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. The first is consumer incomes or how much money they have to spend. The second is buyers' tastes or preferences in what they want to purchase. If they prefer electric vehicles to save on gasoline, then demand for Humvees will drop. The third is their expectations about whether the price will go up. If they are concerned about future inflation they will stock up now, thus driving current demand.
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. Here is an example of a demand schedule:
|Amount of Beef Bought at Each Price Point|
|Price/lb.||Quantity (in lbs.)|
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 that's been detailed 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, then 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:
- Unit elastic is when demand changes by the exact same percentage as the price does.
- Elastic is when demand changes by a greater percentage than the price does.
- Inelastic is when demand changes by a smaller percentage than the price does.
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:
- Consumer spending.
- Business investment spending.
- Government spending.
- Imports, which are subtracted from aggregate demand and GDP.
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. For example, 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.
If demand drops, then businesses will lower prices. They hope that's enough to shift demand from their competitors and take more market share. If that doesn't work, they will innovate and create a better product. If demand still doesn't rebound, then companies will produce less and lay off workers. If that happens across the board, it can cause an economic contraction. That phase of the business cycle creates 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 lowers it during inflation. To boost demand, it either cuts taxes or purchases more goods and services. It can also give subsidies to businesses or benefits to individuals such as unemployment benefits. It increases demand by raising confidence and creating enough jobs. Research shows that the best ways to create those jobs is government spending on mass transit and education.
To lower demand, Congress can raise taxes, cut spending, or withdraw subsidies and benefits. This often angers beneficiaries and leads to the elected officials being booted out of office.
Demand and Monetary Policy
Most inflation fighting is left to the Federal Reserve and monetary policy. The Fed's most effective tool for reducing demand is by raising interest rates. This shrinks the money supply and 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 lowers interest rates and increases 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. That's when Congress must step in with expansionary fiscal policy.