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Determinants of Demand

The Five Factors Affecting Demand Using Examples in the U.S. Economy



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Demand drives economic growth. But what drives demand? In economics, there are five things that drive individual demand. There are six that drive aggregate demand. Businesses seek to increase demand for their goods and services so they can raise prices and boost profits. Governments and central banks try to implement policies that increase demand to get the economy out of the contraction phase of the business cycle, and slow down demand during the expansion phase. Even individuals try to raise demand for their services if they are wage-earners. Therefore, it pays (literally) for everyone to know what drives demand, and how to affect those determinants.

What Are the Five Determinants of Demand

The five determinants of demand are:
  1. Price of the good or service.
  2. Prices of related goods or services. These are either complementary, which are things that are usually bought along with the product in demand. They could also be substitutes for the product in demand.
  3. Income of those with the demand.
  4. Tastes or preferences of those with the demand.
  5. Expectations. These are usually about whether the price will go up.
For aggregate demand, the number of buyers in the market is a sixth determinant.

Demand Equation or Function

The relationship between the five factors and demand is usually expressed as a formula, or function. The following formula tells you that the quantity demanded is a function of these five determinants:

qD = f (price, income, prices of related goods, tastes, expectations)

What does this mean? The important thing to note is that the quantity demanded changes, not overall demand. For more on that, see Demand Curve.

How Each Determinant Affects Demand

How do these factors affect demand? We'll examine each in detail, one at a time. That means that you can understand how a particular determinant affects demand, but you've got to first assume that all of the other determinants don't change. That's the principle known as ceteris paribus -- 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 demanded falls. This also means that, when prices drop, demand will rise. People base their purchasing decisions on price, if all other things are equal. The reverse, of course, is also true. When demand rises, businesses will usually raise the price to avoid being out of stock and disappointing customers. Conversely, when demand falls, businesses will usually drop the price, even if only temporarily for a sale, to sell more of the good or service.

Income - When income rises, so will the quantity demanded. When income falls, so will demand. However, even if your income doubles, you will 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 rich 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. (At least until tomorrow.)

Prices of related goods or services - The price of complementary goods or services raises the overall cost of using the good you demand, so you'll want less. For example, when gas prices rose to $4 a gallon in 2008, the demand for Hummervees fell. Gas is a complementary good to Hummers. The overall 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 less of the good or service. That's why Apple constantly innovates with its iPhones and iPods. As soon as a substitute, such as the Droid, appears at a lower price, Apple comes out with a better product, so now the Droid isn't really a substitute.

Tastes - This is the desire, emotion, or preference for a good or service. When tastes rise, so does the quantity demanded. Likewise, when tastes fall, it will depress the quantity demanded. This is what brand advertising is all about. Companies spend millions to make you feel strongly that you want a product.

Expectations - When people expect that the value of something will rise, then they demand more of it. This explains the housing bubble of 2005. Housing prices rose, but people bought more because they expected the price to continue to go up. This drove prices even further, until the bubble burst in 2006. Between 2007 and 2011, housing prices fell 30%. However, the quantity demanded didn't rise because people expected prices to continue to fall thanks to record levels of foreclosures entering the market. When people expect prices to rise again, so will demand for housing.

Number of buyers in the market -When the number of buyers in the market rises, so will the quantity demanded. This is another reason for the housing bubble. Low-cost mortgages increased the number of people who were told they could afford a house. The number of buyers actually increased, driving up the demand for housing. When they found they really couldn't afford the mortgage, especially when housing prices started to fall, they foreclosed. This reduced the number of buyers, and demand also fell.

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