Following are the main causes responsible for this relationship and downward slope of the demand curve.
1. Effect of the law of diminishing marginal utility:
The law of demand can be explained in terms of the law of Diminishing Marginal Utility. According to this law, the marginal utility of a good to a consumer becomes less and less as he purchases more and more of that good. The phenomenon of diminishing marginal utility is illustrated in Table-7.
While buying a commodity, the consumer compares its marginal utility with price. It stops buying the commodity at that point where MU = Price. For example, if he buys only 3 units of X, because here MUX = Px. If price falls to Rs. 4/- he buys 4 units.
If prices rises to Rs. 8/- buys only 2 units in order to equalise price with marginal utility so as to maximise his satisfaction. Therefore, consumer buys more when price falls and vice versa. Due to this reason the demand curve slopes downwards.
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2. Income effect:
The law of demand operates or the slope of the demand curve slopes downward to right because of the income effect. When the price of a commodity changes, the consumer’s real income or purchasing power of his money income changes leading to a change in quantity demanded. This is called income effect. When the price of a commodity falls, it increases the real income or purchasing power.
This increase in real income induces the consumer to buy more of the same commodity or the same quantity of the commodity by spending less amount of money. To illustrate suppose a consumer has got eight rupees with him. He can get with rupees eight four eggs as the price per unit of egg is rupees two.
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If the price of egg is reduced to rupees one, then he can get four eggs by spending rupees four. He has a surplus income of rupees four. This is called income effect of price reduction.
On the other hand, if he spends rupees eight for purchasing eggs he can get eight eggs. This increases his real income. So when price falls real income increases and people purchase more of eggs.
3. Substitution effect:
Substitution effect also leads the demand curve to slope from left to right. As the price of a commodity falls, prices of its substitute goods remains the same, the consumer will buy more of that commodity.
For instance, tea and coffee are substitute goods. If the price of tea goes down, the consumers may substitute tea for coffee, although price of coffee remains the same.
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Therefore, with a fall in price, the demand will increase due to favourable substitution effect. On the other hand, with the rise in price, the demand falls due to unfavourable substitution effect. This is nothing but the application of law of demand.
4. Entry of new consumers:
With a fall in price of a commodity, some new consumers, who previously could not purchase the commodity, would start purchasing it.
Similarly, with a fall in price some old consumers might be induced to purchase more. The effect of all these will be that as the price falls, the demand for commodity concerned will rise and vice versa.
5. Psychological effect:
Another factor responsible for downward slope of demand curve is the psychological effect. Generally, people favour to buy more when price falls and vice versa.