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What Is the Law of Demand?

The Law of Demand Explained Using Examples in the U.S. Economy



The law of demand affects everyday grocery prices.

Photo: Tetra Images/Getty Images

The law of demand states that, all other things being equal, there will be less demand for higher priced goods and services. This definition makes sense -- you only have so much money to spend, and if the price of something goes up, you can afford less of it.

However, the "all other things being equal" part is really important. It's so important, in fact, that economists have come up with a fancy Latin term to describe it -- ceteris paribus. The "all other things" that need to be equal under ceteris paribus are the determinants of demand. They are: price, prices of related goods or services, income, tastes or preferences, expectations. For aggregate demand, the number of buyers in the market is also a determinant. In other words, if all other determinants remain the same -- the cost of similar products, income, tastes and expectations -- then the quantity demanded will drop as the price of the item or service rises.

Law of Demand Explained

A great example of how the law of demand works is how airlines have responded to higher oil and jet fuel prices. They needed to buy less fuel but still offer the same number of flights. They've done this by buying more fuel-efficient planes, filling all seats, and changing operations to improve efficiency. As a result, they've raised seat-miles per gallon from 55 in 2005 to 60 in 2011. The law of demand would describe this as the quantity of fuel demanded by the airlines dropped as the price rose.

Of course, all other things were not equal during this time period. In fact, demand for jet fuel was further lessened because airlines' income also dropped at the same time. The 2008 global financial crisis meant that travelers cut back on their demand for airline travel. The airlines expectations about the price of jet fuel also changed -- they realized it would probably continue to rise over the long term. However, the other two determinants of airline's demand for jet fuel stayed the same: they couldn't switch to another fuel, and their tastes or desire to use jet fuel didn't change. (Source: EIA, High airline jet fuel costs prompt cost-saving measures)

Retailers understand the law of demand every time they offer a sale. In the short-term, all other things are equal. That's why sales are usually very successful in driving demand. Shoppers respond immediately to the advertised price drop. This works especially well during massive holiday sales, such as Black Friday and Cyber Monday.

The Law of Demand and the Business Cycle

Politicians and central bankers understand the law of demand very well. The Federal Reserve's mandate is to prevent inflation while reducing unemployment. During the expansion phase of the business cycle, the Fed tries to reduce demand for all goods and services by raising the price of everything. It does this with contractionary monetary policy. It raised the Fed funds rate, which raises interest rates on loans and mortgages. This has the same effect as raising prices, first on loans, then on everything bought with loans, and finally everything else.

Of course, when prices go up, so does inflation. That's not always a bad thing. The Fed actually has an inflation target of 2%. This sets an expectation that prices will increase 2% a year. This actually increases demand because people know that things will only cost more next year. Therefore, they may as well buy it now ceteris paribus.

During a recession, or the contraction phase of the business cycle, policy makers have a worse problem. They've got to stimulate demand when workers are losing jobs and homes, and they have less income and wealth. Expansionary monetary policy lowers interest rates, thereby reducing the price of everything. If the recession is bad enough, this doesn't lower the price enough to offset the lower income and, even worse, expectations of continued low income. In that case, fiscal policy is needed. The federal government usually starts spending to create public works jobs, supplement the income of the unemployed by extending benefits, and cutting taxes. This increase the federal deficit, since the government's income through taxes is usually lower. However, this demand side economics says that, once confidence and demand are restored, the deficit will be reduced as tax receipts increase.

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