3 REASONS OR EXPLANATION OF THE LAW OF DEMAND

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An important concept in economics is the law of demand. The law of demand states that "A rational buyer will buy more of an item when the price decreases and less of the item when the price increases, ceteris paribus."

There are three reasons for the law of demand or a downward-sloping demand curve, namely; the income effect, the substitution effect and the law of diminishing marginal utility.

The income effect

This refers to the resultant change in demand caused by a change in the consumer's real income or purchasing power.

Real income refers to an individual income that is adjusted for price changes. Because real income is income that has already been adjusted for inflation, it is used to refer to the actual buying power of a consumer.

The income effect explains the inverse relationship between quantity demanded and price this way: as an good's price increases, a consumer have less real income available to spend on the good, which causes the quantity demanded to decline.

The reverse is also true. A reduction in the price of goods increases the real income that consumers have to spend on the goods so there is an increase in the quantity demand.

For example, assuming Daniel purchases 50 biscuits at N30 each out of his monthly income of N1500. If the price of the biscuit rises to N50, then Daniel will only be able to purchase 30 biscuits from his income of N1500.

Therefore, the income effect states that there is an inverse relationship between quantity demanded and price because of the reduction (or rise) in real income that results from a rise (or reduction) in price.

Substitution effect

This refers to the resultant change in demand for a good when it became relatively cheaper or more expensive than other goods as its price changes.

Simply put, the substitution effect is the tendency for a consumer to substitute a good as its relative price to the goods changes.

The substitution effect states that when a good's price goes up, it becomes more expensive relative to other goods, making it more sensible for customers to switch to less expensive goods.

As a result, the quantity demanded the goods decreases.

By the same reasoning, a fall in the price of a good increases its quantity demanded because it becomes relatively cheaper than other goods.

Please note that the substitution effect assumes that the price of substitute goods remains unchanged. 

To see the substitution effect in action, let us assume that physical books and e-books are both substitutes. When the price of e-books rises, then e-books will become relatively expensive to physical books so that the quantity demanded of e-book falls.

So, the substitution effect says there is an inverse relationship between quantity demanded and price because an increase (or decrease ) in the relative price of a good in relation to other goods will result in a decrease (or increase) in the quantity demanded of the good.

Diminishing marginal utility

According to the law of diminishing marginal utility, the additional utility acquired as a customer consumes more and more units of a good decrease.

In other words, the law of diminishing marginal utility says that all things being equal, the marginal utility declines as the consumption of a commodity increase.  

Generally, the more utility you receive from a unit of a good, the higher the price you are willing to pay for it. 

As a consumer buys more and more units of a good, his marginal utility declines so that the price he is willing to pay for the goods decreases also.

Therefore, according to diminishing marginal utility, there is an inverse relationship between quantity demanded and price because as consumer purchases more and more of a good, his marginal utility decline so that he is only willing to pay less for the goods.

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