Demand, Its Explanation, and Its Impact
What Really Makes the World Go Round
Demand in economics is the consumer's desire and ability to purchase a good or service. It's the underlying force that 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 second is the price of related products, whether they are substitutes or complementary.
Circumstances drive the next three determinants. These are consumers' 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 increases, people buy less. The reverse is also true. If the price drops, people buy more.
But, price is not the only determining factor. The law of demand is only true if all other determinants don't change. In economics, this is called ceteris paribus. 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.
In the chart above, price is on the x-axis and quantity bought is on the y-axis. At P2, the higher price, people will only buy Q0, the lower quantity. If the price drops to P1, then the quantity bought will increase to Q1.
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. It's the percentage change of the quantity demanded divided by the percentage change in price.
There are three levels of demand elasticity:
Aggregate demand, or market demand, is the demand from a group of people. The five determinants of individual demand govern it. There’s also a sixth: the number of buyers in the market.
Aggregate demand can be measured for a country. It's the quantity of the goods or services the country produces that the world's population demands. For that reason, it is composed of the same five components that make up gross domestic product:
Businesses Depend on Demand
All businesses try to understand and guide consumer demand. They seek to understand it with market research. They attempt to guide it with marketing, including public relations and advertising. Companies with a competitive advantage draw more demand. One advantage is to be the low-cost provider. Costco provides bulk purchases with low prices per unit. Another is to be the most innovative. Apple charges higher prices because they are the first to the market with new products.
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. So, 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.
To subdue demand, it can raise taxes, cut spending, and withdraw subsidies and benefits. This often 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. It does so 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.