The Law of Demand
Consumers are most likely to buy more goods and services as price decreases, and buy less goods and services as price rises. This is the law of demand. Such general tendencies of consuemrs can be explained by two reasons:
1. Income effect. At lower prices, an individual has a greater purchasing power. THis means he can buy more goods and services. But at higher prices, naturally he can buy less. For example, before, if the price of the one bottle of softdrink was only 10 cents, a dollar then could buy 10 bottles, since 1 dollar = 100 cents. At present, the same one dollar cannot even purchase one bottle. This shows that the same amount of money or income can buy more goods when prices are lower, but lesser goods when prices are higher.
2. Substitution effect. Consumers tend to buy goods with lower prices. In case the price of a product that they are buying increases, they look for substitutes whose prices are lower. For example, if the price of Softdrink X increases, consumers shift to other softdrinks with lower prices. This is one of the reasons why the rise in price of a certain product reduces the quantity demanded for such product.
Validity of the Law of Demand
The law of demand states that "as price increases, quantity demanded decreases, and as price decreases, quantity demanded increases." Such theory is only true if the assumption of ceteris paribus is applied. It means "all other things equal or constant." The law of demand is correct if the determinants of demand are held constant. That is there is no change in income, taste, or population. For example, if the price of a transistor radio increases by 20 percent, then the quantity demanded for such good decreases. This is true if the income of the buyer is the same. But supposing the income of the buyer has increased by 100 percent. Would quantity demanded for the radio fall since there is an increase of price? Certainly not, because the income of the consumer has increased. This means more purchasing power.
Another explanation in the case of population. Obviously, more goods and services are being bought at present than before the war. And yet prices at present have increased a hundred times compared with pre-war prices. They say one centavo could buy a cone of ice cream that time. If we base this consumers' behavior on the law of demand, then the law is not correct. The quantity demanded for goods at present should be lower than in the past because prices at present are higher. Again, to make the law of demand valid, population or number of buyers should be the same. Precisely, the reason why there are more goods and services that are being demanded at present despite high prices is the great increase in population. Before the war, we were only about 18 million in population.
Similarly, reducing the price of a product which is out of fashion does not increase the quantity demanded for such product. This appears to contradict the law of demand. It shows that the behavior of consumers is not affected by price reduction. This is true because tastes and preferences determine the demand for a product. If people do not like the product, their tendency is not to buy it even the price is reduced. Thus, to make the law of demand valid, we always assume that tastes or preferences does not change.