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Here's a guide to the law of demand.

The law of demand is a basic economics. As the price of at item rises or falls, with all other things staying the same, the demand for it rises or falls. However, despite determining everything from the price of bananas to the average cost of a home in your neighborhood, the law of demand isn’t always as rigid many would like it to be.

What is Demand?

Many consumers can guess that if the price of an item increases, people buy less. Conversely, if the price drops, people buy more.

That’s how the law of demand generally works, but there are five items that help determine the strength of that law. The price of the good is one of them, but so is the price of similar or competing products.

Consumers influence demand as well. Consumer income and taste often play a role in determining an item’s value. Consumer expectations can also either suppress prices or inflate them.

If all of those determining factors stay the same, then the law of demand should function as stated. If not, those factors and others can skew both spending patterns and pricing.

History of the Law of Demand

British economist Alfred Marshall is often credited with developing the law of demand in his book  “Principles of Economics,” published in 1890. Marshall explained how supply and demand work together to influence both the price and the production of goods and services.

“The greater the amount to be sold, the smaller must be the price at which it is offered in order that it may find purchasers,” Marshall wrote. “Or, in other words, the amount demanded increases with a fall in price and diminishes with a rise in price.”

Supply and Demand

Marshall saw the relationship between supply and demand more than a century ago, and the two concepts remain entwined. Consumer demand is weighed against suppliers’ quest for maximum profits.

Suppliers who charge too much can reduce the quantity demanded and drive down profits. Those who don’t charge enough may increase demand, but may not produce enough profit or even cover costs. While suppliers with few competitors or financing plans can produces some extra demand, availability and scarcity can also influence pricing.

Those supply variables can help explain why a gallon of gas never seems to cost the same from one fill-up to the next. It can explain why someone trying to sell a home gets multiple offers or isn’t getting any offers. It can guide choices ranging from which college major to choose to which collectible vehicle to bid on.

 

The Demand Curve

Here's a guide to the law of demand.

The demand curve is a sloping line on a chart that represents the relationship between price and demand. That chart’s vertical axis is the demand for a good or service, while horizontal axis is the price of that good or service.

The demand curve normally slopes downward to the right, signifying that demand rises as price falls. A supply curve, meanwhile, slopes upward as the quantity of goods offered increases with price.

The point where those two curves intersect, the market equilibrium, routinely changes. Determining factors can make demand elastic (demand changes faster than price), or inelastic (demand changes slower than price)  And there are even more variables affecting the law of demand.

Market Demand and Aggregate Demand

Each good creates its own market with its own demand. That market demand is typically covered by the same determining factors as the law of demand, but also considers the number of buyers in the market.

When you put all of the markets for all of the goods and services in one nation together and use them to gauge demand, the result is aggregate demand. That demand from the rest of the globe is determined by a combination of consumer and business investment and government spending. Exports of those goods and service enter the equation as well, and imports are subtracted from the total.

Demand and the Federal Reserve

Here's a guide to the law of demand.

A big part of the Federal Reserve’s job is regulating aggregate demand. To reduce demand, it can raise prices by slowing the supply of money and available credit while raising interest rates. Meanwhile, as it did after the latest financial crisis, the Fed can attempt to increase demand by increasing the supply of money and lowering interest rates.

While the Fed has some ability to increase or decrease the amount of money consumers and businesses spend, it isn’t always successful. When the country copes with recession or unemployment, it’s ultimately up to Congress to increase demand by either cutting taxes or increasing services like unemployment benefits or business subsidies.

Bottom Line

Despite the many variables that affect demand, knowing the law of demand can make it easier to understand economics. It’s may also help you make better decisions about everyday purchases.

Tips on Demand

  • Demand affects everything from the groceries you buy or the neighborhood you live in. A financial advisor may be able to help you use the law of demand to your advantage. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Demand likely will be just one of your worries if you’re starting a small business. SmartAsset’s small business guide can help you see what you’re up against and what you’ll need to create and sustain demand.

Photo credit: ©iStock.com/crazydiva, ©iStock.com/Ildo Frazao, ©iStock.com/blackred

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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