As discussed, marginal utility (MU) is the satisfaction gained from consuming one additional unit of a good. We've already plotted our total utility against our marginal utility on a graph (are we able to link this graph here?).

If we wanted to plot a demand curve using marginal utility, we could replace the price on the Y-axis with MU and keep quantity on the X-axis just like we did on the left hand side above.

Interestingly, the marginal utility curve looks exactly like a demand curve. You might be wondering, why is this the case?

• Remember, we are trying to explain the law of demand in another way using marginal utility which is all about our satisfaction!

Say you have a favourite snack. if the price of the snack remains high, you might stop buying more after a few bites because the added satisfaction just isn't worth the cost.

However, if the price drops, you're more likely to keep buying more because even though each additional bite gives you less satisfaction, the lower cost makes it worth it.

This explains why consumers like you and me buy more units of a product only when the price goes down: the lower price compensates for the lower satisfaction gained from consuming each additional unit.

• This therefore explains using marginal utility why the demand curve slopes downwards!

Now, let's talk about how changes in prices can make you feel richer or poorer, affecting your demand.

Income Effect Definition: The income effect describes how a change in the price of a good affects the purchasing power of a consumer's income, leading to a change in the quantity demanded of that good.

• Example: Imagine you have £10 to spend each day.
• If rice costs £3 per bag, and you spend £3 on rice, you have £7 left for other things.
• Price Drop: If the price of rice drops to £2 per bag, you still have your £10, but now you spend only £2 on rice and have £8 left over. It feels like you have more money, so you might buy more rice or other things.
• Price Increase: If the price of rice goes back up to £3, you spend £3 on rice again, leaving you with only £7 for other things. It feels like you have less money, so you might buy less rice or other things.

• Feeling Richer: When prices drop, you feel richer because your money goes further. This might make you want to buy more of the good whose price dropped or other goods.
• Feeling Poorer: When prices rise, you feel poorer because your money doesn’t go as far. This might make you want to buy less of the good whose price increased or other goods.
• Impact on Demand: This change in your purchasing power helps explain why demand for a product falls when its price rises. It becomes less affordable, so you buy less of it and vice versa.

The substitution effect definition: The substitution effect is the change in the quantity demanded of a good due to a change in its price, making it more or less attractive relative to other substitute goods.

• Substitute goods are products that can be used in place of each other
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Can you think of substitute goods to Rice?

Let’s say pasta and rice both costs £5:

• Price Drop: If the price of rice falls to £3, rice becomes cheaper compared to pasta. Even if the price of pasta stays the same at £5, pasta now feels more expensive. You might buy more rice instead of pasta, increasing the quantity demanded for rice.
• Price Increase: If the price of rice rises to £6, pasta feels cheaper by comparison as its price remains at £5. You might switch from rice to pasta, reducing your demand for rice.

As one good becomes cheaper, we buy more of it instead of its substitutes, and vice versa. This effect also contributes to the downward slope of the demand curve:

However, there are some interesting exceptions to this rule and it is sometimes the case that the demand curve slopes upwards instead of downwards!

Let's explore a few of them.

Definition: Giffen goods involves low-income consumers purchasing more basic food products as prices increase, because they cannot afford to purchase anything else

Imagine you're buying a basic food item like bread. Normally, if the price of bread goes up, you'd buy less bread. But what if bread is such a big part of your diet that you can't afford to buy other foods when it gets more expensive?

In this case, you might actually end up buying more bread because it's still the cheapest way to get full. This kind of strange situation is what economists call a "Giffen good."

• Example: If a staple food like bread gets more expensive and your income doesn't change, you might have to spend more on bread and less on other foods, leading you to buy more bread instead of less.

Definition: Veblen goods involve consumers purchasing more of a good because it is well-known/expensive, to “show off”.

Now let's think about luxury items like designer clothes or fancy cars. Sometimes, people buy these items not just because they need them, but because they want to show off. If the price of these items goes up, they might actually become more desirable because owning them makes you look rich and successful. These are called "Veblen goods."

• Example: If the price of a luxury car increases, some people might want it even more because it shows they can afford something expensive, making it a status symbol.

Definition: Speculation is when consumers purchase more of a good when its price rises because they expect it to rise further in the future

Speculation is all about guessing what will happen to prices in the future and making decisions based on those guesses. Sometimes, if people think the price of something will go up in the future, they might buy more of it now, even if the current price is already high. This can create an exception to the law of demand.

• Example: If people believe the price of a certain stock is going to skyrocket, they might buy a lot of it now, even if it's already expensive, hoping to sell it for a profit later.

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Did you know? Real estate speculation played a significant role in the 2008 financial crisis. Speculators took risky loans to buy lots of houses, hoping their prices would keep going up. When prices crashed, it caused big problems for banks and the economy, leading to a global recession.

Housing speculation and its economic consequences

Housing speculation became a national phenomenon in the low interest rate environment of the US during the mid-2000s. This column argues that speculation, which was largely independent of the credit expansion to subprime households, contributed significantly to US housing and economic cycles in the 2000s. It led not only to greater price appreciation, economic expansions, and housing construction during the boom in 2004–2006, but also to more severe economic downturns during the subsequent bust in 2007–2009.

cepr.org

Definition: Anticipatory purchases occur when consumers buy more of a product as they expect its price to rise in the future.

Anticipatory purchases happen when consumers believe that the price of a product, like petrol before a budget announcement, might increase soon. This behaviour can lead to increased demand even before the price actually rises.

• Example: Motorists might buy more petrol if they anticipate a price increase in an upcoming budget announcement.

Perceived quality and demand refer to situations where consumers associate high price with high quality, leading to increased demand.

When consumers perceive that a high price indicates superior quality, they may be willing to buy more of a product, even if its actual quality is not easily distinguishable.

• Example: Expensive shampoos like Aussie may see increased demand simply because consumers associate higher prices with better quality, regardless of the actual differences in product quality.

• Giffen Goods: Necessities that people buy more of when prices rise, due to budget constraints on other items.
• Veblen Goods: Luxury items that become more desirable as their prices increase, due to their status symbol appeal.
• Speculation: Buying more of something now because you think its price will rise in the future, even if it's already expensive.
• Anticipation: Purchasing more of a product in anticipation of future price increases or scarcity, to benefit from current conditions or avoid higher costs later.
• Perceived Quality and Demand: When consumers associate higher prices with higher quality, leading to increased demand for goods perceived as premium, regardless of actual differences in quality.

These exceptions show that human behaviour can sometimes be unpredictable and doesn't always follow the simple rules of supply and demand!