The demand curve describes the relationship between price and quantity. It states how much of a good a consumer is willing to purchase for a given price.
The demand curve is a negative relationship, which means that as the price of a good increases, the quantity demanded decreases - thus, the demand curve slopes downwards.
Superficially, the demand curve is a negative relationship because people desire to purchase more of a good the cheaper it becomes.
The reason why the demand curve is downward sloping is because of the following two reasons:
Income and Substitution effect
- Income effect: The income effect says that as the price of a good increases, consumers are able to afford less goods, and therefore purchase less goods.
- Substitution effect: The substitution effect says that as the price of a good increases, consumers will substitute towards other goods, and therefore decrease their consumption of this good.
In economic terms, we say that there are two reasons for why the demand curve is downward sloping (1) the income effect and (2) the substitution effect. What does this mean though?
The best way to capture how the income effect works is to imagine that you live in a one-good world.
Imagine you have $10 income which you are going to spend all of this on the one good (remember, we assume that consumers spend all income) - let's assume that this good is donuts.
If the price of donuts are $10, you can obviously only buy 1 donut.
If the price of donuts are $5, you can buy 2 donuts.
If the price of donuts are $1, you can buy 10 donuts.
If you plotted these points onto an axis with price on the vertical axis and quantity of donuts purchased on the horizontal axis, you would see a negative relationship like such:
If you were to connect the dots you would see that the curve you have drawn is downward sloping.
This diagram should also explain why do we call it a demand curve when it is drawn as a linear (straight) line. Demand curves are typically curved, however, for simplicity we draw them as a straight line.
To have a substitution effect, we can no longer assume that we live in a world where we only consume donuts. We must introduce another good. Thus, let's imagine that there is now another good: Beer - oh what a glorious place this would be to live!
The substitution effect states that as the price of one good gets cheaper we will substitute away from the more expensive good towards the cheaper good.
It is assumed that the more you consume of something, the less "happy" you will get from consuming more units - economist call this diminishing marginal returns.
Now suppose that you have an income of only $1, beer is $1 and donuts are $1. In this case you can only consume one donut or one beer. You may decide that you prefer beer to a donut, so you get a beer. In this case you are giving up one donut for a beer.
Now suppose that the price of a donut is 50 cents so you are deciding between 2 donuts and one beer. Since you are now giving up 2 donuts for a beer, which makes the decision more difficult.
If the price dropped to 25 cents a donut, you would be sacrificing 4 donuts for a beer. Unless you really liked beer you would probably get the 4 donuts - and this is the substitution effect.
As the price of a donuts decrease, you need to give up more donuts to purchase a beer. Therefore, the cheaper the donuts become, the more likely you are to drink less beer and buy more donuts. And this summarises the relationship. As the price decreases, the quantity increases as you are more likely to buy donuts instead of beer. There is the negative relationship and this explains why the curve is downward sloping.
So in summary, because your income seems bigger and other goods seem more expensive, the demand curve slopes downwards.
Finally, we tend to make some assumptions for the demand curve.
- It is assumed that the consumer has not reached a satiation point. In non-technical terms this means that they have not consumed too many of the good. The reason it must be assumed that has not reached a satiation point is because if they did they may not wish to consume anymore goods when the price is lower. And for most goods, this rule probably holds true.
- A consumers income is not dependent on the price of the good. If someones income was dependent on the price of the good, this would cause problems as the demand curve would shift when the price changes - this point will become more understandable when you read the rest of this post!
- Consumers spend all their income now and there are no "intertemporal effects" - people do not save or borrow.
- Ceteris paribus, which means all other things stay the same. This just means that we want to isolate the effects. Obviously things do not operate like this in the real world, but we are trying to isolate the effects.