Demand Explanation and Its Impact
Demand, Not Money, Makes the World Go Round
Demand in economics is how many goods and services are bought at various prices during a certain period of time. Demand is the consumer's need or desire to own the product or experience the service. It's constrained by the willingness and ability of the consumer to pay for the good or service at the price offered.
Demand is the underlying force that drives everything in the economy. Fortunately for economics, people are never satisfied.
They always want more. This drives economic growth and expansion. Without demand, no business would ever bother producing anything.
Determinants of Demand
There are five determinants of demand. The most important is the price of the good or service itself. The next is the price of either related products, which are either substitutes or complementary. Circumstances drive the next three: their incomes, their tastes and their expectations.
Law of Demand
The law of demand governs the relationship between the quantity demanded and the price. This economic principle describes something you already intuitively know, if the price goes up, people buy less. The reverse is, of course true, if the price drops, people buy more. But, price is not the only determining factor. Therefore, the law of demand is only true if all other determinants don't change. In economics, this is called ceteris paribus. Therefore, the law of demand formally states that, ceteris paribus, the quantity demanded for a good or service is inversely related to the price.
The demand schedule is a table or formula that tells you how many units of a good or service will be demanded at the various prices, ceteris paribus.
If you were to plot out how many units you would buy at different prices, then you've created a demand curve. It graphically portrays the data in a demand schedule.
When the demand curve is relatively flat, then people will buy a lot more even if the price changes a little. When the demand curve is fairly steep, than the quantity demanded doesn't change much, even though the price does.
Elasticity of Demand
Demand elasticity means how much more, or less, demand changes when the price does. It's specifically measured as a ratio, the percent change of the quantity demanded divided by the percent change in price. There are three levels of demand elasticity:
- Unit elastic is when demand changes the exact same percent as the price does.
- Elastic is when demand changes by a greater percent than the price does.
- Inelastic is when demand changes a smaller percent than the price does.
Aggregate demand, or market demand, is another way of saying demand of any group of people. The five determinants of individual demand governs it. There’s also a sixth: the number of buyers in the market.
The aggregate demand for a country measures the quantity of the goods or services it produces that is demanded by the world's population. For that reason, it is composed of the same five components that make up gross domestic product:
- Consumer spending.
- Business investment spending.
Businesses Depend on Demand
All businesses try to understand or guide consumer demand. They can be the first or the cheapest in delivering the right products and services. If something is in high demand, businesses make more revenue. If they can't make more fast enough, the price goes up. If the price increase sustains over time, then you have inflation.
Conversely, if demand drops then businesses will first lower the price, hoping to shift demand from their competitors and take more market share. If demand isn't restored, they will innovate and create a better product. If demand still doesn't rebound, then companies will produce less and lay off workers. This contraction phase of the business cycle can end in a recession.
Demand and Fiscal Policy
The Federal government also tries to manage demand to prevent either inflation or recession. This ideal situation is called the Goldilocks economy. Policymakers use fiscal policy to boost demand in a recession or subdue demand in inflation. To boost demand, it either cuts taxes, purchases goods and services from businesses. It also gives subsidies and benefits such as unemployment benefits. To subdue demand, it can raise taxes, cut spending and withdraw subsidies and benefits. This usually angers beneficiaries and leads to the elected officials being booted out of office.
Demand and Monetary Policy
Thus, most inflation fighting is left to the Federal Reserve and monetary policy. The Fed's most effective tool for reducing demand is increasing prices, which it does by raising interest rates. This reduces the money supply, which reduces lending. With less to spend, consumers and businesses might want more, but they have less money to do it with.
The Fed also has powerful tools to boost demand. It can make prices cheaper by lowering interest rates and increasing the money supply. With more money to spend, businesses and consumers can buy more.
Even the Fed is limited in boosting demand. If unemployment remains high for a long period of time, then consumers don't have the money to get the basic needs met. No amount of low interest rates can help them, because they can't take advantage of low-cost loans. They need jobs to provide income and confidence in the future. Therefore, demand is based on confidence and enough decent, well-paying jobs. The best ways to create those jobs is government spending on mass transit and education.