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Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.
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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 paid services, you should try 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 five determinants of demand are:
For aggregate demand, the number of buyers in the market is the sixth determinant.
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.
Each factor's impact on demand is unique. When the income of the buyer increases, for example, demand is expected to increase, all other factors equal. 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.
That principle is called ceteris paribus or “all other things being equal.”
So, ceteris paribus, here's how each element affects demand.
The law of demand states that when prices rise, the quantity of demand falls. This 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 at each price level is described in the demand schedule. It's then plotted on a graph to show the demand curve.
The demand curve shows the relationship between price and quantity only. 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.
When income rises, so too 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.
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.
The prices of complementary goods or services raise 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 Android is no longer a substitute.
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.
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.
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. 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.
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.
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 prices remain high.
