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Substitution and income effects and the law of demand

MKT‑3 (EU)
MKT‑3.A (LO)
MKT‑3.A.5 (EK)
Learn about the Law of Demand, which shows that as prices decrease, quantity demanded increases. Explore three reasons for this: substitution effect (buying cheaper alternatives), income effect (extra money to spend), and decreasing marginal utility (less value from additional units), and see how each creates a downward-sloping demand curve.

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Video transcript

- [Narrator] In other videos, we have already talked about the Law of Demand, which tells us, and this is probably already somewhat intuitive for you, that if a certain good is currently at a higher price, that the quantity demanded will be quite low, and then as the price were to decrease, the quantity demanded would increase. So if we were to graph demand, and so this right over here is our demand curve, where price is on our vertical axis and quantity is on our horizontal axis, which is the standard convention for most economists, you would have a downward-sloping demand curve. Well, what we're gonna do in this video is dig a little bit deeper into why we have that downward-sloping demand curve, and I know what some of y'all are saying. "Well, it kind of makes common sense. "As the price goes down, I would want more of that, "and so would everyone else." But let's dig into why you would want more of something as the price goes down. So one category of reasons why you might want more of it as the price goes down, economists will call the substitution effect. Substitution, substitution effect. And this is the idea that if we're looking at the price versus quantity, say, of candy, and let's say at first, the price is right over here at $4, and at $4, the quantity demanded in the market would be, let's say that is 100 units of the candy, maybe it's 100 pounds of the candy, that if the price were to then go to $2 for some reason, so let's say the price is at $2, well, then, a lot of folks could say, "Gee, that candy is looking a lot better "relative to other things that I might buy "with my money." So, for example, people might be picking between candy and fruit, and maybe, at first, they were both $4 a pound, but now all of a sudden, if the candy is $2 a pound, or $2 per unit, well, then, it's looking a lot better relative to the fruit. So some of that quantity of fruit people would have bought, they'll say, "Hey, now candy is a better deal. "I'm going to substitute the fruit with candy." And so that's why you have a higher quantity of candy demanded. This might maybe be now 250 units. Another major category why you would expect this downward-sloping demand curve for normal goods, and we'll talk about things like inferior goods in future videos, is the income effect, income effect. And in some ways, this might be the most intuitive. Well, if the price went from $4 to $2, well, the cost of those 100 units would now be half as much. It would go from $400 to $200. And so the market would have an extra $200 to use to buy things with, and some of that extra $200, they'll buy more candy with. But then they might also buy other things with that. Now the last dimension that economists will often talk about for why the Law of Demand is downward-sloping like this, and we talk about this in other videos, is this idea of decreasing, decreasing marginal utility, and that's that idea that that first, if you're just that first amount of candy, there's gonna be people the market who take a lot of value from it. They are just addicted to candy. Their bodies are dependent on that candy. But as soon as folks are satiated, that next incremental amount, that next marginal amount, the utility might be a little bit lower. And so as you have more and more candy, the marginal utility goes down. And so that's another way of thinking about why we have a downward-sloping demand curve.