What is the Theory of Demand?
Demand is defined as the quantity of a commodity that a Consumer is capable of buying and is willing to pay the given price for it at the given time. The Theory of Demand is a Law that states the relationship between the quantity Demanded of a product and its price, assuming that all the other factors affecting the Demand are constant. According to the Law of Demand Theory, the quantity Demanded of a commodity is inversely related to its price in the market. Through this article, we will try to comprehend the Theory of derived Demand, the factors affecting Demand, the Demand curve and the application of Demand Theory.
Theory of Derived Demand
We have got an idea about “what is the Theory of Demand”. So now let us try to understand the Theory of derived Demand with the help of an example: a Consumer Demands a piece of clothing, let’s say a shirt, which is a finished product that came into existence after undergoing various processes. First, the land for building the plant was acquired by the manufacturing Company and then the labour was employed by the entrepreneur using the Company’s Capital. The Demand for all these resources (factors of production) was indirectly created when the Consumer posed a Demand for the shirt. This is called the Theory of derived Demand.
Factors Affecting Demand
After having discussed the Theory of Demand economics and the Theory of derived Demand, we will now talk about the various factors affecting the quantity Demanded of a product.
Price of the Commodity: As stated in the Law of Demand Theory, the price of a commodity shows an inverse relationship with its quantity Demanded. As the price of the product falls, its Demand increases.
The Number of Consumers: It is directly related to the quantity Demanded of a commodity. The more the number of Consumers, the more is the Demand for that product.
Price of Related Goods: There are two types of related goods: Substitutes and Complementary goods. For example, for milk, the juice is a substitute whereas biscuits are complementary products. If the prices of milk fall, the Demand for juice (substitute) will increase and that for biscuits (complementary goods) will lessen.
Income: With the increment in a Consumer’s income, he will become capable of buying more of a particular commodity, and thereby, his Demand will also rise.
Consumer Expectation: If a Consumer expects that the price of a certain commodity will go up in the future, he will buy more of that product at present, which will lead to a hike in its Demand.
Tastes and Preferences: It has a direct relation with the quantity Demanded.
Solved Example
Q. Explain the Demand Curve.
Ans: We now know “what is the Theory of Demand” and the factors that determine the quantity Demanded. Let us move on to the characteristics of a Demand curve. On the x-axis, we have taken the price of the commodity, and on the y-axis, the quantity Demanded.
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The first graph here shows the movement along the same Demand curve. This downward-sloping curve is in accordance with the Law of Demand Theory as when the price falls from P1 to P2, the quantity Demanded increases from Q1 to Q2.
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In this graph, we can see that there is a shift in the Demand curve from D to D1 at the same price P. For the curve D, the quantity Demanded is Q which is lesser than Q1 (for D1 curve). This right-shift in the Demand curve is due to all the factors affecting the Demand except the price of the commodity (which is responsible for movement along the curve). These are the same factors that are kept constant while explaining “what is the Theory of Demand”.
Application of Demand Theory
After having learned about “what is the Theory of Demand” and how a Demand curve looks like, we will now become familiar with the application of Demand Theory in real life. The Theory of Demand is useful in determining the force of various determinants or factors that affect the quantity Demanded. The application of Demand Theory for estimating the ups and downs in the equilibrium prices of various commodities is important for investors and entrepreneurs.
Fun Fact
Named after Sir Robert Giffen, Giffen goods are considered inferior goods that do not obey the Law of Demand Theory. According to the Theory of Demand, the Demand for a particular commodity diminishes with an increase in its price, but for Giffen goods, it increases with the rise in price. A historical example of the Giffen goods concept is the Irish Potato Famine of the 19th century. When the price of potatoes (Giffen goods) inflated, people cut their expenses by buying fewer luxury goods like meat and bought more potatoes.
FAQs on Theory of Demand: Basics and Applications
1. What is the basic concept of the Theory of Demand in economics?
The Theory of Demand explains the relationship between the price of a good or service and the quantity that consumers are willing and able to purchase. In simple terms, it states that, all other factors being equal (ceteris paribus), as the price of a product falls, the quantity demanded for it will rise, and as the price rises, the quantity demanded will fall. It is a foundational concept in microeconomics that helps understand consumer behaviour and market dynamics.
2. How is 'demand' different from a 'want' or a 'desire'?
While often used interchangeably in daily language, these terms have distinct meanings in economics:
- A desire is a mere wish to own something, without any ability or intention to buy it. For example, wishing you had a private jet.
- A want is a desire that is backed by the financial ability to purchase, but not necessarily the willingness to do so at a specific price. You might be able to afford a luxury car but are not willing to spend the money on it.
- Demand is the specific quantity of a product that a consumer is both willing and able to purchase at a given price and during a specific period. It is a want backed by the willingness to pay.
3. What are the key determinants that influence the demand for a commodity?
The demand for a commodity is influenced by several factors other than its own price. The main determinants of demand include:
- Price of the Commodity: The primary factor affecting demand.
- Consumer's Income: Demand for normal goods increases with income, while demand for inferior goods decreases.
- Prices of Related Goods: This includes substitutes (e.g., tea and coffee) and complementary goods (e.g., cars and petrol).
- Tastes and Preferences: Consumer choices influenced by trends, advertising, and habits.
- Consumer Expectations: Beliefs about future price changes or income can alter current demand.
4. What is the important difference between a 'change in quantity demanded' and a 'change in demand'?
This is a crucial distinction in the theory of demand. A 'change in quantity demanded' refers to a movement along the same demand curve, caused solely by a change in the product's own price. For example, if the price of apples drops, you buy more apples—this is a change in quantity demanded. A 'change in demand' refers to a complete shift of the entire demand curve (either to the right or left), caused by changes in determinants other than price, such as income or the price of related goods. For instance, if your income increases, you might buy more apples even if their price remains the same, shifting the whole demand curve to the right.
5. Why does the demand curve for most goods slope downwards from left to right?
The downward slope of the demand curve illustrates the inverse relationship between price and quantity demanded. This happens for two main reasons:
- Income Effect: When the price of a good falls, the consumer's real income (or purchasing power) increases. This allows them to buy more of that good with the same amount of money.
- Substitution Effect: When the price of a good falls, it becomes relatively cheaper compared to its substitutes. Consumers will therefore substitute the cheaper good for other, now relatively more expensive, goods.
- Law of Diminishing Marginal Utility: As a person consumes more units of a good, the additional satisfaction (marginal utility) from each extra unit decreases. Therefore, they will only be willing to buy more units if the price is lower.
6. How can the price of a related good, like a substitute or a complement, affect the demand for a product? Give an example.
The prices of related goods are a major determinant of demand. For substitute goods (like tea and coffee), an increase in the price of one leads to an increase in the demand for the other. For example, if the price of coffee rises, more people will start drinking tea, thus increasing the demand for tea. For complementary goods (like cars and petrol), an increase in the price of one leads to a decrease in the demand for the other. For instance, if petrol prices soar, the demand for cars, especially those with low mileage, may decrease.
7. In what real-world situations might the law of demand not apply?
While the law of demand is widely applicable, there are certain exceptions where a higher price might lead to higher demand. These are known as exceptions to the law of demand and include:
- Giffen Goods: These are highly inferior goods where the income effect outweighs the substitution effect. For a very poor household, if the price of a staple food like bajra rises, they may cut spending on more expensive foods and buy even more bajra to meet their basic calorie needs.
- Veblen Goods: These are luxury or status goods (e.g., designer watches, high-end cars). Their appeal lies in their high price, so an increase in price can make them more desirable and increase demand.
- Expectations of Future Price Rise: If consumers expect the price of a commodity to rise even further in the future, they may buy more of it at a higher price today to avoid paying even more later.
