WHY DOES THE DEMAND CURVE SLOPES DOWNWARD?

Learning Contents:

·           Reasons for the downward slope of the demand curve.

 

Why the slope of the demand curve is downward?

The law of demand states that there is an inverse relationship between price and the demand for a commodity. When the price of commodity increases, its demand decreases, and when the price of a commodity falls, its demand increases. The following points will explain the reasons for the downward slope of a demand curve:

1. Law of diminishing marginal utility:

The law of diminishing marginal utility states that as more and more units of a good are consumed, the marginal utility (satisfaction) derives from the consumption of every additional unit of a good go on diminishing and therefore, the consumer would be willing to pay less price and the demand will fall.

The following points would clearly explain how the utility of a good is related to the price and demand.

A consumer receives maximum utility after consuming the very first unit of a good as it satisfies his very urgent need or desire.

Consumption of the second unit of the good would give him less utility as he is now less in need of this good.

Further, consumption of the third unit of good would give a consumer zero or no utility because he is not needed it at all anymore. Therefore, a consumer would be willing to pay less for second and subsequent units of goods as its marginal utility declines.

Thus, when more quantity of a good is consumed, the marginal utility declines and the consumer is not willing to pay more prices, and its demand declines. As a result, the demand curve slopes downward.

2.      Impact of Price change:

The impact of price change on the demand of the goods can be separated in two components:

2.1 Income effect

2.2  Substitution effect

2.1 Income Effect

Assuming that money income is constant, the income effect is the effect of change in the price of a commodity on the real income of a consumer i.e. changes in quantity demanded. In other words, it means how much quantity of good a consumer purchases after its price changes? For e.g. when the price of a good goes up, a consumer is not able to buy the same quantity of goods as he could buy before. The effect of change in price on the real income of the consumer can be studied in two aspects:

a.Income effect with regard to fall in price:

When the price of a good falls, a consumer can either choose to buy more quantity of it or would buy the same quantity of good as before, with some money left with him as he is now paying less for the same quantity of a good due to fall in its price. In other words, consumer’s real income increases due to fall in the price of a good. Let’s understand this with the help of a simple example.

For e.g. Ravi earns ₹100 per month and spends his entire income on only two goods, juice (₹10 per bottle) and cheese (₹5 per packet). We can make the following statements about Ravi’s income:

Ravi earns 10 units of juice bottles per month.

Ravi earns 20 packets of cheese per month.

Therefore, if the price falls by 50%, i.e. price of juice is now (₹5 per bottle) and cheese (₹2.5 per packet).  We can now make the two statements about Ravi’s income:

Ravi earns 20 units of juice bottles per month.

Ravi earns 40 packets of cheese per month.

The income effect could be seen from the above example that Ravi’s real income is increased due to a 50% fall in price i.e. purchase of more quantity of both goods  i.e. juice from ( 10 units to 20 units) and cheese from (20 packets to 40 packets) per month.

b. Income effect with regard to rise in price:

Assuming that money income is constant, when the price of good rises, a consumer would buy less quantity of that good. In other words, consumer’s real income decreases due to rise in the price of a good. Let’s understand this with the help of a simple example.

For e.g. Ravi earns ₹100 per month and he spends his entire income on only two goods, juice (₹10 per bottle) and cheese (₹5 per packet). We can make the following statements about Ravi’s income:

Ravi earns 10 units of juice bottles per month.

Ravi earns 20 packets of cheese per month.

Therefore, if the price rises by 100%, i.e. price of juice is now (₹20 per bottle) and cheese (₹10 per packet).  We can now make the two statements about Ravi’s income:

Ravi earns 5 units of juice bottles per month.

Ravi earns 10 packets of cheese per month.

The income effect can be seen from the above example that Ravi’s real income is decreased due to a 100% rise in price i.e. purchase of less quantity of both goods  i.e. juice from ( 10 units to 5 units) and cheese from (20 packets to 10 packets) per month.

Therefore, when the price is lowered, a consumer buys more quantity of goods i.e. his real income increases. Conversely, when the price is increased, a consumer buys less quantity of goods i.e. his real income decreases.

2.2 Substitution effect

Consumers often have the tendency to switch from one good to another good when the price of the substitute good changes. Supposing a restaurant sells two different types of soft drinks say Pepsi and coke. If the price of coke goes up, but the price of Pepsi stays the same, consumers might be attracted to buy more Pepsi. This tendency to change the purchasing decision from one good to another good based on the change in the price of its substitutes is called substitution effect. The effect of change in the price of one good on the demand of its substitute goods can be studied in two aspects:

a. Substitution effect with regard to rise in price:

For e.g. The price of two soft drink brands says coke and Pepsi are ₹20 per bottle. Now the price of coke increases to ₹25 per bottle with no change in the price of Pepsi. This will increase the demand for Pepsi but decrease the demand for coke. Therefore, the demand curve for coke slopes downward.

Substitution effect with regard to fall in price:

Continuing the above example, The price of two soft drink brands say coke and Pepsi are ₹20 per bottle. Now the price of coke decreases to ₹10 per bottle with no change in the price of Pepsi. This will decrease the demand for Pepsi but increase the demand for coke. Therefore, the demand curve for coke slopes downward.

3.      New buyers

When the prices of the good fall the new consumers get attracted towards it and thus start buying those and therefore increase its demand. For e.g. Due to fall in the prices of internet services, many new consumers gained access to it and thus increased its demand.

4. Old buyers

When the prices of the goods fall the old buyers tend to buy more goods than usual and thus increase their demand. This causes the demand curve to slope downward.

5. Change of the number of uses:

A good may have many uses and if the price falls, increases the demand. Milk, for example, is used for drinking, making cheese, sweets, butter, curd, cream, etc. If its price falls, then consumers will buy more quantity of milk to make many things out of it and therefore its demand will increase. Hence, the demand for a good with many uses increases, if its price falls and vice versa.

Let’s try some questions

Choose the Correct Answer

1. A fall in own price of the commodity leads to

a. increase in real income of the consumer

b. decrease in real income of the consumer

c. increase in purchasing power of the consumer

d. both a. and c.

2. Substitution effect takes place when the price of the commodity becomes:

a. relatively cheaper

b. relatively dearer

c. stable

d. both a. and b.

3. The slope of the demand curve is

a. negative

b. positive

c. constant

d. Both a. and c.

4.  Demand curves have a negative slope because

a. firms tend to produce less of a good that is more costly to produce.

b. the substitution effect always leads consumers to substitute higher quality goods for lower quality goods

c. the substitution effect always causes consumers to try to substitute away from the consumption of a commodity when the commodity's price rises.

d. increase in price reduces real income and the income effect always causes consumers to reduce consumption of a commodity when income falls.

5. People buy more of good 1 when the price of good 2 rises

a. Normal goods

b. Complements

c. Substitutes

d. Inferior goods

6. The law of demand can be derived with the help of

a. Law of D.M.U. (Diminishing Marginal Utility)

b. Law of EMU (Equi-Marginal Utility)

c. Any of these two

d. None of these

7. Decrease or fall in the price of a commodity leads to increase in demand because of

a. Substitution Effect, i.e., relatively cheaper than related goods

b. Income Effect, i.e., consumer become better off

c. Both a. and b.

d. None of these

 

Answer Key

1.d	2.d	3.a	7.c
4.c	5.c	6. c

 

 

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