Exam (elaborations) Economics (Determinants of Demand)
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Economics
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Economics
The determinants of demand are crucial factors that influence the quantity of a good or service that consumers are willing and able to purchase at various price levels. Price, being a primary determinant, reflects the basic economic principle of demand: as prices rise, the quantity demanded tends t...
1. The price of the good or service
2. The income of buyers
3. The prices of related goods or services—either complementary and purchased
along with a particular item, or substitutes bought instead of a product
4. The tastes or preferences of consumers will drive demand
5. Consumer expectations about whether 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) 1
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.1
, 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 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. If the quantity demanded responds a lot to price, then it's known
as elastic demand. If demand doesn't change much, regardless of price, that's inelastic
demand.
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 are only so many pints of ice cream you'd want to buy, no matter how
wealthy you are, and this is an example of "marginal utility." 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.2 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.
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.
Expectations
When people expect that the value of something will rise, they demand more of it. That
helps explain 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. 3 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.
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