Law of demand states the inverse relationship between price of a commodity and its quantity demanded, other things remaining the same. The demand of a commodity is more at a lower price and less at a higher price.
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That is why, the demand curve slopes downward, (linear on non linear) But, a question arises as to why more quantity is demanded at a lower price and less quantity is demanded at a higher price. The factors responsible for the downward slope of the demand curve are:
(a) Law of Diminishing Marginal Utility:
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The law of diminishing marginal utility states that as the consumption of a commodity by a consumer increases, the satisfaction obtained by the consumer from each additional unit (i.e., marginal utility) of the commodity goes on diminishing. A thirsty man gets too much satisfaction by drinking a glass of water. But, the second glass of water will not be as much satisfying to him, as the first glass of water.
The satisfaction derived from the third glass will even be lesser. The price that a consumer is willing to pay for a commodity is directly related to the satisfaction that he derives from that commodity.
As we have seen, the consumer gets more satisfaction from the initial units of a commodity. He is ready to pay a high price for it. Further, the satisfaction that he gets from the successive units diminishes; he will purchase additional units of the commodity only at a lower price. Thus, more quantity is bought at a lower price and less quantity is bought at a higher price.
(b) Income Effect:
A fall in the price of a commodity increases the purchasing power (or the real income) of the consumer. In other words, the consumer has to spend less to buy the same quantity of the commodity as before.
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The money so saved because of a fall in the price of the commodity can be spent by the consumer in any way he likes. He will spend a part of this money on buying some more units of the same commodity, whose price has fallen.
Thus, a fall in the price of this commodity increases its demand. This is called income effect. Same explanation can be given for a rise in price. In this case, demand for the commodity under consideration will increase due to fall in purchasing power of the consumer.
(c) Substitution Effect:
This is another important reason for increase in demand as a result of a fall in the price of the commodity and vice-versa. When the price of a commodity falls, it becomes relatively cheaper than other commodities, whose prices have not fallen. So, the consumer substitutes this commodity for other commodities, which are now relatively dearer.
This is known as substitution or complementarily effect. Because of this substitution effect, demand for the commodity in question rises. In most of the cases, substitution effect is stronger than the income effect. Marshall explained the downward slope of the demand curve with the help of substitution effect, ignoring the income effect.
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Later on, income effect was also considered by Hicks and Allen (under the indifference curve analysis) to explain the downward slope of the demand curve. The sum of income effect and substitution effect is called price effect. The demand curve slopes downward, as a fall in price of a commodity causes more of it to be demanded and vice-versa.
(d) Changes in the Number of Consumers:
Many people cannot afford to buy a commodity at a high price. When the price of the commodity falls, a number of persons who could not afford it at a higher price, can purchase it at the reduced priced. This increases the number of consumers of the commodity. Thus, at a lower price, the quantity demanded of the commodity increases because of the increase in the number of consumers of the commodity and vice-versa.
(e) Diverse Uses of a Commodity:
Many commodities can be put to several uses. A commodity having several uses is said to have a composite demand. For example, electricity can be used for fighting, cooking, heating, cooling and so on. At a higher price, electricity may not be used for all of these purposes, i.e., the use of electricity may be restricted to lighting only. But, if price of electricity falls, people may afford to use it for other purposes also. Thus, the demand of electricity at a lower price will increase.
All the factors discussed above are responsible for the downward slope of the demand curve. In other words, these factors explain the operation of the law of demand.