What is the law of demand?

Definition:

The law of demand states that all else being equal, the quantity purchased of a good or service is a function of its price.

Definition and Examples of the Law of Demand

According to the law of demand, the quantity purchased of a good or service is a function of its price – with all else being equal. As long as nothing else changes, people will buy less of something when its price rises. They will buy more when its price falls.

The law of demand can help explain why things are priced the way they are. For example, merchants utilize the law of demand every time they offer a discount. In the short run, all else is equal. Sales are often very successful at boosting demand. Shoppers respond immediately to the advertised price drop. This works especially well during huge holiday sales, such as Black Friday and Cyber Monday.

How the Law of Demand Works

There are two main ways to visualize the law of demand: the demand schedule and the demand curve.

A demand schedule tells you the exact quantity that will be purchased at any given price. The demand curve plots these figures on a graph. The quantity is on the horizontal axis or x-axis, and the price is on the vertical axis or y-axis.

If the quantity purchased changes significantly when the price changes, this is called elastic demand. An example might be buying ice cream. If the price rises significantly beyond your preferences, you can easily buy a different treat instead.

If the quantity does not change much when the price changes, this is called inelastic demand. An example of this is gasoline. You need to purchase enough to get to work no matter the price.

The factors that determine the level of demand are called “determinants.” These are also part of “all else” that must be equal under the ceteris paribus framework. Demand determinants include the prices of related goods or services, income, tastes or preferences, and expectations.

The Law of Demand and the Business Cycle

Politicians and central banks understand the law of demand very well. The Federal Reserve operates with a dual mandate to prevent inflation while simultaneously reducing unemployment.

During the expansion phase of the business cycle, the Federal Reserve attempts to reduce demand for all goods and services by raising the price of everything. It does this through contractionary monetary policy. It raises interest rates on loans and mortgages.

Of course, when prices rise, inflation also increases. But this is not always a bad thing. The Federal Reserve has a target inflation rate of 2% for core inflation. The national central bank aims for this level of mild inflation. It sets an expectation that prices will rise by 2% per year. Demand increases because people know that things will cost more next year. They may buy them now, ceteris paribus.

During a recession or the contraction phase of the business cycle, policymakers face a worse problem. They must stimulate demand when workers are losing jobs and homes and have less income and wealth. Expansionary monetary policy lowers interest rates, thereby reducing the price of everything. If the recession is bad enough, it does not reduce the price enough to compensate for the lower income.

In this case, expansionary monetary policy is needed. During times of high unemployment, the government may extend unemployment benefits and reduce taxes. As a result, the deficit increases as the government’s tax revenue declines. Once confidence and demand are restored, the deficit should contract as tax revenues rise.

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Sources:

– The Library of Economics and Liberty. “Demand.” Accessed June 24, 2021.

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Saylor Academy. “ECON101: Principles of Microeconomics.” Accessed June 24, 2021.

– Corporate Finance Institute. “What Is a Demand Curve?” Accessed June 24, 2021.

– Lumen Learning. “Reading: Examples of Elastic and Inelastic Demand.” Accessed June 24, 2021.

– California State University (Northridge). “Understand How Various Factors Shift Supply or Demand and Understand the Consequences for Equilibrium Price and Quantity,” Pages 1-2. Accessed June 24, 2021.

– University of Wisconsin-Madison. “Supply and Demand.” Accessed June 24, 2021.

– Federal Reserve Bank of St. Louis. “Stable Prices, Stable Economy: Keeping Inflation in Check Must Be No. 1 Goal of Monetary Policymakers.” Accessed June 24, 2021.

– Federal Reserve Bank of St. Louis. “Making Sense of the Federal Reserve.” Accessed June 24, 2021.

– Federal Reserve Bank of St. Louis. “The Fed’s Inflation Target: Why 2 Percent?” Accessed June 24, 2021.

– Federal Reserve Bank of St. Louis. “A Closer Look at Open Market Operations.” Accessed June 24, 2021.

– Federal Reserve. “What Is the Difference Between Monetary Policy and Fiscal Policy, and How Are They Related?” Accessed June 24, 2021.

– Washington State Employment Security Department. “Benefits Extensions.” Accessed June 24, 2021.

Source: https://www.thebalancemoney.com/law-of-demand-definition-explained-examples-3305707