What is 'Demand Theory'

Demand theory is a theory 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 for goods and services in an economy to satisfy their wants, such as food, healthcare, clothing, entertainment, shelter, etc. The demand of 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 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 price of a commodity increases, demand decreases, provided other factors remain constant. Also, as prices decrease, 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 slopes 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 alternative goods or substitutes to a product that has 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. Law of Supply and Demand

    The law of supply and demand explains the interaction between ...
  2. Aggregate Demand

    Aggregate demand is the total amount of goods and services demanded ...
  3. Demand Shock

    A sudden surprise event that temporarily increases or decreases ...
  4. Normal Good

    A normal good is one whose demand increases when people's incomes ...
  5. Supply

    Supply is a fundamental economic concept that describes the total ...
  6. Change In Demand

    Change in demand is used to describe a shift in total demand ...
Related Articles
  1. Insights

    Introduction to Supply and Demand

    Learn about one of the most fundamental concepts of economics - supply and demand - and how it relates to your daily purchases.
  2. Insights

    Understanding the Substitution Effect

    The substitution effect is an economic term used to describe consumer behavior relative to price or income changes.
  3. Investing

    Why You Can't Influence Gas Prices

    Neither big oil companies nor consumers are responsible for oil prices: it's basic economics.
  4. Insights

    A Practical Look At Microeconomics

    Learn how individual decision-making turns the gears of our economy.
  5. Insights

    Do Deflationary Shocks Help Or Hurt The Economy?

    Find out how deflationary shocks can both benefit and hurt consumers and businesses.
  6. Insights

    What Is Elasticity?

    Elasticity measures the relationship between a good and its price based on consumer demand, consumer income, and its available supply. Learn the basics about it here.
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. How Does the Law of Supply and Demand Affect Prices?

    Learn how the law of supply and demand affects prices, as when one outweighs the other, prices can rise or fall in response. Read Answer >>
  3. Are there any exceptions to the law of demand?

    Learn more about the law of demand and if exceptions exist for different products. Find out more about how price elasticity ... Read Answer >>
  4. How does aggregate demand affect price level?

    Read about the relationship between aggregate demand and the general price level, and learn why it is difficult to determine ... Read Answer >>
  5. Which factors have the most influence on the law of demand?

    Find out what factors most influence the level of demand for a good or service, and see why demand is based on individual ... Read Answer >>
  6. 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 >>
Hot Definitions
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  2. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  3. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  4. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  5. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  6. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
Trading Center