Demand theory — quick overview
Demand theory is the part of microeconomics that explains how consumers’ desire for goods and services affects market prices and quantities. In bookkeeping terms, demand is the quantity people are both willing and able to buy at a particular price over a given time. The theory links that willingness (driven by satisfaction or utility) to observable patterns like the demand curve and the market equilibrium price.
Core definitions (jargon defined on first use)
– Demand: quantity consumers are prepared and able to buy at a specified price and time.
– Utility: the satisfaction or usefulness a consumer expects from consuming a good or service.
– Law of demand: all else equal, when a good’s price rises, quantity demanded falls; when price falls, quantity demanded rises.
– Demand curve: a graph that plots price on the vertical axis and quantity demanded on the horizontal axis; it typically slopes downward from left to right.
– Income effect: when a price change changes consumers’ real purchasing power, causing them to buy more or less of a good.
– Substitution effect: when a price change makes consumers switch between similar goods (substitutes), changing demand for each.
– Change in quantity demanded vs. change in demand: a movement along the curve is a change in quantity demanded (caused by price change). A shift of the entire curve (left/right) is a change in demand (caused by non-price factors such as income, tastes, expectations).
– Giffen good: a rare case (an inferior good) where quantity demanded rises when price rises because the income effect outweighs the substitution effect.
– Market equilibrium: the price where quantity demanded equals quantity supplied; when not at equilibrium, price pressures push the market toward it.
Why demand matters for companies and markets
Demand shapes pricing, output, and competitive strategy. Firms use demand estimates to set price, plan production, and forecast revenues. In markets, prices move to balance supply and demand: excess demand (shortage) tends to push prices up; excess supply (surplus) tends to push prices down.
Checklist: how to evaluate demand (practical steps)
1. Define the product and market scope (geography, segments).
2. Measure willingness and ability to pay (surveys, past sales, price experiments).
3. Identify close substitutes and complements.
4. Estimate demand responsiveness (price elasticity): how much quantity changes for a given price change.
5. Check income effects and customer income distribution.
6. Monitor tastes, trends, and non-price shocks (advertising, regulations, seasonality).
7. Translate insights into a demand function or curve for scenario testing.
8. Re-run estimates periodically and after major market changes.
Small numeric example (worked)
Suppose simple linear demand and supply functions:
– Demand: Qd = 100 − 2P
– Supply: Qs = 10 + 3P
Solve for equilibrium where Qd = Qs:
100 − 2P = 10 + 3P
90 = 5P → P* = 18
Quantity at equilibrium: Q* = 100 − 2(18) = 64
Interpretation:
– At price P = 18, buyers want 64 units and sellers will supply 64 units (market clears).
– If the seller prices too high, e.g., P = 25:
Qd = 100 − 2(25) = 50 (
= 50) while sellers will supply: Qs = 10 + 3(25) = 85 — so there is excess supply of 85 − 50 = 35 units. That surplus creates downward pressure on P until the market moves back toward equilibrium.
If the seller prices too low, e.g., P = 10:
– Qd = 100 − 2(10) = 80
– Qs = 10 + 3(10) = 40
– Shortage = 80 − 40 = 40 units, creating upward pressure on P until supply and demand balance.
Worked comparative-statics examples (how shifts change equilibrium)
1) Demand increase (non-price shock — e.g., higher income, successful advertising)
– New demand: Qd’ = 120 − 2P (intercept increases by 20)
– Solve Qd’ = Qs: 120 − 2P = 10 + 3P → 110 = 5P → P*’ = 22
– Q*’ = 120 − 2(22) = 76
Interpretation: demand growth raises both equilibrium price (from 18 → 22) and quantity (64 → 76).
2) Supply increase (e.g., productivity gains, lower input costs)
– New supply: Qs’ = 20 + 3P (intercept increases by 10)
– Solve Qd = Qs’: 100 − 2P = 20 + 3P → 80 = 5P → P*’ = 16
– Q*’ = 100 − 2(16) = 68
Interpretation: supply expansion lowers price (18 → 16) and raises quantity (64 → 68).
Price elasticity of demand (PED) — quick calculation and meaning
– Definition: PED = percentage change in quantity demanded / percentage change in price. Point elasticity for a differentiable function: PED = (dQ/dP) × (P/Q).
– For our linear demand Q = 100 − 2P, dQ/dP = −2. At the original equilibrium (P = 18, Q = 64):
PED = −2 × (18/64) = −0.5625 (inelastic: |PED| < 1).
– Implication (ceteris paribus): because demand is inelastic at that point, a small increase in P raises total revenue. Example:
– TR at P = 18: TR = 18 × 64 = 1,152
– If P rises to 19: Qd = 100 − 2(19) = 62 → TR = 19 × 62
TR at P = 19: TR = 19 × 62 = 1,178 — an increase of 26 (from 1,152). That numerical change illustrates the general rule: when demand is inelastic (|PED| 1), a price increase lowers total revenue; when unit elastic (|PED| = 1) total revenue is at a local maximum and small price changes leave TR unchanged to first order.
Worked percent-change check (consistency with PED):
– Percent change in price = (19 − 18) / 18 = 0.05556 = +5.556%
– Percent change in quantity = (62 − 64) / 64 = −0.03125 = −3.125%
– Elasticity (arc/approx) = %ΔQ / %ΔP = −3.125% / 5.556% ≈ −0.5625 (matches point-elasticity result −0.5625)
– Percent change in TR = (1,178 − 1,152) / 1,152 ≈ +2.26% — TR rose because |PED| 25, demand is elastic (raising P reduces TR); for P < 25, demand is inelastic (raising P increases TR).
Quick checklist: how to evaluate the revenue impact of a small price change
1. Compute or estimate price elasticity of demand (PED) at the current P,Q:
– For a differentiable demand function, PED = (dQ/dP) × (P/Q).
– For discrete changes, use %ΔQ / %ΔP (midpoint method for larger changes).
2. If |PED| 1 → elastic → price increase tends to lower total revenue.
If |PED| = 1 → unit elastic → small price changes do not change TR to first order.
3. Check signs and magnitudes using concrete numbers (compute TR before and after).
4. Remember assumptions: ceteris paribus (all else equal), no supply-side responses, and “small” changes are usually implied when using point elasticity.
Short notes on related concepts
– Movement vs. shift: A change in price causes movement along the demand curve (and changes quantity demanded); a shift in demand (say, from income, tastes, or prices of related goods) changes demand at
every price — the whole demand curve shifts left or right.
Other short notes and practical details
– Substitutes and complements. A substitute good is one consumers buy instead of this good (e.g., tea vs. coffee). If close substitutes exist, demand tends to be more elastic. A complement is used with the good (e.g., cars and gasoline); if a complement’s price rises, demand shifts left.
– Normal vs. inferior goods. A normal good has demand that rises when income rises; an inferior good’s demand falls as income rises. These are captured by income elasticity of demand: %ΔQ/%ΔIncome.
– Cross-price elasticity. Measures how quantity demanded of good A responds to price change of good B: Exy = (%ΔQA)/(%ΔPB). Exy > 0 → substitutes; Exy 1).
– Total revenue (TR) before = 10 × 100 = $1,000. After = 12 × 80 = $960. TR falls, consistent with elastic demand.
2) Inelastic example
– Price 10 → 12, quantity 100 → 95.
– ΔQ = −5, avg Q = 97.5, %ΔQ = −5.13%. %ΔP = 18.18% as above.
– ε = −5.13% / 18.18% = −0.28 (inelastic).
– TR before = $1,000. After = 12 × 95 = $1,140. TR rises, consistent with inelastic demand.
3) Point elasticity on a linear demand curve
– Suppose Q = 200 − 10P. Then dQ/dP = −10.
– At P = 10, Q = 200 − 100 = 100.
– ε = (−10) × (10 / 100) = −1.0 (unit elastic at that point). Small percentage increases in price will not change TR to first order.
Practical checklist for estimating elasticity (for traders and analysts)
1. Define the good precisely