demand for the cars through the substitution effect. The substitution effect is thus always negative, in the sense that the price change and the change in demand through the substitution effect are the opposite direction.
A price change, which produces both the income and substitution effect thus leads to a change in the demand for the good whose price has undergone a change. The total effect is negative (i.e. the law of demand holds good) under two conditions:
1. when the good in question is a superior good; and
2. when the good in question is an inferior good but the positive income effect is weaker than the negative substitution effect.
When the product is a superior item, both the income and substitution effects are negative and hence this sum (total effect) is obviously negative. In a situation when a good in question is an inferior item, the two effects work, in the opposite direction and their sum could ether be negative or positive. But if the positive income effect is out-weighted by the negative substitution effect the price effect continues to be negative, substantiating the law of demand. The law of demand does not hold good for that inferior good whose positive income effect is stronger than the negative substitution effect. Thus, for a good to be Giffen, it must be an inferior good, it must have a strong income effect which would be possible if and only if the consumer spends a significant part of his income on this good and it must have a relatively weak substitution effect (which would happen if and only if there are no close substitutes for that product). The demand for a Giffen varies directly with its price and thus it provides an exception to the law of demand. The Irish potato was considered one such good.
Exceptions to the law of demand could arise under the following situations:
1. When the good in question is a luxury item, having some snob value.
2. When the good in question goes out of fashion.
Rich people buy costly items such as diamonds in large quantities in spite of their high prices and sometimes they increase such purchase in the face of rising process, for the acquisition of such expensive items expensive items distinguish them from common people, who cannot afford them. Also, some consumers judge quality by high prices, and if so, they might purchase more of a product when its price is high than when its price was low. Similarly, with the television, the demand for radios has gone down even though their prices have declined. This is because radios are out of fashion these days.