Demand in economics describes a consumer’s desire to purchase goods and services and their willingness to pay a specific price for those goods and services.
Adam Smith, considered the father of modern economics, in his famous book “Wealth of Nations” made the following assertions about the actions of economic actors:
“Individual actors acting in their self-interests lead to the promotion of the interests of the larger society more effectively than if they had a direct intention to want to promote the welfare of the society.”
He meant that without any interference, the economic actors by furthering their self-interests end up promoting the interests of the larger community and society. By dealing with the problem of allocating resources individually, they solve the issue at the higher societal level.
Economics studies the problem of scarcity and choice; how do economic actors (individuals, households, firms, and the government) allocate scarce resources to unlimited needs and wants?
Taking the market as made up of consumers and producers, we can easily understand the two main fundamental laws in economics: demand and supply. Demand is driven by the consumers, while the producers are responsible for the supply side.
Law of Demand
Demand is about the willingness and the ability of consumers (buyers) to buy and pay for a set of goods and services.
The law of demand states that there is an inverse relationship between the price of goods and services and the quantity demanded.
Therefore, when the price goes down, the quantity the consumers are willing and able to buy increases. When the price of goods and services goes up (increases), the quantity consumers will buy decreases.
This quantity is called the “quantity demanded”.
Demand Curve
The demand curve has a downward-sloping shape as shown below:
The curve is a plot of prices of goods and services on the vertical axis, with the quantity demanded on the horizontal axis.
Reasons for the Downward Sloping Shape of the Demand Curve
The following factors are responsible for the downward-sloping shape of the demand curve:
Substitution Effect
A substitute good is a product or a service that replaces another good with very little to no difference to the consumer. If the price of one good increases, consumers will switch to buy relatively cheaper substitute goods. Therefore, the quantity demanded for the first good decreases.
Income Effect
The income effect describes the change in the quantity of goods and services demanded by the consumers when their income changes. A change in a person’s income affects their purchasing power. However, a distinction of this effect should be made between normal and inferior goods.
When the disposable income increases, the demand for inferior goods decreases. When the income decreases, the demand for inferior goods increases. As people become wealthier, they tend to buy more expensive brands than regular store items.
When the disposable income increases, the demand for normal goods increases. This is reflected in the downward-sloping demand curve that moves upwards.
The distinction between normal goods and inferior goods is best explained by this video from Khan Academy:
Law of Diminishing Marginal Utility
Utility is the economic satisfaction that is obtained from the consumption of goods and services.
The law of diminishing marginal utility says that “as you continue to consume a given product, you will eventually get less additional utility from each extra unit you consume.”
Movement Along the Demand Curve vs. A Shift in the Demand Curve
A movement along the demand curve is the effect of a change in the price of a good which produces a change in the quantity demanded.
The various points on a demand curve show the possible combinations of prices of goods and services and the quantity demanded at a given level of demand.
A shift in the demand curve shows either an increase in demand (a shift to the right) or a decrease in demand (a shift to the left).
This shift in the demand curve is not caused by changes in the price of goods and services.
Factors that Cause the Demand Curve to Shift
As earlier highlighted, a shift in the demand curve shows either an expansion or a contraction in demand. A change in the product price does not cause this, but by the following factors:
Changes in Consumer Tastes and Preferences
Consumers may prefer to consume one product over the other depending on personal reasons. If there is a shift in tastes and preferences to another product, then the demand for our product decreases. This will result in a shift in the demand curve to the left.
For the product that the consumers prefer more, its demand increases (its demand curve shifts to the right).
Change in the Number of Consumers
An increase in the total number of consumers will lead to an increase in demand.
If the total number of consumers decreases, then the demand for that particular product will decrease.
Changes in the Prices of Related Goods
Related goods are either perfect substitutes or complementary goods.
A perfect substitute is a good that can be used in place of the other and the consumer will gain the same economic satisfaction they would have gained from the original good. A good example is coffee and tea.
When the price of a substitute good falls, consumers will be willing to buy more quantities of the substitute good. This will reduce the demand for the good in question, shifting the demand curve to the left.
Complementary goods are goods that are consumed together as a pair. For example, printers and inkjets, or toothpaste and toothbrush.
The demand for complementary goods is related. When the price of a complementary good goes up, demand for both goods declines. The demand curve shifts to the left. When the price goes down, the demand for both goods will increase.
Change in Income
The impact of a change in income on demand depends on whether it’s a normal good or an inferior good.
For a normal good, the income and demand are directly related. This means that the demand for normal goods increases when the income increases.
On the other hand, income and the demand for inferior goods are inversely related. This means that the demand for inferior goods goes down when the consumers’ income increases.
Expectations
What are the expectations of consumers about the future market trends and conditions of prices of goods and services?
When consumers expect that the general prices of goods and services will go up in the future, they will increase their consumption of those goods today (including buying more quantities to store for future use when prices are expected to go up). This will increase the demand for goods and services at present.
However, consumers may also expect that in the future prices of goods and services will go down. Maybe they have some key information about accurate and reliable market predictions for the near future. This will decrease the demand for goods at the present. They will reduce their consumption now in anticipation of purchasing more when prices go down in the future.