Earn your certification as a Financial Modeling & Valuation Analyst (FMVA)™. Register today!

Law of Demand

The inverse relationship between the quantity of the good demanded and its price

What is the Law of Demand?

The law of demand states that the quantity demanded of a good shows an inverse relationship with the price of a good when other factors are held constant (cetris peribus). It means that as the good’s quantity demanded increases, the price of the good decreases.

The law of demand is a fundamental principle in macroeconomics. It is used together with the law of supply to determine the efficient allocation of resources in an economy and finding the optimal price and quantity of goods.

 

Law of Demand
Figure 1. Demand Curve Approximation

 

Graphical Representation of the Law of Demand

The law of demand is usually represented as a graph. The graphical representation of the law of demand is a curve that determines the relationships between the quantity demanded and the prices of a good.

The shape of the demand curve can vary among different types of goods. Most frequently, the demand curve shows a concave shape. However, in many economics textbooks, we can also see the demand curve as a straight line.

The demand curve is drawn against the quantity demanded on the x-axis and the price on the y-axis. The definition of the law of demand determines that the demand curve is downward sloping.

It is always worth to distinguish the difference between the demand and the quantity demanded. The quantity demanded is the number of goods that the consumers are willing to buy at a given price point. On the other hand, the demand represents all the available relationships between the good’s prices and the quantity demanded.

 

Exceptions to the Law of Demand

Unlike the laws of mathematics or physics, the laws of economics are not universal. For example, the law of demand comes with a few exceptions. Some goods do not show an inverse relationship between the price and the quantity. Therefore, the demand curve for these goods is upward-sloping.

 

1. Giffen goods

They are inferior goods that lack close substitutes that represent the large portion of the consumer’s income. The existence of such goods was proposed by Scottish economist Sir Robert Giffen in the 19th century. Giffen goods violate the law of demand because the prices of these goods increase with the increase in the quantity demanded. However, Giffen goods remain mostly a theoretical concept as there is limited empirical evidence of their existence in the real world.

 

2. Veblen goods

They are certain types of luxury goods that violate the law of demand. Veblen goods are named after American economist Thorstein Veblen. Generally, they are luxury goods that indicate the economic and social status of the owner. Therefore, consumers are willing to consume Veblen goods, even more with the price increases. Some examples of Veblen goods include luxury cars, expensive wines, and designer clothes.

 

The Law of Demand in the Real World

The law of demand comes with important applications in the real world. The economic principle guides the actions of politicians and policymakers. The law of demand is quintessential for the fiscal and monetary policies that are undertaken by governments around the world. The policies generally intend to increase or decrease demand to influence the country’s economy.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)™ by completing CFI’s online financial modeling classes!