2. Demand Theory
• What Is Demand Theory?
• Demand theory is an economic principle relating to the relationship
between consumer demand for goods and services and their prices in the
market. 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
• Demand theory highlights the role that demand plays in price formation,
while supply-side theory favors the role of supply in the market.
3. Understanding Demand Theory
• Demand is simply 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 goods and services in an economy to satisfy their wants, such as
food, healthcare, clothing, entertainment, shelter, etc. The demand for 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 a 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.
• 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
• 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
5. The Law of Demand and the Demand Curve
• The law of demand introduces an inverse relationship between price and
demand for a good or service. It simply states that as the price of a
commodity increases, demand decreases, provided other factors remain
constant. Also, as the price decreases, 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 charts 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 more costly goods to substitutes that have fallen in
price. As more people buy the good with the lower price, demand
6. • 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
7. 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 that
relationship affects the price of goods and services. It's 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 the supply and prices of
goods and services when demand is unchanged. If there is an
increase in supply for goods and services while demand remains the
same, prices tend to fall to a lower equilibrium price and a
higher equilibrium quantity of goods and services. If there is a
decrease in supply of goods and services while demand remains the
same, prices tend to rise to a higher equilibrium price and a lower
quantity of goods and services.
8. • The same inverse relationship holds for the demand of goods and
services. However, when demand increases and supply remains the
same, the higher demand leads to a higher equilibrium price and vice
• Supply and demand rise and fall until an equilibrium price is reached.
For example, suppose a luxury car company sets the price of its new
car model at $200,000. While the initial demand may be high, due to
the company hyping and creating buzz for the car, most consumers
are not willing to spend $200,000 for an auto. As a result, the sales of
the new model quickly fall, creating an oversupply and driving down
demand for the car. In response, the company reduces the price of
the car to $150,000 to balance the supply and the demand for the car
to ultimately reach an equilibrium price.