# Demand Theory: Definition in Economics and Examples

![Demand Theory: A principle that emphasizes the relationship between consumer demand for goods and services and their prices.](https://www.investopedia.com/thmb/3uJB4d5qyhzruJi0u1oMho8JdI4=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/demand_theory.asp-final-37a8b4900a484ee7b5e3a57d5b4a4016.png)

*— Investopedia / Zoe Hansen*

> **Definition**
>
> Demand theory addresses how consumer demand affects market prices.

## What Is Demand Theory?

Demand theory is an economic principle that attempts to explain how consumer demand influences the prices for goods and services in the market.

It 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 price.

Demand theory highlights the role that demand plays in price formation, while supply-side theory focuses on the role of supply in the market.

### Key Takeaways

*   Demand theory describes the way that changes in the quantity of a good or service demanded by consumers produce changes in its price.
*   The theory states that the higher the price of a product is, all else equal, the less it will be demanded, resulting in a downward-sloping demand curve.
*   Likewise, the greater the demand, the greater the price will be for a given supply.
*   Demand theory places primacy on the demand side of the supply-demand relationship.

## Understanding Demand Theory

[Demand](https://www.investopedia.com/terms/d/demand.asp) 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 it.

In effect, real demand occurs 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 address basic questions about how badly people want things and how demand is impacted by income levels and satisfaction (utility).

### Importance of Demand for Companies

Based on consumers' perceived utility of goods and services, companies adjust the supply available and the prices charged.

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](https://www.investopedia.com/terms/e/equilibrium.asp). When demand is higher than supply, prices increase to reflect scarcity. Conversely, when demand is lower than supply, prices fall due to the surplus.

## 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.

As the price decreases, demand increases. This relationship can be illustrated graphically using a tool known as the demand curve.

The demand curve shows a downward slope from left to right to reflect the inverse relationship between the price of an item and the quantity demanded over a period of time.

### Income or Substitution Effect

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 increases.

Sometimes, consumers buy more or less of a good or service due to factors [other than price](https://www.investopedia.com/ask/answers/042815/which-economic-factors-most-affect-demand-consumer-goods.asp). This is referred to as a change in demand.

A change in demand is reflected by 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 demand curve.

> **Fast Fact**
>
> The law of demand is violated when dealing with Giffen (inferior) goods. People consume more Giffen goods as prices rise, and vice versa. Since a Giffen good does not have easily available substitutes, the income effect dominates the substitution effect.

## Supply and Demand

The [law of supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp) is an economic theory that explains the relationship of supply and demand and how that relationship affects the price of goods and services.

It's a fundamental economic principle that states 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.

The same inverse relationship holds for the demand for goods and services. However, when demand increases and supply remains the same, the higher demand leads to a higher equilibrium price and vice versa.

### Example

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 unwilling to spend $200,000 for an auto.

As a result, the sales of the new model quickly fall, creating an [oversupply](https://www.investopedia.com/terms/o/oversupply.asp) 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 and to ultimately reach an equilibrium price.

## Who Is the Father of Demand Theory?

Adam Smith is one of several people who observed that the costs of products rise and fall according to customer needs and included this theory in their study of markets and economic analysis. The theory was later expressed more formally by [David Ricardo](https://www.investopedia.com/terms/d/david-ricardo.asp) in "The Principles of Political Economy and Taxation."

## What Is the Demand Function Theory?

Demand function theory is a part of the broader demand theory. It's a mathematical approach to explaining the principle of demand theory.

## What Does Demand Theory State?

The theory states that prices tend to increase during periods of high consumer demand and fall when demand is low. This is because consumers compete with one another to secure scarce goods, effectively bidding the price higher. Note that this is true even if there is an official [ceiling](https://www.investopedia.com/terms/p/price-ceiling.asp) to price growth. If the government attempts to cap prices, it may create an informal black market with high prices.

## The Bottom Line

The theory of demand represents one half of the theory of supply and demand that forms the organizing principle for market economies.

It states that prices rise for goods that are in demand, and fall for goods that are not in demand. These prices act as a market signal to producers, telling them when to produce more or less of a given good.