Substitution and income effects and the Law of Demand

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, then the quantity demanded will be quite low.

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.

What we're going to do in this video is dig a little bit deeper into why we have that downward-sloping demand curve. I know what some of y'all are saying: "Well, it kind of makes common sense; if 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. One category of reasons why you might want more of it as the price goes down economists will call the substitution effect. Substitution effect 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 four dollars—then at four dollars, the quantity demanded in the market would be, let's say, that is 100 units of the candy; maybe it's a hundred pounds of the candy.

If the price were to then go to two dollars for some reason—so let's say the price is at two dollars—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." For example, people might be picking between candy and fruit, and maybe at first they were both four dollars a pound.

But now, all of a sudden, if the candy is two dollars a pound or two dollars 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."

That's why you have a higher quantity of candy demanded; this might now be 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 four dollars to two dollars, the cost of those hundred units would now be half as much. It would go from four hundred dollars to two hundred dollars. Therefore, the market would have an extra two hundred dollars to use to buy things with, and some of that extra two hundred dollars they'll buy more candy with, and 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 marginal utility. That's that idea that the first—if you're just getting that first amount of candy, there are going to be people in 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 those folks are satiated, that next incremental amount, that next marginal amount, the utility might be a little bit lower. So as you have more and more candy, the marginal utility goes down. That’s another way of thinking about why we have a downward-sloping demand curve.