3 Reasons for the Downward Slope of Demand

Contains description and examples of substitution effect, income effect, and law of diminishing marginal utility

1. THREE REASONS FOR THE DOWNWARD SLOPE OF DEMAND Prepared by Sue Quirante

2. SUBSTITUTION EFFECT When the price of a good increases, the quantity demanded for that good decreases as people switch consumption to a close substitute or alternative which can give them almost the same satisfaction. An example would be if the price of spaghetti increases at the canteen. Instead of buying the spaghetti which is now more expensive, you will tend to buy a close substitute that can make you feel just as full/satisfied for a lower price.

3. LAW OF DIMINISHING MARGINAL UTILITY For every additional unit of consumption of a particular product, there is also an additional satisfaction (marginal utility) that we receive/derive. But this additional satisfaction becomes less and less as we consume even more of the good . For example, when we buy one ice candy and consume it, we feel satisfaction. When we buy one more piece and consume it, we feel satisfaction but to a lesser degree than the first ice candy. If we buy a third piece, we would still feel a certain satisfaction, but it is even less than the second one .

4. LAW OF DIMINISHING MARGINAL UTILITY Another facet to the LDMU though concerns MU/P (marginal utility per peso) or the amount of satisfaction earned for each peso spent on a particular good .   For example, when we spend P10 on ice candy which gives us 100 utils of satisfaction, each peso we spent on that ice candy earned us 10 utils of satisfaction. If the price of ice candy increased to P15, our MU/P would decrease to 6.67 utils per peso. Although we would not calculate in this way when we’re buying ice candy, we would likely feel that now the ice candy is more expensive and not “ sulit ” to buy.

5. INCOME EFFECT There are many facets to the income effect. First , when consumer income increases, ceteris paribus, demand for normal goods increase. This can be illustrated through the shift of the demand curve to the right. Likewise, if consumer incomes drop, demand would decrease, causing the demand curve to shift to the left .   Second, the price increase of a good results in a decrease in the real value of consumer income. Though the nominal (face) value of income stays the same, the real value or purchasing power has in fact decreased .

6. INCOME EFFECT Consider the situation : Suppose a single young professional (yuppie) earns 10,000 net income. 10,000 is the nominal value of his income but its real value is based on its purchasing power. If a spaghetti meal costs 50 pesos, the purchasing power of income is (10,000/50) 200 spaghetti meals.* If the price of a spaghetti meal increases to 75 pesos, the real value of income would decrease (10,000/75) to 133 spaghetti meals, a significant reduction from the previous 200 meals that the yuppie had the potential to buy. Now while we don’t go out into the market and calculate the real value of our income in this way, we typically experience that when the price of a good increases, ceteris paribus (all other factors constant including our income), we feel poorer.

7. INCOME EFFECT *From this situation we can see that the real value of income is based on how much a person’s income can buy not on its nominal (face) value. This is a useful insight you could apply in real life. For example, later on when you’re considering where to work you can use this to compare salaries between a highly-urbanized city and a third class city like Metro Manila and Dumaguete . Although the face value of income in Metro Manila can be very high nominally, its real value may be comparable or even less than the real value of income in Dumaguete because of the difference in the general prices of basic needs in both cities.

8. INCOME EFFECT So it wouldn't be farfetched that an employee earning 20,000 in Metro Manila would only be able to afford watching a movie once a month while an employee earning only 15,000 in Dumaguete would be able to afford watching a movie twice or thrice a month. It’s not just limited to consumption of entertainment either. You can also think about ability to buy real estate (house and lot), medical services, food, travel, etc.