# Theory of Demand

By Aidan Hackett. Edited by Arjun Chandrasekar.

Overview

The law of demand is incredibly simple on the surface level, positing that “there is an inverse relationship between price and quantity demanded.” The opposite of supply-side theory, this theory is Keynesian in nature, meaning that most of the ideas and behaviors of markets are explained by demand-side theories, i.e. pertaining to the consumer. Going back to the definition before, it is simply saying that as prices fall, quantity demanded rises, and as prices rise, quantity demanded falls.

What is Quantity Demanded and How Can It Be Changed?

The simplest representation of quantity demanded is through a “demand schedule.” In one column you have the price, and in the other, you have the quantity demanded at said price. It can be said that the quantity demanded is a function of the price. Using this schedule, you can graph it on a plane. Rather counterintuitively, the graph has the function of the variable on the x-axis, and the variable on the y-axis, so plotting them takes on the form (x,y)->(f(x),x)->(quantity demanded, price). See Figure 1 for a graphic representation to help you visualize it better.

Figure 1:

Figure 1 in the upper right corner is the demand schedule, and in the main image, we can see the demand schedule grafted onto a plane to give us the demand curve.

Note here that the demand curve is downward sloping, meaning that the trade-off between price and quantity changes at every point on the graph. Now that that’s established, how do we move along this graph, what makes the price change, and what makes the quantity demanded change? There are 3 answers to this.

Firstly, we have the substitution effect. Changes in price motivate consumers to buy relatively cheaper substitute goods. Why would you buy a used Ford when the price of a new Lamborghini has gone from \$300,000 to \$30,000? Radical example, but this demonstrates the effect. Also, if you were looking at buying a new Ford, but the price of Fords increases, you are now more likely to start looking at Toyotas or Nissans instead. So, by having a substitute, the number of people willing to buy your car at the cost can change, as they can just go somewhere else.

Secondly, we have the income effect. Changes in price in turn change the purchasing power of a consumer’s income. When the price decreases for an item, you can get more of that item with the same amount of money – your money can go a long way, which is another way of saying it has changed its purchasing power. In the same way, when the price increases, you can buy less than before with the same income, so you will be inclined to buy a smaller quantity of it – your quantity demanded has decreased.

Thirdly, we have the law of diminishing marginal utility. This has a few things to it. Marginal can be seen as meaning added, or extra from each additional unit. Utility is the use you get from a product, be it sustenance, happiness, usefulness, etc. What this law states is that things can get to a stage where having more than you did before is not actually a good thing, or at least not as good as it was before. So imagine you have a kettle. 1 is good, 2 is also good, but upon receiving it, it was less useful than receiving the first kettle, because who needs to boil that much water? Now imagine you have 9 kettles, and someone gives you a tenth kettle. That tenth kettle might not only be less helpful than before but might actually be a hindrance, because where are you meant to store 9 kettles that you aren’t using. So, going back to the theory of demand, it states that people need a base level of these goods, but as you increase the supply, the demand will decrease because of the diminishing marginal utility of purchasing them. Think about that for a bit, it can be a little tricky to wrap your head around.

What is Demand and How Can It Be Changed?

Changing the quantity demanded only shifts us up and down a given demand curve. But what if we want 10,000 customers, but we also don’t want to lower prices? Well, this is where the demand for the product comes into play. Demand is the whole curve – given any price, how much are people willing to pay. So what can affect demand?

Firstly, you can have a shift in preference. Imagine Apple releasing a new phone, but it starts to explode. This will shift the whole of the demand curve to the left as fewer people are willing to buy it at any price because of this hazard. Now imagine Apple releases a phone and a study comes out saying that the new phone gives people superpowers. This will shift the whole of the demand curve to the right as people are willing to buy more of it at any given price because they want to be able to fly.

Secondly, you can change the curve for the number of consumers in a market. Naturally, more people lead to a higher demand for most products in a market.

Thirdly, you need to consider the price of related goods, substitutes, and compliments. If Apple releases a new phone, but then Nokia comes out with some other really new and modern phone that rivals Apple’s, then people will buy less of Apple’s phone at all prices. A compliment, and very convenient one at that, would be something like Apple releasing AirPods, and then subsequently releasing phones without headphone jacks, meaning people will buy more AirPods at every price they could be offered at.

Another factor is income, but this one is a bit more nuanced, as a change in income does not have the same effect on all goods and services. For example, imagine a town where everyone suddenly gets a \$25k bonus, just for living in that town. This town will probably buy more luxury items such as branded clothes, expensive lobster dinners, nice cars, etc. but less on cheaper items like home brand foods, instant coffee, other things associated with “being poor”, for lack of a better term that accurately describes this. The former type of goods are called normal goods – income and demand go up together – they are proportional, and the latter type of goods are called inferior goods – demand and supply have an inversely proportional relationship.

The final main shifter is expectation. Basically, what do you think will happen next week or month with the prices, compared with today. If you think prices will go up, demand increases, if you think prices will decrease, demand decreases too. It is like the futures or the stock market in a way.

Demand vs. Quantity Demanded

A change in demand is a change along the demand curve. This is a change in price causing a change in quantity demanded, or vice versa. A change in demand affects the entire curve, moving left or right. In these circumstances, the price can stay the same while the demand for the product has increased or decreased. So, remember it like this; quantity demanded is a point along the curve, demand is the curve.

If you want to extend yourself and find out how to actually derive the demand curve yourself, we highly recommend watching this video!