Causes Of Operation Of Law Of Demand

Causes Of Operation Of Law Of Demand

• Law of Diminishing Marginal Utility

The operation of law of demand can be explained on the basis of the law of diminishing marginal utility. The law states that as more of a commodity is purchased, its marginal utility to the consumer will be less and less. Therefore the consumer while purchasing the commodity values less and less the additional units of the commodity. So he will purchase more only if price falls. Suppose a consumer derives satisfaction worth $5 from the first apple and $3 worth of satisfaction from the second apple. If the price per unit of apple is $5 then he will purchase only one unit to equalize price with utility. If the price of apple $3 each, then he will purchase two units. This shows when price falls, the consumer purchase more. Thus the law of demand is nothing but a reflection of the law of diminishing marginal utility.

• Income Effect

When price of a good falls, real income of the consumer rises. If the consumer has $15 and price per unit of apple is $5. then he can purchase 3 units of apple. If price falls to $3 then to purchase same 3 units, the consumer will spend $3×3 = $9. This leaves a surplus of $6 with the consumer. Thus a fall in price has the same effect of increase in money income and hence is known as the income effect of a price reduction. The consumer can purchase some more units of the good with the surplus income released through the fall in price. Therefore when price falls amount purchased increases. When price rises, the consumer’s real income falls. This reduces his expenditure on the good leading to the fall in demand.

• Substitution Effect

Another effect of changes in price of a good is the substitution effect. When price of a good falls, other things remaining constant, the good becomes cheaper in comparison to other goods. The consumer will substitute the cheaper goods for the costlier goods so that he will gain. If the price of fish falls, the consumer to some extent will substitute it for meat leading to the rise in demand for fish. On the other hand, if price of a good rises, the good becomes costlier in demand for fish. On the other hand, if price of a good rises, the good becomes costlier in comparison to other goods, Hence other goods will be purchased to some extent in its place. This will lead to the fall in demand of the commodity whose price has risen.

• Change in the Number of Consumers

With the change in price of a good, number of consumers willing to purchase the commodity also changes. For example, when price falls, the consumers who were in the borderline of their ability can now come to the market to buy it as it is now affordable to them. The existing consumers will no doubt purchase more. The combined result is the rise in quantity demanded as price falls.