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 Five 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 and bought instead of a product.
- The tastes or preferences of consumers will drive demand.
- Consumer expectations. Most often, this refers to whether a consumer believes 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.
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. 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.
The demand curve shows just the relationship between price and quantity. If one of the other determinants changes, the entire demand curve shifts.
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's only so many pints of ice cream you'd want to eat, 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.
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.
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 explains 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.