Law of Demand Explained with Examples
The Law of Demand Explained Using Examples in the U.S. Economy
The law of demand states that all other things being equal, the quantity bought of a good or service is a function of price. As long as nothing else changes, people will buy less of something when its price rises. They'll buy more when its price falls.
The demand schedule tells you the exact quantity that will be purchased at any given price. A real-life example of how this works in the demand schedule for beef in 2014.
The demand curve plots those numbers on a chart. The quantity is on the horizontal or x-axis, and the price is on the vertical or y-axis.
If the amount bought changes a lot when the price does, then it's called elastic demand. An example of this is ice cream. You can easily get a different dessert if the price rises too high.
If the quantity doesn't change much when the price does, that's called inelastic demand. An example of this is gasoline. You need to buy enough to get to work regardless of the price.
This relationship holds true as long as "all other things remain equal." That part is so important that economists use a Latin term to describe it: ceteris paribus. The "all other things" that need to be equal under ceteris paribus are the other determinants of demand. These are prices of related goods or services, income, tastes or preferences, and expectations. For aggregate demand, the number of buyers in the market is also a determinant.
If the other determinants change, then consumers will buy more or less of the product even though the price remains the same. That's called a shift in the demand curve.
Law of Demand Explained
For example, airlines want to lower costs when oil prices rise to remain profitable. They also don't want to cut flights. Instead, they buy more fuel-efficient planes, fill all seats, and change operations to improve efficiency. As a result, they've raised seat-miles per gallon from 55 in 2005 to 60 in 2011. The law of demand would describe this as the quantity of fuel required by the airlines dropped as the price rose.
Of course, all other things were not equal during this period. In fact, demand for jet fuel was further lessened because airlines' income also dropped at the same time. The 2008 global financial crisis meant that travelers cut back on their demand for air travel. The airlines' expectations about the price of jet fuel also changed. They realized it would probably continue to rise over the long term. The other two determinants of airline's demand for jet fuel stayed the same. They couldn't switch to another fuel, and their tastes or desire to use jet fuel didn't change.
Retailers use the law of demand every time they offer a sale. In the short-term, all other things are equal. Sales are very successful in driving demand. Shoppers respond immediately to the advertised price drop. It works especially well during massive holiday sales, such as Black Friday and Cyber Monday.
The Law of Demand and the Business Cycle
Politicians and central bankers understand the law of demand very well. The Federal Reserve's mandate is to prevent inflation while reducing unemployment. During the expansion phase of the business cycle, the Fed tries to reduce demand for all goods and services by raising the price of everything. It does this with contractionary monetary policy. It raised the fed funds rate, which increases interest rates on loans and mortgages. That has the same effect as raising prices, first on loans, then on everything bought with loans, and finally everything else.
Of course, when prices go up, so does inflation. That's not always a bad thing. The Fed has a 2 percent inflation target for the core inflation rate. The nation's central bank wants that level of mild inflation. It sets an expectation that prices will increase 2 percent a year. Demand increases because people know that things will only cost more next year. They may as well buy it now ceteris paribus.
During a recession or the contraction phase of the business cycle, policymakers have a worse problem. They've got to 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 doesn't reduce the price enough to offset the lower income.
In that case, fiscal policy is needed. The federal government starts spending to create public works jobs. It extends unemployment benefits and cuts taxes. As a result, the deficit increases because the government's tax revenue falls. Once confidence and demand are restored, the deficit should shrink as tax receipts increase.