The Five Determinants of Demand

The Five Determinants of Demand The five determinants of demand are: 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 and bought instead of a product. 4. The tastes or preferences of consumers will drive demand. 5. Consumer expectations. Most often, this refers to whether a consumer believes 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 Function This equation expresses the relationship between demand and its five determinants: 1 qD = f (price, income, prices of related goods, tastes, expectations) 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. The demand curve shows just the relationship between price and quantity. If one of the other determinants changes, the entire demand curve shifts. 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's only so many pints of ice cream you'd want to eat, no matter how wealthy you are, and this is an example of "marginal utility." Marginal utility is the concept that each unit of a good or service is a little less useful to you than the first. At some point, you won’t want it anymore, and the marginal utility drops to zero. 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 explains 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 2011.4 So why didn't the quantity demanded increase as the price fell? It's in part because the broader economy was experiencing a recession. People expected prices to continue falling, so they didn't feel an urgency to buy a home. Record levels of foreclosures entered the market due to the subprime mortgage crisis. Demand for homes didn't increase until people expected future home prices would, too. Number of buyers in the market The number of consumers affects overall, or “aggregate,” demand. As more buyers enter the market, demand rises. That's true even if prices don't change, and the U.S. saw this during the housing bubble of 2005. Low-cost and sub-prime mortgages increased the number of people who could afford a house.5 The total number of buyers in the market expanded. This increased demand for housing. When housing prices started to fall, many realized they couldn't afford their mortgages. At that point, they foreclosed. That reduced the number of buyers and drove down demand. Determinants of Supply: i. Price: ii. Cost of Production: iii. Natural Conditions: iv. Technology: v. Transport Conditions: vi. Factor Prices and their Availability: vii. Government's Policies: viii. Prices of Related Goods: In economics, supply refers to the quantity of a product available in the market for sale at a specified price at a given point of time. Unlike demand, supply refers to the willingness of a seller to sell the specified amount of a product within a particular price and time. Determinants of Supply: Supply can be influenced by a number of factors that are termed as determinants of supply. Generally, the supply of a product depends on its price and cost of production. In simple terms, supply is the function of price and cost of production. Some of the factors that influence the supply of a product are described as follows: i. Price: Refers to the main factor that influences the supply of a product to a greater extent. Unlike demand, there is a direct relationship between the price of a product and its supply. If the price of a product increases, then the supply of the product also increases and vice versa. Change in supply with respect to the change in price is termed as the variation in supply of a product. Speculation about future price can also affect the supply of a product. If the price of a product is about to rise in future, the supply of the product would decrease in the present market because of the profit expected by a seller in future. However, the fall in the price of a product in future would increase the supply of product in the present market. ii. Cost of Production: Implies that the supply of a product would decrease with increase in the cost of production and vice versa. The supply of a product and cost of production are inversely related to each other. For example, a seller would supply less quantity of a product in the market, when the cost of production exceeds the market price of the product. In such a case the seller would wait for the rise in price in future. The cost of production rises due to several factors, such as loss of fertility of land, high wage rates of labor, and increase in the prices of raw material, transport cost, and tax rate. iii. Natural Conditions: Implies that climatic conditions directly affect the supply of certain products. For example, the supply of agricultural products increases when monsoon comes on time. However, the supply of these products decreases at the time of drought. Some of the crops are climate specific and their growth purely depends on climatic conditions. For example Kharif crops are well grown at the time of summer, while Rabi crops are produce well in winter season. iv. Technology: Refers to one of the important determinant of supply. A better and advanced technology increases the production of a product, which results in the increase in the supply of the product. For example, the production of fertilizers and good quality seeds increases the production of crops. This further increase the supply of food grains in the market. v. Transport Conditions: Refer to the fact that better transport facilities increase the supply of products. Transport is always a constraint to the supply of products, as the products are not available on time due to poor transport facilities. Therefore even if the price of a product increases, the supply would not increase. In India sellers usually use road transport and the poorly maintained road makes it difficult to reach the destination on time the products that are manufactured in one part of the city need to be spread in the whole country through road transport This may result in the damage of most of the products during the journey, which can cause heavy loss for a seller. In addition the seller can also lose his/her customers because of the delay in. the delivery of products. vi. Factor Prices and their Availability: Act as one of the major determinant of supply. The inputs, such as raw material man, equipment, and machines, required at the time of production are termed as factors. If the factors are available in sufficient quantity and at lower price, then there would be increase in production. This would increase the supply of a product in the market. For example, availability of cheap labor and raw material nearby the manufacturing plant of an organization would help in reducing the labor and transportation costs. Consequently, the production and supply of the product would increase. vii. Government’s Policies: Implies that the different policies of government, such as fiscal policy and industrial policy, has a greater impact on the supply of a product. For example, increase in tax on excise duties would decrease the supply of a product. On the other hand, if the tax rate is low, then the supply of a product would increase. viii. Prices of Related Goods: Refer to fact that the prices of substitutes and complementary goods also affect the supply of a product. For example, if the price of wheat increases, then farmers would tend to grow more wheat than nee. This would decrease the supply of rice in the market. What Is Price Elasticity of Demand? Elasticity = % change in quantity / % change in price Price elasticity of demand is a measure of the responsiveness of consumers to a change in a product's cost. The more general term demand elasticity measures the impact of a change in any of a variety of factors including the product's price. The formula for any calculation of demand elasticity is the percentage of change in the quantity that is in demand divided by the percentage change in the economic variable. So, if the price elasticity of demand is being measured, the formula would be the percentage of change in the quantity in demand divided by the percentage change in price. KEY TAKEAWAYS Price elasticity of demand is an indicator of the impact of a price change, up or down, on a product's sales. Demand elasticity is a more general term, allowing the impact on demand of a number of factors to be estimated. Higher price elasticity of demand suggests that consumers are more responsive to a product's price change. Understanding Price Elasticity of Demand Like demand elasticity for any factor, price elasticity of demand is typically measured in absolute terms. If the price elasticity of demand is greater than 1, it is elastic. That is, demand for the product is sensitive to an increase in price. A price increase for a fancy cut of steak, for example, may make many customers choose hamburger instead. A bargain price for the fancy cut will lead many customers to upgrade to the fancy cut. Tracking price elasticity of demand helps businesses set their production targets as well as adjust their prices. Price elasticity of demand that is less than 1 is inelastic. Demand for the product does not change significantly after a price increase. For example, a consumer either needs a can of motor oil or doesn't need it. A price change will have little or no effect on demand. But not many will stock up on motor oil if its price decreases. Demand is said to be "unit elastic" when it equals 1. That means that demand for the product will move proportionately with the price change. If a candy bar's price increases 5% then 5% of its regular buyers will switch to another brand. Suppose that a soft drink company calculates that the demand for a bottle of its soda increases from 100 to 110 after the price is cut from $2 to $1.50. The price elasticity of demand is calculated as the percentage change in quantity demanded (110 - 100 / 100 = 10%) divided by a percentage change in price ($2 $1.50 / $2). The price elasticity of demand, in this case, is 0.4. Since the result is less than 1, it is inelastic. The change in price had little impact on the quantity demanded. ow to calculate price elasticity of demand. Price elasticity of demand = % change in Q.D. / % change in Price To calculate a percentage, we divide the change in quantity by initial quantity. If price rises from $50 to $70. We divide 20/50 = 0.4 = 40% Example of calculating PED When the price of CD increased from $20 to $22, the quantity of CDs demanded decreased from 100 to 87. What is the price elasticity of demand for CDs? Calculating a Percentage The price increases from $20 to $22. Therefore % change = 2/20 = 0.1 (10%) 0.1 = 10% (0.1 *100) Quantity fell by 13/100 = – 0.13 (13%) Therefore PED = 13/-10 (change in quantity/ change in price) Therefore PED = -1.3 In this case demand is price elastic. i) Suppose the price of commodity X falls from Rs. 5 per kg. to Rs. 3 per kg. and its quantity demanded increases from 10 kgs.to 30 kgs. Then This shows elastic demand or elasticity of demand greater than unitary Where q refers to quantity demanded, p to price and Δ to change. If EP>1, demand is elastic. If EP< 1, demand is inelastic, and Ep= 1, demand is unitary elastic.