Price and Quantity Changes
The law of demand states that buyers of a good will purchase more of the good if its price is lower, and vice versa.
This assumes that no other economic changes take place. If the price of apples decreases from $1.79 per pound to $1.59 per pound, consumers will buy more apples.
The law of demand assumes that no other changes take place. This assumption is called “ceteris paribus.” If we don’t make this assumption, then we may notice that the price of apples decreases while fewer apples are purchased. One explanation for this may be that the price of oranges, a substitute product, has decreased more than the price of apples, so that consumers will substitute oranges for apples. Does this violate the law of demand?
There are two primary reasons why people purchase more of a product as its price decreases. One is the “substitution effect.” The substitution effect states that as the price of a product decreases, it becomes cheaper than competing products (assuming that prices of the other products don’t decrease). Consumers will substitute the cheaper product for the more expensive product, and vice versa. For example, if the price of apple juice decreases, then “ceteris paribus,” people will purchase more apple juice instead of, for example, orange juice.
The other effect is the “income effect.” The income effect states that as the price of a product decreases, buyers will have more income available to purchase more products, and vice versa. For example, if someone purchases 10 mobile phone applications each month at $2.00 each, this buyer’s total monthly expenditure on these apps is $20.00. If the price of the apps falls to $1.25, the total expenditure drops to $12.50. This means that this buyer now has $7.50 more income compared to when the price of the apps was $2.00. In essence, this buyer’s real income has increased. This allows the buyer to purchase more apps (law of demand).