What is Demand Theory?
Demand theory is a principle that emphasizes the relationship between consumer demand and the price for goods and services within a market. It can also be illustrated as the demand curve, which is downwards sloping in a horizontal manner, as the price of the good decreases as quantity increases. Vice-versa, where the price of the good increases as the quantity decreases.
Ultimately, when applying the supply curve together, the equilibrium price shifts accordingly. Essentially, demand theory highlights the consumer’s perspective, while supply focuses on the business’s point of view.
Understanding Demand Theory
Demand is the quantity of a good or service the consumer is willing to purchase at specific prices during a time period. The demand for a good at a certain price generally reflects the consumer’s willingness to pay and expectation for consuming that product. The goods indeed range in price, from necessities to luxuries.
For example, regarding necessities, people need food, healthcare, clothing, entertainment, shelter, and water across all welfares. The price of the goods tends to be fairly affordable for most individuals. Whereas, designer bags, for example, tend to be priced at a premium, as such goods are considered wants and are not required to continue to live a healthy life.
The demand for a good or service is generally driven by two factors – utility and ability to pay for the good or service.
The two aspects coincide with one another. Demand happens when a good or service yields some level of utility while being backed by the ability, which ultimately provides satisfaction to the consumer.
Demand aims to convey how bad people wish to purchase specific goods, along with how much is bought based on their income levels and utility. Based on the satisfaction that the good provides, companies adjust their supply level accordingly, which changes prices.
For example, if a good is extremely popular and with high utility, companies will first see a scarce supply, shifting the supply curve and raising prices. However, over time, they will increase production, shifting the supply curve back to its original position, bringing the price back down.
Factors That Affect Demand
Various factors affect demand, including:
- Consumer preferences
- Related goods
As various factors may affect demand, businesses need to evaluate demand, as it is one of the most integral decision-making drivers that must be considered to grow the business and continue to stay competitive within the market.
Defining the Market System
Supply and demand determine the price within the market. When supply is equivalent to demand, price is in a state of equilibrium. However, when demand is higher than price, prices rise to reflect scarcity in quantity. On the other hand, when supply is higher than demand, then prices fall due to a surplus in goods.
The Law of Demand
The law of demand illustrates the inverse relationship between price and demand for a good or service within the market. As the commodity increases in price, the demand decreases. However, if the commodity decreases in price, the demand increases, assuming all other factors remain constant.
At times, consumers may purchase goods or services beyond factors in price. It is also known as a change in demand. A change in demand is a shift in the curve from right to left or left to right, based on the factors mentioned above.
For example, if an individual has more disposable income, they may be willing to spend more goods within the market, regardless of whether the price lowers; in such a case, the demand curve would shift to the right.
Expansion and Contraction of Demand
An expansion or contraction of demand may occur during the income or substitution effect.
As the price of a commodity drops, an individual may receive the same satisfaction for spending less, assuming it is a normal good. Given that the price of the commodity falls, it will allow the consumer to purchase more of the goods with their current financial position. It is known as the income effect.
The substitution effect happens when the consumer transitions from purchasing costly goods to ones that have fallen in price. As people purchase goods with lower prices, demand rises for such products and less for the original.
CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful: