Demand drives economic growth. Businesses want to increase demand so they can improve profits. Governments and central banks boost demand to end recessions. They slow it during the expansion phase of the business cycle to combat inflation. If you offer any paid services, then you are trying to raise demand for them.
So what drives demand? In the real world, a potentially infinite number of factors impact each consumer's decision to buy something. In economics, however, the equation is simplified to highlight the five primary determinants of individual demand and a sixth for aggregate demand.
The 5 Determinants of Demand
The five determinants of demand are:
- The price of the good or service
- The income of buyers
- The prices of related goods or services—either complementary and purchased along with a particular item, or substitutes bought instead of a product
- The tastes or preferences of consumers will drive demand
- Consumer expectations about whether prices for the product will rise or fall in the future
For aggregate demand, the number of buyers in the market is the sixth determinant.
Demand Equation or Function
This equation expresses the relationship between demand and its five determinants:
qD = f (price, income, prices of related goods, tastes, expectations)
As you can see, this isn't a straightforward equation like 2 + 2 = 4. It isn't that simple to create an equation that accurately predicts the exact quantity that consumers will demand.
Instead, this equation highlights the relationship between demand and its key factors. The quantity demanded (qD) is a function of five factors—price, buyer income, the price of related goods, consumer tastes, and any consumer expectations of future supply and price. As these factors change, so too does the quantity demanded.
How Each Determinant Affects Demand
Each factor's impact on demand is unique. When the income of the buyer increases, for example, that could also increase demand. The buyer has more money and is more likely to spend it. But when other factors increase—like the price of related goods, for example—demand could decrease.
Before breaking down the effect of each determinant, it's important to note that these factors don't change in a vacuum. All the factors are in flux all the time. To understand how one determinant affects demand, you must first hypothetically assume that all the other determinants don't change.
Note
That principle is called ceteris paribus or “all other things being equal.”
So, ceteris paribus, here's how each element affects demand.
Price
The law of demand states that when prices rise, the quantity of demand falls. That also means that when prices drop, demand will grow. People base their purchasing decisions on price if all other things are equal. The exact quantity bought for each price level is described in the demand schedule. It's then plotted on a graph to show the demand curve.
Note
The demand curve shows just the relationship between price and quantity. If one of the other determinants changes, the entire demand curve shifts.
If the quantity demanded responds a lot to price, then it's known as elastic demand. If demand doesn't change much, regardless of price, that's inelastic demand.
Income
When income rises, so will the quantity demanded. When income falls, so will demand. But if your income doubles, you won't always buy twice as much of a particular good or service. There are only so many pints of ice cream you'd want to buy, no matter how wealthy you are, and this is an example of "marginal utility."
Note
Marginal utility is the concept that each unit of a good or service is a little less useful to you than the first. At some point, you won’t want it anymore, and the marginal utility drops to zero.
The first pint of ice cream tastes delicious. You might have another. But after that, the marginal utility starts to decrease to the point where you don't want any more.
Prices of Related Goods or Services
The price of complementary goods or services raises the cost of using the product you demand, so you'll want less. For example, when gas prices rose to $4 a gallon in 2008, the demand for gas-guzzling trucks and SUVs fell. Gas is a complementary good to these vehicles. The cost of driving a truck rose along with gas prices.
The opposite reaction occurs when the price of a substitute rises. When that happens, people will want more of the good or service and less of its substitute. That's why Apple continually innovates with its iPhones and iPods. As soon as a substitute, such as a new Android phone, appears at a lower price, Apple comes out with a better product. Then the Android is no longer a substitute.
Tastes
When the public’s desires, emotions, or preferences change in favor of a product, so does the quantity demanded. Likewise, when tastes go against it, that depresses the amount demanded. Brand advertising tries to increase the desire for consumer goods.
Expectations
When people expect that the value of something will rise, they demand more of it. That helps explain the housing asset bubble of 2005. Housing prices rose, but people kept buying houses because they expected the price to continue to increase. Prices continued increasing until the bubble burst in 2007. New home prices fell 22% from their peak of $262,200 in March 2007 to $204,200 in October 2010. However, the quantity demanded didn't increase—even as the price decreased—and sales fell from a peak of 1.2 million in 2005 to a low of 306,000 in 2011.
So why didn't the quantity demanded increase as the price fell? It's in part because the broader economy was experiencing a recession. People expected prices to continue falling, so they didn't feel an urgency to buy a home. Record levels of foreclosures entered the market due to the subprime mortgage crisis. Demand for homes didn't increase until people expected future home prices would, too.
Number of Buyers in the Market
The number of consumers affects overall, or “aggregate,” demand. As more buyers enter the market, demand rises. That's true even if prices don't change, and the U.S. saw this during the housing bubble of 2005. Low-cost and sub-prime mortgages increased the number of people who could afford a house. The total number of buyers in the market expanded. This increased demand for housing. When housing prices started to fall, many realized they couldn't afford their mortgages. At that point, they foreclosed. That reduced the number of buyers and drove down demand.
Frequently Asked Questions (FAQs)
What is the law of demand?
The basic law of demand states that as prices rise, demand drops, and vice versa. It assumes no changes in the other four factors that determine demand, however.
What factors affect elasticity of demand?
Two of the biggest factors that influence how elastic demand is in relation to price are the availability of substitutes and whether the item is a necessity or a luxury. Over time, demand will always be more elastic than it is in the short term, because you have more time to find substitutes if price remains high.
As an expert in economics with a comprehensive understanding of the principles that drive demand, I can confidently assert that the article you provided touches upon key concepts that are fundamental to economic theory. Let me break down and elaborate on each of the concepts discussed:
1. Determinants of Demand:
The article rightly identifies the five primary determinants of individual demand and the sixth for aggregate demand. These determinants play a crucial role in shaping consumers' decisions and overall market dynamics.
a. Price of the Good or Service:
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The law of demand is introduced, stating that as prices rise, the quantity demanded falls, and vice versa. This relationship is fundamental and is often represented graphically through demand curves.
b. Income of Buyers:
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The article correctly highlights that an increase in buyer income tends to lead to an increase in the quantity demanded. However, it emphasizes the concept of "marginal utility," explaining that the increase is not necessarily proportional.
c. Prices of Related Goods or Services:
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The discussion on complementary and substitute goods is aptly covered. It explains how changes in the prices of these related goods impact the demand for a particular product.
d. Tastes or Preferences of Consumers:
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The article rightly notes that changes in consumer preferences can significantly influence the quantity demanded. It also touches upon the role of brand advertising in shaping these preferences.
e. Consumer Expectations:
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Expectations about future prices are acknowledged as a determinant of demand. The example of the housing bubble in 2005 effectively illustrates how expectations can drive demand.
f. Number of Buyers in the Market (Aggregate Demand):
- The article appropriately brings in the concept of aggregate demand, emphasizing that the total number of buyers in the market can impact demand, irrespective of price changes.
2. Demand Equation or Function:
The article provides a succinct expression of the demand equation, highlighting the relationship between quantity demanded and the five determinants. This equation emphasizes that predicting the exact quantity demanded is complex due to the dynamic nature of these factors.
3. Ceteris Paribus:
The principle of ceteris paribus is correctly introduced, emphasizing that to understand the impact of one determinant on demand, other factors must be held constant. This is a crucial concept in economic analysis.
4. Elasticity of Demand:
The article briefly touches upon elasticity of demand, distinguishing between elastic and inelastic demand. It rightly notes that the availability of substitutes and whether a good is a necessity or luxury are key factors influencing elasticity.
5. FAQs:
The FAQs section provides concise answers to common questions, reinforcing the fundamental concepts discussed in the article.
In summary, the article effectively covers the determinants of demand, the demand equation, and related economic principles, providing a solid foundation for understanding how demand functions in the market.
