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Assumptions underlying the law of demand (HL only)

Let us delve a little deeper into what lies behind the law of demand in terms of the behaviour of the consumer. The two assumptions underlying the law of demand that we will consider are:

  1. The income and substitution effect

  2. The law of diminishing marginal utility

Income and substitution effect

Suppose the three items at the school cafe that interest you during break are:

  1. Cappuccino

  2. Croissant

  3. Sandwich

Their prices in the Romanian currency - the Romanian Leu (RON) are shown below. Your weekly allowance is 100 RON and you distribute your weekly consumption across these three items every week.

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Now, if the price of a croissant is lowered to 10 RON, how will your spending behaviour change? How is this going to affect your weekly consumption of these three items?

 

Let us look at some possibilities:

 

  1. A croissant is now relatively cheaper compared to a sandwich, in particular. You are likely to increase your consumption of croissants. In other words, you might substitute a croissant for a sandwich. This behaviour is referred to as the substitution effect. When the price of a good falls, ceteris paribus, the good becomes cheaper relative to other goods in the consumer’s basket. The consumer will therefore substitute this good for other goods. This is known as the substitution effect.

  2. The fall in the price of the croissant makes you feel richer. This is because your 'real' allowance is now higher as you can purchase more than you were able to earlier. This notional increase in your allowance encourages you to spend more on all goods including a croissant. This behaviour is called the income effect. Economists use the term real income for income adjusted for purchasing power. When the price of a good falls, ceteris paribus, the consumer’s real income increases and the consumer can buy more of all goods including the one under consideration. This is known as the income effect.

Both the income and the substitution effects enable us to explain the law of demand. In other words, the negative relation between price and quantity demanded rests on the assumption of the income and substitution effects being relevant.

The law of diminishing marginal utility

When looking at the evolution of economic thought, we discussed the marginal revolution in economics. As a result of this shift in thinking, the importance of the marginal (or additional or last) unit as opposed to the total in decision-making was universally acknowledged. We will now look more closely at marginal utility and how it varies with the increased consumption of the good. 

 

Let's recall a few definitions first:

 

  1. Utility is the use-value or satisfaction gained from the consumption of goods and services.

  2. Total utility is the total satisfaction gained from all the units consumed upto that point. For example, the total utility gained from the consumption of two slices of pizza.

  3. Marginal utility is the satisfaction gained from consuming the last unit of a good or service. It is the satisfaction from that specific unit such as the utility of the second slice of pizza.

How do we measure utility? Utility is subjective - your utility from playing FIFA 20 is different from the kind of utility that I can hope to get from the same! This makes it very difficult to measure utility. Economists measure utility in terms of the price a person is willing to pay for a unit of the good. lf you are willing to pay $2 for a hairband, the pleasure or utility or satisfaction that you expect to get from it must be, at least, worth $2. The unit of utility is therefore a monetary unit.

Utility is measured in terms of the amount of money a person is willing to pay for a certain amount of the good.

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Consider an example: you are on your way back from school in the afternoon. It has been a long day and you are very, very hungry. You stop at a cafe on your way home and see a stack of chocolate chip cookies. You ask for one and start devouring it. Your blood sugar rises and you get instant satisfaction. Under these circumstances, how much would you be willing to pay for this cookie? Perhaps, a very high price as you are desperate for food? May be 5 $? What about the next one? Note that this is not the price that you actually pay but the price that you are willing to pay. Try completing the following table in your notebooks:

Does your table look similar to the second column in the table below? What you have just done is to identify the marginal utility, for you, of the last cookie consumed. With reference to the table below, the second unit is still welcome so you might get a utility worth 4.5 $ . However, you will notice that successive units become less and less worthwhile as your hunger gets satisfied. This principle is known as the law of diminishing marginal utilityAs a consumer consumes increasing quantities of the same good in a given period of time, ceteris paribus, the marginal utility of the extra unit declines.

Having considered, marginal utility let us turn to total utility. Total utility is the sum of the utilities from all the units consumed up to that point. We have added the third column above to show total utility. Note as the consumer consumes more, the total utility may increase but the marginal or additional utility decreases.

What is the relation between marginal utility and the quantity demanded by a consumer? As a consumer consumes more and more of a good its marginal utility progressively decreases. Thus, the maximum price that the consumer is willing to pay for an additional unit of the good decreases. This negative relation between quantity demanded and the price that the consumer is willing to pay for an extra unit of the good manifests (appears) as the negative relation between price and the quantity demanded at that price. Thus, the principle of diminishing marginal utility also lies behind the law of demand. 

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