Economics Finance Money Opinions

The Law of Demand

Most people would know that the law of demand states that if nothing changes other than the price of a particular good/service itself, a decrease in price of that good/service will result in a greater quantity of that good/service being purchased.

TLTR – The higher the price, the lower the quantity demanded.

There are two reasons why a consumer would be expected to purchase more of a good/service when price falls or vice versa – (1) the substitution effect; and (2) the income effect. Though I will briefly explain through these two, it’s not the main purpose of writing this post.

Normal goods – An increase in income would cause consumers to buy more.

Inferior goods – An increase in income would cause consumers to buy less.

The Substitution Effect

The substitution effect suggests that when the price of a good/service falls, consumers tend to purchase more of that good.

Let me give you an example, say you take public transportation because of high gasoline prices. One day the price of gasoline falls steeply. Suddenly, it’s relatively cheaper to drive to work rather than to take public transportation.

What happens next? You are more likely to substitute a little more driving to work for a little less public transportation due to cheaper gasoline prices.

In this scenario, gasoline is the normal good, and public transportation is the inferior good.

The Income Effect

The income effect suggests that an increase in purchasing power/real income from the decline of a good/service’s price causes people to buy even more of this good/service when its price falls.

Let me illustrate, so assume you love the premium yet expensive wagyu beef. One day the price of wagyu beef falls steeply, but your pay-check did not change. Your purchasing power increased due to the fall of price of wagyu beef, and you can now buy more wagyu beef.

So in this case, wagyu beef is the normal good, and if because you decide to binge on wagyu beef to take advantage of the price drop and buy less of chicken, chicken in this case, is the inferior good.

Exceptions to the Law of Demand

Now what’s really interesting are the exceptions to the law of demand.

Griffen Goods

Is it ever possible for the income effect to be so strong and so negative that it can overpower the substitution effect? Meaning, more of a good/service will be consumed as price rises and less would be consumed as price falls.

Studies have found that in poor rural communities where large portions of a person’s income is spent on rice. Logically speaking, under the law of demand, if the price of rice were to fall, they would purchase more of it, right? Apparently for a certain subset of consumers, that were not the case. They purchased less quantity of their staple rice, but purchase alternate sources of calories for their diet, like meat.

But these examples are few and hard to find in modern society, the next exception is much more common.

Veblen Goods

Veblen goods are another odd duck. With some goods, the item’s price tag might drive the consumer’s preference for it.

Take a high-status luxury good, like a luxury car – the Ferrari, or an expensive jewellery. These goods derive their value from the consumption of them as symbols of the purchases’s high status in society. In a way, the price tag actually partly imparts value to such a good.

Thorstein Veblen, the economist behind Veblen goods, argues that by increasing the price of a Veblen good, the higher the desirability, thus, the more inclined the consumer would be to purchase it.

And that’s why brands like Louis Vuitton can charge you RM2,150 for a pencil pouch.

To buy – click here to go to Louis Vuitton’s official site

With this, take some time to evaluate your current purchase behaviour. Are you normal and following the law of demand? Or are you defying it?

Also, it’s good to think of the applications of these in everyday life. If you’re in sales you could perhaps apply these theories in your pricing strategies and market your goods/services accordingly to boost sales. Or you might even try to break the law of demand and target to create a Veblen good/service!

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