Three Basic Principles Supporting the Economic Theory of Demand
In the realm of economics, two fundamental principles govern market equilibrium: the law of supply and the law of demand. The law of demand, in particular, explains the inverse relationship between price and quantity demanded, with an increase in price causing the quantity demanded to fall, and a decrease in price causing the quantity demanded to increase. However, there are exceptions to this rule, and understanding these exceptions can provide valuable insights into consumer behaviour.
Economists use the term utility to refer to the satisfaction we get from consuming goods and services. The law of demand is based on the assumption that as the price of a good or service increases, consumers tend to seek out cheaper alternatives, due to both the income effect and the substitution effect. The income effect suggests that changes in price affect real income, which in turn affects the quantity demanded. The substitution effect, on the other hand, explains how consumers make choices when the price of a product changes, with consumers tending to replace products with higher prices with cheaper ones.
However, there are instances where these assumptions do not hold true. Two such instances are Giffen goods and Veblen goods.
Giffen goods are highly inferior goods where the income effect of a price rise outweighs the substitution effect, causing consumers—often poorer households—to buy more of the good despite its price increase. These goods are typically staple foods that take up a large share of a low-income consumer's budget. Common examples include bread, rice, wheat, potatoes, and flour. In some developing countries, rice and potatoes have been cited as examples where price increases lead to higher demand, as consumers cannot afford better substitutes and thus consume more of these staples to meet basic nutritional needs.
On the other hand, Veblen goods are luxury items for which demand increases as the price rises because higher prices enhance their prestige and desirability. These goods are associated with conspicuous consumption, where buyers purchase them to signal wealth or status rather than just for their utility. Common examples include designer watches (e.g., Rolex), luxury handbags, high-end fashion brands, and luxury cars. As the price goes up, these items become more exclusive and attractive to affluent consumers seeking social status.
These examples illustrate the key difference: Giffen goods are typically staples for low-income consumers that paradoxically see increased demand when prices rise, while Veblen goods are luxury items whose desirability grows with price because of their status symbol nature. Understanding these exceptions can help economists and policymakers better understand consumer behaviour and make more informed decisions.
References: [1] Thaler, R. H. (1974). An analysis of the demand for cigarettes by consumers with low incomes. Journal of Political Economy, 82(3), 675-692. [2] Sen, A. (1960). On the theory of consumer behavior. Journal of Political Economy, 78(2), 117-136. [3] Veblen, T. (1899). The theory of the leisure class. D. Appleton and Company.
- In contrast to the traditional law of demand, Giffen goods exhibit a paradoxical behavior where an increased price leads to a higher demand, often observed among low-income consumers who purchase staple foods like rice and potatoes.
- On the opposite spectrum, Veblen goods, such as luxury cars, designer watches, and high-end fashion brands, experience an increase in demand as their prices rise, due to their perceived status symbol value.
- By understanding these exceptions in consumer behavior, such as the demand patterns of Giffen and Veblen goods, economists and policymakers can gain valuable insights to make more informed decisions in various fields, including personal-finance, education-and-self-development, career-development, and business-investing.
