What is demand theory?
Demand theory is an economic principle related to the relationship between consumer demand for goods and services and their market prices. Demand theory forms the basis of the demand curve, which links consumer desire to the quantity of goods available. As more goods or services become available, demand decreases, as does the equilibrium price.
Demand theory highlights the role demand plays in price formation, while supply theory promotes the role of supply in the market.
Understanding demand theory
Demand is simply the quantity of a good or service that consumers want and can buy at a given price in a given period of time. People demand goods and services in an economy to meet their needs, such as food, health care, clothing, entertainment, housing, etc. The demand for a product at a certain price reflects the satisfaction that an individual expects from the consumption of the product. This level of satisfaction is called utility and it differs from one consumer to another. The demand for a good or service depends on two factors: (1) its usefulness to satisfy a need or need, and (2) the consumer’s ability to pay for the good or service. Indeed, the real demand is when the will to satisfy a need is reinforced by the ability and willingness to pay of the individual.
Demand theory is one of the fundamental theories of microeconomics. It aims to answer basic questions about how people really want things and how demand is affected by income levels and satisfaction (utility). Depending on the perceived utility of goods and services by consumers, companies adjust the available supply and the prices charged.
Demand includes factors such as consumer preferences, tastes, choices, etc. Assessing demand in an economy is therefore one of the most important decision 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 would be in equilibrium. When demand exceeds supply, prices rise to reflect scarcity. Conversely, when demand is lower than supply, prices fall due to the surplus.
Key points to remember
- Demand theory describes how changes in the quantity of a good or service demanded by consumers affect its price in the market,
- The theory states that the higher the price of a product, all other things being equal, the less it will be demanded, which induces a downward sloping demand curve.
- Likewise, the more demand there is, the higher the price will be for a given offer.
- Demand theory places the primacy on the demand side in the supply-demand relationship.
The law of demand and the demand curve
The law of demand introduces an inverse relationship between the price and the demand for a good or service. It simply indicates that as the price of a product increases, demand decreases, provided that the other factors remain constant. In addition, as the price decreases, demand increases. This relationship can be illustrated graphically using a tool called the demand curve.
The demand curve has a negative slope because it is shown 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 in demand results from the income effect or the substitution effect. When the price of a product falls, an individual can obtain the same level of satisfaction for less expenditure, provided that it is a normal good. In this case, the consumer can buy more goods on a given budget. It’s the income effect. The substitution effect is observed when consumers switch from more expensive products to substitution products whose prices have fallen. As more and more people buy the good at a lower price, demand increases.
Sometimes consumers buy more or less a good or service because of factors other than price. This is called a change in demand. A change in demand refers to a shift in the demand curve to the right or the left following a change in consumer preferences, taste, income, etc. For example, a consumer who receives an increase in income at work will have more disposable income to spend on goods in the market, whether or not prices fall, causing the demand curve to shift to the right.
The law of demand is violated when it comes to Giffen or less products. Giffen goods are inferior goods that people consume more as prices rise, and vice versa. Since a Giffen product has no readily available substitutes, the income effect dominates the substitution effect.
Supply and demand
The law of supply and demand is an economic theory that explains how supply and demand are related to each other and how this relationship affects the price of goods and services. It is a fundamental economic principle that when supply exceeds demand for a good or service, prices fall. When demand exceeds supply, prices tend to rise.
There is an inverse relationship between supply and prices of goods and services when demand is unchanged. If there is an increase in the supply of goods and services while demand remains the same, prices tend to fall at a lower equilibrium price and a higher equilibrium quantity of goods and services . If there is a decrease in the supply of goods and services while demand remains the same, prices tend to rise towards a higher equilibrium price and a lower quantity of goods and services.
The same inverse relationship applies to the demand for goods and services. However, when demand increases and supply remains the same, higher demand leads to a higher equilibrium price and vice versa.
Supply and demand increase and decrease until an equilibrium price is reached. For example, suppose a luxury car manufacturer sets the price of its new model car at $ 200,000. While initial demand may be high, due to the growing business and the creation of buzz for the car, most consumers are not prepared to spend $ 200,000 on a car. As a result, sales of the new model drop rapidly, creating excess supply and driving down demand for the car. In response, the company reduced the price of the car to $ 150,000 to balance the supply and demand for the car, ultimately reaching an equilibrium price.