The Theory of Demand: What Decides How Much People Buy

The the­ory of demand explains the rela­tion­ship between the price of a good or ser­vice and how much of it con­sumers want to buy. It is usu­ally shown as a demand curve that slopes down­wards: as the price falls, the quan­tity demanded rises, and as the price rises, the quan­tity demanded falls.

Demand is the quan­tity of a good or ser­vice that con­sumers are will­ing and able to buy at each price dur­ing a period of time. The demand for a good at a given price reflects how much con­sumers are will­ing to pay and how much they expect to get out of con­sum­ing it. Goods range widely in price, from neces­si­ties to lux­u­ries.

Neces­si­ties such as food, water, cloth­ing, shel­ter and health­care are needed by every­one, and are usu­ally priced within most peo­ple's reach. A designer hand­bag, on the other hand, is sold at a pre­mium, because it is a want and not some­thing any­one needs to live a healthy life.

Demand for any good rests on two things: its util­ity (the sat­is­fac­tion it gives) and the buy­er's abil­ity to pay. Both must be present. Demand exists only when a good gives some sat­is­fac­tion and the con­sumer can afford it.

Demand there­fore tells us how strongly peo­ple want a good and how much of it they actu­ally buy, given their incomes and the util­ity they expect. Firms watch this closely and adjust their sup­ply, which in turn moves prices.

For exam­ple, when a prod­uct sud­denly becomes very pop­u­lar, sup­ply is scarce at first and the price goes up. Over time firms increase pro­duc­tion, sup­ply catches up, and the price comes back down.

Sev­eral fac­tors affect demand, includ­ing:

• Con­sumer tastes and pref­er­ences
• Income
• Prices of related goods

Because so many things influ­ence demand, busi­nesses need to study it care­fully. It is one of the most impor­tant inputs into deci­sions about grow­ing the busi­ness and stay­ing com­pet­i­tive.

Deter­mi­nants of indi­vid­ual demand#

The demand for a com­mod­ity rises or falls because of the fol­low­ing fac­tors.

1. Price of the com­mod­ity itself#

This is the most impor­tant fac­tor. In gen­eral, price and quan­tity demanded are inversely related: as the price rises, the quan­tity demanded falls, because the good now gives less sat­is­fac­tion for each rupee spent.

2. Prices of related goods#

Demand for a com­mod­ity also changes when the prices of related goods change. Related goods are of two types.

Sub­sti­tute goods can be used in place of one another to sat­isfy the same want, like tea and cof­fee. A rise in the price of a sub­sti­tute increases the demand for the com­mod­ity, and a fall reduces it.

Com­ple­men­tary goods are used together to sat­isfy a want, like tea and sugar. A rise in the price of a com­ple­ment reduces the demand for the com­mod­ity, and a fall increases it.

3. Income of the con­sumer#

Demand also depends on the con­sumer's income, but the effect depends on the kind of good.

For a nor­mal good, a rise in income increases demand and a fall in income reduces it.

For an infe­rior good, a rise in income reduces demand and a fall in income increases it.

4. Tastes and pref­er­ences#

Tastes and pref­er­ences, shaped by fash­ion, cus­toms and habits, directly influ­ence demand. When a com­mod­ity is in fash­ion or pre­ferred by con­sumers, its demand rises; when con­sumers lose inter­est in it, demand falls.

5. Expected change in future price#

If peo­ple expect the price of a com­mod­ity to rise soon, they buy more of it now than they nor­mally would. So an expected future price rise increases present demand.

Change in quan­tity demanded ver­sus change in demand#

Change in quan­tity demanded: when the demand for a com­mod­ity changes only because its own price has changed, it is called a change in quan­tity demanded. For exam­ple, if peo­ple buy more Pepsi because Pepsi has become cheaper, that is a change in quan­tity demanded.

Change in demand: when the demand for a com­mod­ity changes because of any fac­tor other than its own price, it is called a change in demand. For exam­ple, if peo­ple buy more Pepsi because Coke has become dearer, or because incomes have risen, or because tastes have changed, that is a change in demand.

Deter­mi­nants of mar­ket demand#

Mar­ket demand depends on all the fac­tors above, and on three more.

Size and com­po­si­tion of the pop­u­la­tion#

A larger pop­u­la­tion raises mar­ket demand and a smaller one reduces it. The make-up of the pop­u­la­tion, that is, the pro­por­tion of men, women, chil­dren and elderly peo­ple, also mat­ters. For exam­ple, a mar­ket with a larger share of women will have more demand for goods such as sarees and cos­met­ics.

Sea­son and weather#

Demand changes with the sea­son. In win­ter, demand for woollen clothes and jack­ets goes up; in the rainy sea­son, demand for rain­coats and umbrel­las goes up.

Dis­tri­b­u­tion of income#

When income is spread fairly evenly across the pop­u­la­tion, mar­ket demand for most com­modi­ties is higher. When income is very unevenly spread, with a few very rich peo­ple and many poor ones, mar­ket demand stays lower.

Demand func­tion#

A demand func­tion shows the rela­tion­ship between the quan­tity demanded of a com­mod­ity and the fac­tors that influ­ence it. It can be writ­ten for one con­sumer (the indi­vid­ual demand func­tion) or for all con­sumers in the mar­ket (the mar­ket demand func­tion).

Indi­vid­ual demand func­tion#

The indi­vid­ual demand func­tion is the func­tional rela­tion­ship between one con­sumer's demand and the fac­tors affect­ing it. It is writ­ten as

Dx = f (Px, Pr, Y, T, F)

where

• Dx = demand for com­mod­ity x
• Px = price of com­mod­ity x
• Pr = prices of related goods
• Y = income of the con­sumer
• T = tastes and pref­er­ences
• F = expected change in price in future

Mar­ket demand func­tion#

The mar­ket demand func­tion is the func­tional rela­tion­ship between mar­ket demand and the fac­tors affect­ing it. It can be writ­ten as

Dx = f (Px, Pr, Y, T, F, Po, S, D)

where

• Dx = mar­ket demand for com­mod­ity x
• Px = price of com­mod­ity x
• Pr = prices of related goods
• Y = income of the con­sumers
• T = tastes and pref­er­ences
• F = expected change in price in future
• Po = size and com­po­si­tion of the pop­u­la­tion
• S = sea­son and weather
• D = dis­tri­b­u­tion of income

Demand sched­ule#

A demand sched­ule is a table show­ing the quan­ti­ties of a com­mod­ity demanded at dif­fer­ent prices dur­ing a given period. It shows the rela­tion­ship between the price of the com­mod­ity and its quan­tity demanded.

A demand sched­ule can be drawn up for one buyer or for the whole mar­ket, so there are two types:

• Indi­vid­ual demand sched­ule
• Mar­ket demand sched­ule

An indi­vid­ual demand sched­ule is a table show­ing the quan­ti­ties of a com­mod­ity that one con­sumer is will­ing to buy at dif­fer­ent prices dur­ing a given period.

A mar­ket demand sched­ule is a table show­ing the quan­ti­ties of a com­mod­ity that all con­sumers together are will­ing to buy at dif­fer­ent prices dur­ing a given period. It is found by adding up the indi­vid­ual demands at each price:

Dm = DA + DB + …

where Dm is the mar­ket demand and DA, DB, … are the indi­vid­ual demands of house­hold A, house­hold B and so on.

Related read­ing#

• What Demand Means in Eco­nom­ics
• The Law of Demand
• Elas­tic­ity of Demand