What is the Demand Curve?

A demand curve is like a model car…

A model car is a scaled-down version of the real thing. It doesn’t actually drive around the way a real car does. But it does give a visual representation of how all the pieces fit together. It’s a useful tool that demonstrates the general concept of a car (consumer behavior). Even though it requires a lot of simplifications, a model (demand curve) conveys a lot of information.

The demand curve is a microeconomics tool, which appears as a downward sloping line that shows how consumers respond to price changes. Traditionally, the price of a good goes on the y-axis and the quantity goes on the x-axis. The demand curve usually slopes down because consumers tend to decrease purchases when the price rises. But a company can theoretically face a flat demand curve if it operates under perfect competition (several companies offering identical products for sale, leaving no one able to raise prices without losing all their sales).

The demand curve is a visual representation of the law of demand, which states that there is an inverse relationship between price and quantity. In other words, if you want to sell more of something, you need to offer a lower price.

Demand curves can vary in shape, giving rise to different types of curves. They can be straight lines, curved, kinked, or even discontinuous. For simplicity, most demand curves are drawn as straight lines (linear). The slope of the line indicates how sensitive consumers are to changes in price.

In one extreme, the demand curve would be vertical, suggesting a slope of infinity. That demand curve would be called perfectly inelastic — meaning that consumers are insensitive to price changes. No matter what the price is, the same volume to get sold.

At the other end of the spectrum, the demand curve would be horizontal, suggesting a slope of zero. That curve would be called perfectly elastic. In that case, customers are extremely sensitive to price changes. In fact, any increase in price at all would result in no sales. Perfectly competitive markets theoretically face a perfectly elastic demand curve. Most demand curves fall between these two extremes, but can be described based on how close they are to one or the other.

In the real world, demand curves are rarely linear. Economists use sophisticated statistical analysis and calculus to estimate the shapes of demand curves. The result is typically something that resembles a curve rather than a line.

In some situations, a market might have constraints or requirements that complicate the matter. For example, imagine the market for single-dose vaccinations. Because nobody needs two, there is a maximum number of potential sales. No matter what the price is, there is a limit to the number that can be sold. In that case, the demand curve might slope down gradually, then fall sharply to zero when it hits that limit.

Demand elasticity, also called the price elasticity of demand, refers to how sensitive buyers are to prices. A high elasticity means consumers are very sensitive to prices. In that case, the demand curve has a gradual slope. Luxury goods, like jewelry and lobster dinners, tend to have high elasticity.

A low elasticity would suggest that people don’t respond to price increases by reducing consumption. Therefore, the slope of the demand curve is steep. Basic necessities (like bread), life-sustaining items (like medication), structurally required items (like gasoline), and addictive goods (like cigarettes) all tend to be highly inelastic.

Determining the demand elasticity of a product requires comparing changes in price to changes in quantity sold. The elasticity formula is:

Demand Elasticity = % change in quantity / % change in price

For example, assume that a restaurant charges $10 for lunch and serves 100 people. Then, the owner decides to increase the price to $12. At the new price, only 90 people come in to eat. We can use this information to estimate the demand elasticity for these lunches.

Going from $10 to $12 is a 20% price increase. And, going from 100 customers to 90 customers is a 10% decrease in sales. Therefore, the demand elasticity is 10% / 20%, which equals 0.5. Because the demand elasticity is less than 1, it is considered to be relatively inelastic at this point on the demand curve. Therefore, increasing the price will increase gross revenues (in this example, revenues went from $10 x 100 = $1,000 to $12 x 90 = $1,080).

A demand schedule is an alternative way to illustrate a demand function. While the demand curve sketches the equation on a graph, a demand schedule lists points along the demand curve in a table. A demand schedule would have two columns, one for price and one for quantity. Then, it lists various prices and shows the corresponding volume of sales.

Whenever a determinant of demand changes, the demand curve shifts. Let’s unpack what that means. A demand curve is a relationship between the price of a product and the amount that people buy. However, more things influence a decision to buy something than its price. Those other things are called determinants of demand. The primary determinants are income, preferences, and the cost of complementary or substitute goods.

A demand curve assumes that all of those determinants are held constant, called a ceteris paribus assumption. So, if one of those underlying values change, it voids that assumption and disrupts the whole demand curve. Consequently, it creates a new demand curve. If you draw the old and the new demand curves on the same graph, it looks like the demand curve shifted to the right or left.

For instance, if you suddenly started earning a higher salary, your consumption patterns would probably change. You’d be unlikely to save all of that extra cash, implying that you would increase spending on a few things. That increase in demand means you have new demand curves for everything you buy. Your demand curves (for normal goods) shifted to the right.

There are a few situations in which the general rule that demand curves slope down doesn’t apply. These exceptions can be broken down into three types.

Giffen goods violate the law of demand because of unique circumstances. On these rare occasions, increasing the price of a good can increase the amount of it people buy. This outcome can occur when the product in question is essential and a price increase crowds out the ability to buy other items. Imagine the price of potatoes goes up, which makes buying meat unaffordable. Consequently, the person diverts what money would have gone to meat toward more potatoes.

Veblen goods also violate the law of demand. In these situations, a buyer interprets a higher price for a signal of higher quality. You can imagine this situation playing out with a bottle of wine. If the label looks cheap and has a low price, people assume it’s a low-quality wine. But, if you put that same wine in a fancy bottle with a higher price tag, you might end up with more sales.

Information asymmetry can also upset the law of demand and change the shape of demand curves. One example is called a “lemon problem,” in which a buyer and a seller don’t have the same information about a product. Consider a used car. The buyer knows that the seller has more information about the quality of the car than she does. Therefore, she might try to interpret the price as an indication of quality. If the seller puts a low price on the vehicle, the buyer might be put off, thinking the car is a piece of junk. That’s the opposite response to a price reduction a demand curve would expect.

The demand curve is vital for a business owner to understand. It shows how price changes will impact sales. If a business owner or manager doesn’t understand the demand for her products, it is nearly impossible to maximize her profits. The demand curve interacts with the supply curve to explain the market’s dynamics. Using these curves, and the information they convey, is a crucial component to running a successful company.