Economics Terms A-Z - The most important terms in economics.

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Economics Terms A-Z

Demand Curve

A demand curve shows the relationship between an item’s price and the quantity of the item demanded, either by an individual or by all participants in the market. Demand curves are downward-sloping for most items as greater quantities are demanded at lower prices.

The following graph shows the demand curve for a typical good or service: as the item’s price falls from pD1 to pD2 to pD3, the quantity demanded rises from qD1 to qD2 to qD3.
Demand CurveNote how the demand curve shown might be representing the preferences of a single individual for the item: the individual decides to buy more (less) of the item as its price falls (rises).  Alternatively, it represents the quantities of the item demanded by all participants in the market at various prices, i.e. the market demand curve. The market demand curve is simply the sum of all individual demand curves for the item in the economy.  In general, firms will be interested in estimating market demand rather than individual demand for their products and services.

A demand curve need not be linear (hence the name “curve”!) and its slope at each point represents the price elasticity of demand, i.e. how sensitive the individual is or consumers in the market are to changes in price. Demand curves are drawn at a given level of income for the individual or consumers in the market. Should the income level change, the demand curve will shift inwards or outwards (left or right), depending on whether income has risen or fallen and the item’s income elasticity of demand.  For “normal” consumer goods and services, greater quantities will be demanded if income rises and the demand curve will shift outwards to the right.  For so-called “inferior” consumer goods and services, lower quantities will be demanded if income rises and the the demand curve will shift inwards to the left, as consumption of such goods and services is replaced by consumption of other goods and services that have become affordable due to the rise in income.

A special case arises when people buy goods and services in order to display their income or wealth to others, so-called “conspicuous consumption”. In this case the demand curve can be upward-sloping because the item’s value to the individual rises, the higher the price: the show-off, social-status power of the item rises, the higher its price.  Such items are typically branded as “luxury” and are known by economists as “Veblen” goods or services due to the economist and sociologist Thorstein Veblen who first studied them.

In practice, demand curves can be estimated by experimentation with price changes, observing consumer behaviour for similar products or by surveying consumers about hypothetical changes in prices. Economists will generally choose to observe actual behaviour rather than rely on hypothetical claims, i.e. revealed preferences are more meaningful than stated preferences. Market research is a huge industry but it essentially boils down to understanding the relationship between price and quantity and calculating demand curves.

Further reading

Most introductory economics text books cover the theories of demand and supply extensively.  For a more in-depth understanding of the demand curve, a neat critique of Alfred Marshall’s original theory of demand is presented by the free-market economist and 1976 Nobel prize winner Milton Friedman in “The Marshallian Demand Curve” (Journal of Political Economy, 1949).

Good to know

Many firms today conduct real-time analysis of customer demand and engage in “dynamic pricing”. Understanding how willingness-to-pay changes at different times of the day, week or year and differentiating prices accordingly allows producers to capture some of the consumer surplus for themselves. The markets for electricity and air travel are examples where dynamic pricing has become standard practice.  As a consumer it is, therefore, often worth observing how prices change over time before making important purchases.