Five Determinants of Demand with Examples and Formula
The Five Factors Affecting Demand Using Examples in the U.S. Economy
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, even you try to raise demand for them.
What drives demand? In economics, there are five 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.
- Prices of related goods or services. These are either complementary (purchased along with) or substitutes (purchased instead of).
- Income of buyers.
- Tastes or preferences of consumers.
- Expectations. These are usually about whether the price will go up.
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)
It says that the quantity demanded of a product is a function of five factors: price, income of the buyer, the price of related goods, the tastes of the consumer and any expectation the consumer has of future supply, prices, etc.
How Each Determinant Affects Demand
You can understand how each determinant affects demand if you first 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.
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 demand curve only shows the relationship between the price and quantity. If one of the other determinants changes, the entire demand curve shifts.
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's only so many pints of ice cream you'd want to eat, no matter how wealthy you are. That's where the concept of marginal utility comes into the picture. 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 Hummers fell.
Gas is a complementary good to Hummers. The cost of driving a Hummer 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. For example, Buick spent millions to make you think its cars are not only for older people.
Expectations. When people expect that the value of something will rise, they demand more of it. That explains the housing asset bubble of 2005. Housing prices rose, but people bought more because they expected the price to continue to go up. Prices increased even more until the bubble burst in 2006. Between 2007 and 2011, housing prices fell 30 percent. But the quantity demanded didn't grow. Why? People expected prices to continue falling. Record levels of foreclosures entered the market due to the subprime mortgage crisis. Demand didn't increase until people expected future 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. That was another reason for the housing bubble. 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, which 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, driving down demand.