Demand Theory

Article byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Demand Theory?

Demand theory is an economic principle studying the relationship between consumer demand and the price of goods and services available in a market. It provides the basis for the demand curve, which establishes a link between a product or resource’s price and demand.

Demand Theory

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This concept is one of the main theories of microeconomics. It offers information concerning individuals’ cravings for things and how different income levels and satisfaction impact demand. Moreover, the theory highlights the consumer perspective and demand’s role in price formation. Organizations set the price and adjust the supply based on consumers’ utility of goods and services.

Key Takeaways

  • Demand theory refers to an economic principle emphasizing the relationship between a product or service’s price and demand within a market.
  • As the price of a commodity rises, the quantity demanded falls, assuming all factors stay constant, per the law of demand theory. However, there are two exceptions to the law of demand — Giffen goods and Veblen goods.
  • A downward demand curve slows, representing an inverse relationship between the price and quantity demanded. It can shift to the right or left owing to changes in factors like consumer taste, preference, income, etc.

Demand Theory In Economics Explained

Demand theory definition refers to a principle that focuses on the relationship between demand for products and services and their price within a market. It provides the basis for the demand curve, a downward-sloping curve linking the quantity demanded by consumers for products with their price. According to the law of demand theory, consumer demand falls as the supply of goods and services surges in a market. Resultantly, the equilibrium price drops.

In simple terms, demand is the quantity of a product or service consumers want to purchase for a given price during a certain duration. In an economy, individuals demand goods and services to fulfill their wants, like healthcare, clothing, food, etc. Therefore, the demand for any product at a certain price represents the satisfaction a consumer will get after utilizing the product. This level of satisfaction is utility, and it varies from one consumer to another.

Two factors influence the demand for a product or service. They are as follows:

  • The utility to fulfill a want
  • Consumers’ purchasing power

Effectively, real demand is the willingness to buy a product backed by purchasing power to fulfill a want.

Various factors, such as consumers’ tastes, choices, and preferences, impact demand in an economy. Hence, businesses must consider it a vital decision-making variable and assess it to compete with their peers and expand operations.

The demand and supply forces interact to determine the price of goods and services within a market. All prices were in equilibrium when the quantity demanded equals the quantity supplied. However, when the quantity demanded exceeds the quantity supplied, the price surges to reflect scarcity. Lastly, when demand is lower than supply, prices drop. This is because of the surplus goods available in the market.

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Example

Let us look at this demand theory example to understand the concept better.

Suppose move ticket prices drop to $5 each from $9. The demand for movie tickets will increase. The demand will continue to rise if the utility generated from going to the theaters is more than that price. Once consumers are satisfied and decide that they have watched enough movies for the nonce, the demand for movie tickets will decrease.

Law Of Demand Theory

Per the law of demand theory, an inverse relationship exists between the demand for goods or services and the price. In other words, when a product’s price increases, the quantity demanded decreases. On the flip side, if a commodity’s price falls, the quantity demanded increases, assuming all factors remain constant.

Let us look at the demand curve illustrating the inverse relationship between a product’s price and demand.

law of demand theory graph

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As one can observe, when the price falls from P1 to P2, the quantity demanded falls from Q1 to Q2.

There are times when the demand curve shifts causing a different quantity demanded at a given price. Factors that can shift the demand curve include a change in the following factors:

  • Consumer taste and preferences
  • Income
  • Population
  • Prices of related (substitute or complementary) goods
  • Expectations concerning prices and future conditions

For instance, a person with a higher disposable income would be willing to purchase more products or services at a given price. In this case, the demand curve will shift to the right. 

One must remember that Giffen goods and Veblen goods are two exceptions to the law of demand.

Expansion And Contraction Of Demand

An expansion or contraction of demand may happen owing to the substitution effect or income effect. When a product’s price decreases, a person can get the same satisfaction by spending less, assuming the commodity is a normal good. Since the commodity price falls in this case, consumers can buy a higher quantity of the goods within their budget. This is the income effect.

One can observe the substitution effect when consumers transition from buying expensive goods to substitutes that have become cheaper. As individuals switch to cheaper commodities, the demand rises for substitutes.

Frequently Asked Questions (FAQs)

1. Why do we study consumer demand theory?

Consumer demand theory forms the bedrock of modern economics. It helps one understand consumer behavior as it applies to the decisions concerning purchasing goods or services within a market. It primarily focuses on the utility generated from satisfying wants. The law of diminishing marginal utility is its main principle.

2. What do you mean by reciprocal demand theory?

This theory developed by J.S. Mills refers to the export volumes a nation would offer at different terms of trade in exchange for different import volumes. In other words, reciprocal demand is two nations’ relative strength and elasticity of demand for each other’s commodity in respect of their product.

3. When demand theory does not work?

This theory does not work in the case of Veblen goods and Giffen goods. Another exception to the law of demand is the expectation of price change.

4. What is kinked demand theory?

This theory applies to oligopolistic markets where every firm offers a differentiated commodity. According to it, a firm faces a relatively elastic market demand curve at high prices. Whereas, at low prices, the firm will face a relatively inelastic demand curve.

This article has been a guide to What is Demand Theory and its definition. We explain the law of demand and the expansion and contraction of demand with an example. You can learn more about it from the following articles –

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