A consumer’s willingness to pay for a good or service

Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Start Free

What is Demand?

Demand is a principle that refers to a consumer’s willingness to pay for a good or service. Assuming that all else is equal, a rise in the price of a good or service will result in a fall in the quantity demanded. It works the other way around as well. A decline in the price of a good or service is equivalent to an increase in the quantity demanded.

The two types of demand are:

  1. Market demand: The total quantity demand of all consumers in the market for a particular good
  2. Aggregate demand: Total demand for all goods and services that exist within the economy.

How Demand Works

In order to understand demand, it is critical to be cognizant of the relationship between the price and the willingness to purchase the goods. Many businesses often attempt to analyze the demand for a good from the public and determine how much of the good they are capable of selling at various prices.

As the public are customers to businesses, demand is crucial and a key component that drives the economy. Without demand, there would be no profit, and without profit, there would be no jobs or any production of goods due to the lack of cash flow circulation.

It is important to note that demand correlates with supply. While businesses (suppliers) attempt to maximize their profits by increasing prices on goods, consumers try to pay the lowest prices to save money. Knowing such a fact, if suppliers raise prices too high above the consumer’s willingness to pay, quantity demand will drop as well; hence, suppliers will likely lose out on sales and potential profits.

However, if suppliers charge too low for their good, quantity demand will rise quickly, but the price businesses are selling their goods for may not be able to cover fixed costs of producing that particular good in the first place; thus, losing out on profits.

Factors Affecting Demand

Several factors that affect demand are:

  1. Appeal of a good or service
  2. Availability (scarcity) of the good
  3. Availability to finance the good

Illustrating Supply and Demand

Supply and demand can be plotted on an X and Y axis graph, where the vertical axis represents the price, and the horizontal axis represents the quantity demanded or supplied.

Supply and Demand - Graph

The graph looks like an “X,” where the demand curve is a downwards sloping line – higher on the left side and gradually moving lower towards the right side. Thus, as price increases, demand decreases, whereas when price decreases, demand correspondingly increases. It is true, as consumers are more willing to buy a higher quantity of goods when they are cheaper relative to when they are more expensive.

On the other hand, the supply curve is upwards sloping. Meaning, as the price increases, suppliers are willing to provide more of that particular good or service, and vice versa, if the price decreases. Illustratively, the supply curve is lower on the left side and higher on the right.

Example of Demand

Bob loves chips. At Shopper Drugs, he sees Doritos for $3 per pack. As the price is fairly high, he would only buy one pack.

The following week, when he goes to Shopper Drugs, he sees that the Doritos are now on sale for $1.50. As he believes the price is lower compared to before, he would be more inclined to purchase additional packs of chips rather than just one due to the great perceived deal.

Example of Supply

Bob owns a mug business, where he sells high-quality, customized cups. The market price is $5 per cup, and its cost price is $2. One day, the market price of cups moves to $10, yet his cost price stays at $2. It would encourage Bob to produce more mugs, as the margins are not only greater, but he is aware that mugs are popular due to the increase in market price.

On the other hand, if Bob found out that the market price of cups was $4, while his cost was $2, he would likely reduce the number of goods to purchase and sell. The cups might not be as popular as expected, which was the cause for the decrease in market price.

Also, the cost of producing the good might be more than the sale itself; therefore, he might even stop producing cups as a whole.

Understanding Market Equilibrium

Market equilibrium is perceived as the point where supply and demand intersect each other. As the supply curve shifts to the right, for example, the equilibrium price moves down, while the equilibrium price moves up when the supply curve shifts to the left. For demand curves, as it shifts to the right, the price moves up.

When the curve shifts to the left, it moves down. It is important to recognize that a shift to the right represents “more” or an “increase in” demand or supply, while a shift to the left represents “less” or a “decrease in” supply or demand.

Consumers typically pay the equilibrium price. As factors that affect supply and demand are continuously changing, which causes the curves to shift, the equilibrium price is respectively moving as well based on the movements.

The Federal Reserve’s Role

The Federal Reserve is capable of affecting demand by doing the following:

To increase demand:

  • Lower interest rates
  • Increase the money supply by distributing stimulus checks

To reduce demand:

Related Readings

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!

0 search results for ‘