Explaining the Law of Demand

In Section 2 we introduced the demand curve and the law of demand. To this point, we have accepted that the demand curve has a negative slope. And we have drawn demand curves that are somewhere in the middle between flat and steep (with a negative slope). In this module, we present more detail about why demand curves slope downward and what the slope of the demand curve tells us. We begin with the income and substitution effects, which explain why the demand curve has a negative slope.

The Substitution Effect

When the price of a good increases, an individual will normally consume less of that good and more of other goods. Correspondingly, when the price of a good decreases, an individual will normally consume more of that good and less of other goods. This explains why the individual demand curve, which relates an individual’s consumption of a good to the price of that good, normally slopes downward—that is, it obeys the law of demand.

The substitution effect of a change in the price of a good is the change in the quantity of that good demanded as the consumer substitutes the good that has become relatively cheaper for the good that has become relatively more expensive.

An alternative way to think about why demand curves slope downward is to focus on opportunity costs. For simplicity, let’s suppose there are only two goods between which to choose. When the price of one good decreases, an individual doesn’t have to give up as many units of the other good in order to buy one more unit of the first good. That makes it attractive to buy more of the good whose price has gone down. Conversely, when the price of one good increases, one must give up more units of the other good to buy one more unit of the first good, so consuming that good becomes less attractive and the consumer buys fewer. The change in the quantity demanded as the good that has become relatively cheaper is substituted for the good that has become relatively more expensive is known as the substitution effect. When a good absorbs only a small share of the typical consumer’s income, as with pillowcases and swim goggles, the substitution effect is essentially the sole explanation of why the market demand curve slopes downward. However, there are some goods, like food and housing, that account for a substantial share of many consumers’ incomes. In such cases, another effect, called the income effect, also comes into play.

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The Income Effect

AP® Exam Tip

The substitution effect comes from a change in the price of one good relative to the price of another good. The income effect comes from a change in purchasing power, which can result from a change in one or more prices or from a change in the actual income received.

The income effect of a change in the price of a good is the change in the quantity of that good demanded that results from a change in the consumer’s purchasing power when the price of the good changes.

Consider the case of a family that spends half of its income on rental housing. Now suppose that the price of housing increases everywhere. This will have a substitution effect on the family’s demand: other things equal, the family will have an incentive to consume less housing—say, by moving to a smaller apartment—and more of other goods. But, in a real sense, the family will also be made poorer by that higher housing price—its income will buy less housing than before. When income is adjusted to reflect its true purchasing power, it is called real income, in contrast to money income or nominal income, which has not been adjusted. And this reduction in a consumer’s real income will have an additional effect, beyond the substitution effect, on the family’s consumption choices, including its consumption of housing. The income effect of a change in the price of a good is the change in the quantity of that good demanded that results from a change in the overall purchasing power of the consumer’s income when the price of the good changes.

It’s possible to give more precise definitions of the substitution effect and the income effect of a price change, but for most purposes, there are only two things you need to know about the distinction between these two effects.

First, for the majority of goods and services, the income effect is not important and has no significant effect on individual consumption. Thus, most market demand curves slope downward solely because of the substitution effect—end of story.

Second, when it matters at all, the income effect usually reinforces the substitution effect. That is, when the price of a good that absorbs a substantial share of income rises, consumers of that good become a bit poorer because their purchasing power falls. And the vast majority of goods are normal goods, goods for which demand decreases when income falls. So this effective reduction in income leads to a reduction in the quantity demanded and reinforces the substitution effect.

Giffen Goods

In the mid-nineteenth century, when Ireland was a desperately poor country, it was claimed that the Irish would eat more potatoes when the price of potatoes went up. That is, some observers claimed that Ireland’s demand curve for potatoes sloped upward rather than downward.

Can this happen? In theory, yes. If Irish demand for potatoes actually sloped upward, it would have been a real-life case of a “Giffen good,” named after a nineteenth-century statistician who thought (probably wrongly) that he saw an upward-sloping demand curve in some data he was studying.

Here’s the story. Suppose that there is some good that absorbs a large share of consumers’ budgets and that this good is also inferior—people demand less of it when their income rises. The classic supposed example, as you might guess, was potatoes in Ireland, back when potatoes were an inferior good—they were what poor people ate—and when the Irish were very poor.

Now suppose that the price of potatoes increases. Other things equal, this would cause people to substitute other goods for potatoes. But other things are not equal: given the higher price of potatoes, people are poorer. And this increases the demand for potatoes, because potatoes are an inferior good.

If this income effect outweighs the substitution effect, a rise in the price of potatoes would increase the quantity demanded; the law of demand would not hold.

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In a way the point of this story—which has never been validated in any real situation, nineteenth-century Ireland included—is how unlikely such an event is. The law of demand really is a law, with few exceptions.

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However, in the case of an inferior good, a good for which demand increases when income falls, the income and substitution effects work in opposite directions. Although the substitution effect decreases the quantity of any good demanded as its price increases, the income effect of a price increase for an inferior good is an increase in the quantity demanded. This makes sense because the price increase lowers the real income of the consumer, and as real income falls, the demand for an inferior good increases.

If a good were so inferior that the income effect exceeded the substitution effect, a price increase would lead to an increase in the quantity demanded. There is controversy over whether such goods, known as “Giffen goods,” exist at all. If they do, they are very rare. You can generally assume that the income effect for an inferior good is smaller than the substitution effect, and so a price increase will lead to a decrease in the quantity demanded.