What is 'Demand Theory'

Demand theory is a principle relating to the relationship between consumer demand for goods and services and their prices. Demand theory forms the basis for the demand curve, which relates consumer desire to the amount of goods available. As more of a good or service is available, demand drops and so does the equilibrium price.

BREAKING DOWN 'Demand Theory'

Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. People demand goods and services in an economy to satisfy their wants, such as food, healthcare, clothing, entertainment, shelter, etc. The demand for a product at a certain price reflects the satisfaction that an individual expects from consuming the product. This level of satisfaction is referred to as utility and it differs from consumer to consumer. The demand for a good or service depends on two factors: (1) its utility to satisfy a want or need, and (2) the consumer’s ability to pay for the good or service. In effect, real demand is when the readiness to satisfy a want is backed up by the individual’s ability and willingness to pay.

Built into demand are factors such as consumer preferences, tastes, choices, etc. Evaluating demand in an economy is, therefore, one of the most important decision-making variables that a business must analyze if it is to survive and grow in a competitive market. The market system is governed by the laws of supply and demand, which determine the prices of goods and services. When supply equals demand, prices are said to be in a state of equilibrium. When demand is higher than supply, prices increase to reflect scarcity. Conversely, when demand is lower than supply, prices fall due to the surplus.

The law of demand introduces an inverse relationship between price and demand for a good or service. It simply states that as the price of a commodity increases, demand decreases, provided other factors remain constant. Also, as the price decreases, demand increases. This relationship can be illustrated graphically using a tool known as the demand curve.

The demand curve has a negative slope as it charts downward from left to right to reflect the inverse relationship between the price of an item and the quantity demanded over a period of time. An expansion or contraction of demand occurs as a result of the income effect or substitution effect. When the price of a commodity falls, an individual can get the same level of satisfaction for less expenditure, provided it’s a normal good. In this case, the consumer can purchase more of the goods on a given budget. This is the income effect. The substitution effect is observed when consumers switch from more costly goods to substitutes that have fallen in price. As more people buy the good with the lower price, demand increases.

Sometimes, consumers buy more or less of a good or service due to factors other than price. This is referred to as a change in demand. A change in demand refers to a shift in the demand curve to the right or left following a change in consumers’ preferences, taste, income, etc. For example, a consumer who receives an income raise at work will have more disposable income to spend on goods in the markets, regardless of whether prices fall, leading to a shift to the right of the demand curve.

The law of demand is violated when dealing with Giffen or inferior goods. Giffen goods are inferior goods that people consume more of as prices rise, and vice versa. Since a Giffen good does not have easily available substitutes, the income effect dominates the substitution effect.

Demand theory is one of the core theories of microeconomics. It aims to answer basic questions about how badly people want things, and how demand is impacted by income levels and satisfaction (utility). Based on the perceived utility of goods and services by consumers, companies adjust the supply available and the prices charged.

RELATED TERMS
  1. Demand

    Demand is an economic principle that describes consumer willingness ...
  2. Demand Curve

    The demand curve is a representation of the correlation between ...
  3. Income Effect

    The income effect is the change in demand for a good or service ...
  4. Consumer Surplus

    Consumer surplus is an economic measure of consumer satisfaction, ...
  5. Demand Shock

    A demand shock is a sudden surprise event that temporarily increases ...
  6. Derived Demand

    Derived demand is the demand for a good or service resulting ...
Related Articles
  1. Insights

    How supply and demand affects inelastic goods

    Find out how the laws of supply and demand function for goods and services that are considered highly inelastic, including goods not yet discovered.
  2. Investing

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  3. Insights

    Why We Splurge When Times Are Good

    The concept of elasticity of demand is part of every purchase you make. Find out how it works.
  4. Insights

    4 Factors That Shape Market Trends

    Discover the four major factors that shape market trends: Government, international transactions, speculation/expectation, and supply and demand. These areas are all linked as expected future ...
  5. Insights

    The Dangers Of Deflation

    We look at what life would be like in a deflationary environment, and what you can do to protect your investments.
  6. Personal Finance

    How Microeconomics Affects Everyday Life

    Microeconomics is the study of how individuals and businesses make decisions to maximize satisfaction. To illustrate, we use the example of renting a New York City apartment.
  7. Investing

    What is the Income Effect?

    In economics, the income effect is the change in the consumption of goods caused by a change in income, whether income goes up or down.
RELATED FAQS
  1. Are there any exceptions to the law of demand in economics?

    Read about some possible exceptions to the law of demand in microeconomics price charts, and learn why those exceptions do ... Read Answer >>
  2. What are some examples of the law of demand in real markets?

    Find out how the price of a good or service affects the quantity demanded, and explore instances of consumption reflecting ... Read Answer >>
  3. How does aggregate demand affect price level?

    Prices coordinate supply and demand, and they are also determined by it; there is no clean, direct and one-dimensional link ... Read Answer >>
  4. Why are price and quantity inversely related according to the law of demand?

    Discover why the cost of a good is inversely correlated to its quantity demanded according to the law of demand in microeconomic ... Read Answer >>
  5. How does the law of supply and demand affect the housing market?

    Learn about the law of supply and demand, the relationship between supply and demand, and how it affects the housing market. Read Answer >>
  6. Which factors are more important in determining the demand elasticity of a good or ...

    Learn about demand elasticity of goods and services and the main factors that influence the elasticity of demand. Read Answer >>
Trading Center