The classic microeconomics supply and demand model shows price on the vertical axis and demand on the horizontal axis. In between, them is a downward-slowing demand curve where price and quantity demanded to have an inverse relationship. The general concept is intuitive: as goods become more expensive, people tend to demand less of them.
Key Takeaways
- The law of supply and demand is a keystone of modern economics.
- According to this theory, the price of a good is inversely related to the quantity offered.
- This makes sense for many goods, since the more costly it becomes, less people will be able to afford it and demand will subsequently drop.
Supply & Demand
The law of supply and demand, one of the most basic economic laws, ties into almost all economic principles in some way. In practice, supply and demand pull against each other until the market finds an equilibrium price. For many simple markets, this inverse relationship holds true. If the cost of a shirt doubles, consumers buy fewer shirts, all else being equal. If the shirts go on sale, consumers tend to buy more. However, multiple factors can affect both supply and demand, causing them to increase or decrease in various ways.
There are several practical issues with the simple supply and demand model as depicted in the graph below. In addition to the theoretical existence of goods that actually rise in demand as the price goes up (known as Giffen and Veblen goods), a basic microeconomics chart like this one cannot possibly contain all of the various variables at work that impact supply and demand. Nevertheless, it is typically the case that price and quantity are inversely related: the more costly the same good becomes, they less people will want it – and vice versa.
Image by Sabrina Jiang © Investopedia 2021
Deducing the Law of Demand
The law of demand is actually a deductive, logical construct. It holds a few observations as true: resources are scarce, there is a cost to acquiring them, and human beings employ resources to achieve meaningful ends.
Cost does not necessarily mean a dollar amount. Cost simply represents what is given up to acquire something, even if it is time or energy. True cost also implies opportunity costs.
Since human beings act, economists deduce that their actions necessarily reflect value judgments. Every nonreflex action is taken to obtain or increase value in some sense; otherwise, no action takes place. This definition of value is incredibly broad and could be considered a tautology. As the cost of acquiring a good increases, its relative marginal utility decreases compared to other goods. Even if all relative costs increased by exactly the same proportion at the exact same time, consumers’ resources are finite.
The Bottom Line
Consumers only enter into a voluntary trade if they believe, or ex-ante, they receive more value in return; otherwise, no trade occurs. When the relative cost of a good increases, the gap between value and cost shrinks. Eventually, it goes away. Thus, the law of demand really states: as a good’s true cost increases, consumers demand relatively less of it.