The Law of Demand in Neoclassical Economics

The two videos below give us a basic summary of the law of demand in neoclassical economics.






First, I will prefix all I say below with the obvious fact that, empirically speaking, we can see many commodity markets where prices and demand do indeed seem to behave like supply and demand curves: that is, demand will rise as the price falls (Keen 2011: 72–73). But this is a synthetic proposition whose truth is established empirically, and admits that there are many exceptions, and important exceptions, too. Above all, a description of an observed regularity in economic life is not the same thing as asserting a highly abstract, universal and necessarily true law, as in the law of demand.

Supply and demand are the basis of the neoclassical model of how prices are set in a market economy. For the law of demand, these are the crucial concepts:

Demand
The want, need or desire for an individual good backed by the necessary means of exchange (usually just money) to purchase it. That is, demand is understood as both desire for a good and the ability to pay for it.

Normal good
A good the demand for which increases as income rises, or for which demand decreases when income falls. A non-inferior good.

Inferior good
A good for which demand falls as income increases.

Substitute
Goods that are economically interchangeable. A good which can be substituted for another in the sense of fulfilling the same or similar wants, desires or needs. Formally, if one product sees increased demand when another’s price rises, and when consumer income is raised to compensate for the loss of purchasing power, then it is a substitute. A “gross substitute” is a good substituted for another without any compensating change in income. The concept of a substitute can also be used to refer to groups of commodities.

Complement
A good whose demand is related to another good, e.g., cars and petrol.

Cross elasticity of demand
The proportionate change in the quantity demanded of a good divided by the proportionate change in the price of another good. It serves as a measure of the degree of substitutability between two products.

Substitution effect
This is the substitution of one good for another that arises from changes in their relative prices but when total utility of consumers is left constant (that is, if there were a compensating transfer of income). This is supposed to isolate the impact of a change in relative prices from the income effect. When a good’s price falls, demand for it increases partly because it is cheaper relative to other goods for which it is a substitute. Along with the income effect, this is supposed to explain why demand curves are downward sloping.

Demand schedule
The relation between various prices and quantities of a good demanded illustrated in a table. One can construct a demand curve from a demand schedule.

Demand curve
This is the graphical representation of a demand schedule, or a graph showing the relationship between each price of a good and the quantity demanded at that price, constructed from a demand schedule. Price is shown on the vertical axis, and the quantity demanded on the horizontal axis. Demand curves may show the demand of an individual consumer or the whole market. The curve slopes downwards from left to right since the quantity demanded is negatively related to the price. When economists speak of “demand” in relation to demand curves, this can mean the whole curve, while quantity demanded is a point on the curve.

The law of demand asserts that, as the price of a good rises, the quantity demanded falls, and as the price of a good falls the quantity demanded rises. That is, the price and quantity demanded are always negatively inclined ceteris paribus.

Yet another way to describe this is to say that demand is a relation between price and quantity demanded ceteris paribus.

It is clear that the “law” is expressed in terms that are highly artificial and abstract. The phrase ceteris paribus is Latin for “[all] other things being equal.” The factors that must be held constant are vast: incomes, prices of other goods, fashions, expectations, information, preferences/tastes, population, the weather, etc. In fact, in economics textbooks it is sometimes stated that ceteris paribus includes anything except price. If one or more factors other than price changes, then a demand curve may shift to the right or left, which reflects an increase in demand or decrease in demand respectively. When a demand curve shifts, it is called a “change in demand.” One must always distinguish between

(1) movements along demand curves, and

(2) shifts in demand curves from the left or right.

Even so, the ceteris paribus assumption required in the law of demand gives neoclassical economics a “get-out-of-jail-free” card, because it limits the conditions under which the law holds true, and allows advocates of the law of demand to say in response to virtually all obvious real world exceptions that they violate the ceteris paribus assumption.

For example, one can point to these exceptions to the law of demand:

(1) Giffen goods/inferior goods;

(2) Veblen goods/”snob” goods;

(3) goods/assets on speculative markets in a bubble;

(4) goods where a psychological bias relating to the relationship between price and quality exists
E.g., Some consumers evaluate the quality of a good from its price. That means that some consumers could in theory prefer higher priced goods to lower priced goods and shun cheaper goods under the impression that cheaper goods are inferior (even when they are not);

(5) Demand during times of scarcity or fear of scarcity
Fear of expectation of shortages or scarcity during abnormal times (disaster or war) can cause people to buy more of a good even as their price rises, to stock up in the expectation of insufficient supply in the future;

(6) Necessities
The basic staples of everyday life often have a stable demand even when prices rise.

Some of these have moderate to profound significance in capitalist economies, such as (3), (2), and (6). The real world existence of (1) is sometimes disputed (indeed Blaug [1997: 335, n. 3] goes so far as to assert that “no clear-cut example of a Giffen good has ever been found”).

But the response of a neoclassical advocate of the law of demand to these examples is, quite simply, that they do not invalidate the law of demand, because most of the examples themselves violate the ceteris paribus assumption. Technically, that is correct, but immediately raises the question of what use a highly abstract law is when its ceteris paribus assumption can arguably never hold true in the real world.

So when somebody asserts that the law of demand is universally true, what this means is that, in an imaginary, utterly abstract and artificial world in which “all other things were equal,” demand for a product would always rise as its price falls, and demand would always fall as the price rises. Eventually as the price falls, there would be an equilibrium (or market-clearing) price, which would equate demand with supply, assuming that there is actual demand for the good.

But pick up most economics textbooks and it is freely admitted that in the real world the quantity demanded of a good at any particular price depends on many different variables apart from price. That is why a universal “law of demand” reeks of anti-empirical and unrealistic abstraction.

Lazy users of the law of demand invoke it as an (imagined) argument against many forms of government intervention, such as, for example, minimum wage laws. The complaint will be that minimum wage laws can only ever necessarily increase unemployment, because a rise in the price of labour reduces demand for labour, according to the law of demand. Yet these types of arguments are absurd beyond words, because

(1) the real world never fulfils the ceteris paribus assumption and hence the law of demand, properly formulated, is irrelevant, and

(2) economies are immensely complex and the level of employment is dependent on many factors well beyond the simple dynamics of supply and demand curves. The demand for labour is dependent, above all, on aggregate demand for products, and this, along with many other factors, would compensate for and overwhelm any reduction in demand from higher wages, even assuming the abstract formulation of the law is true.

It does not follow that minimum wage laws can only ever necessarily increase unemployment at all.

Note that all this is before we get to higher-level criticism of the law of demand on its own abstract terms.

For the simple question is: how can it even be proven that the “law of demand” is true even in its highly abstract definition? Steve Keen demonstrates how the law of demand can be proven only in the case of a single consumer (Keen 2011: 51). Nor can we generalise the law of demand and prove that it necessarily applies to a whole market either (Keen 2011: 51). But I will leave a thorough critique of the law of demand for another post.

BIBLIOGRAPHY
Blaug, Mark 1996. Economic Theory in Retrospect (5th edn.). Cambridge University Press, Cambridge.

Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn). Zed Books, London and New York.