Businesses need to keep demand for their products as high as possible so that they can grow, but that’s not always easy. The way demand works is complex, with a number of factors affecting it. As we’ll see in this article, the determinants of demand are a crucial factor in business operation and economics.
Anyone can benefit from learning about the basics behind these forces can help shed light on the ebbs and flows of what’s driving the economic engine behind consumer-facing industries.
Companies can develop strategies to take advantage of the impact of some of these factors of demand, also called “determinants.” However, not all of the determinants of demand are within a company’s power to control.
Still, fully understanding how the forces of demand work, including how the determinants of demand relate to each other, can help give businesses an edge in achieving the growth they need to succeed.
What is Demand?
Demand, as an economic principal, is basically consumers’ willingness to buy an item or a service. The more people want a product and are willing to pay for it, the higher the demand. When consumers avoid a product for whatever reason – whether it’s too expensive, they just don’t want it, or they see its value declining in the future, or any number of other reasons – then demand is lower.
Economists recognized five main factors that affect demand – price changes, consumers’ income, competition, consumer tastes and consumer expectations. As they study demand more in depth, they can calculate future demand with more precision through different equations that account for each factor.
The determinants of demand each affect demand in a different way, but they are all connected to one another. When we examine how these determinants affect demand, we’re also assuming that the other factors don’t change.
In reality, each determinant of demand works in flux with the others at any given time.
1. Price of Goods
The price charged to consumers for goods or services has an impact on the demand for that product. This is the fundamental principal behind the law of demand. According to this law, when the price of something increases, then demand for that product decreases and vice versa. Essentially, there is an inverse relationship between price and demand.
That’s because a higher price means less consumers can afford it or are willing to pay for it. A lower price puts the goods or services within the price range of more consumers. Lower prices make a product more desirable.
Again, that’s assuming all other factors are equal, or that the other determinants remain the same. In some cases, demand can increase even if price increases if other determinants of demand are working in other ways.
Elastic Demand versus Inelastic Demand
When demand for a product changes significantly as the price changes, then the demand is considered “elastic.” If there’s minimal change to demand even with significant price changes, then the demand is considered “inelastic.” Take these examples:
- Elastic Demand. Gasoline is among the more elastic products because as its price rises and falls, so does demand for it – in nearly direct correlation. When consumers can afford to buy more gas, they tend drive more miles and buy that gas. When the price of gas is higher, they tend to be more conservative with how much they drive, so they don’t buy as much gas.
- Inelastic demand. A good that has “perfectly inelastic” demand is not affected by price changes at all, although this situation is fairly rare. One example may be a life-saving drug. The demand for medicine that could save your life would remain the same, no matter how high the price rises.
Companies that have a good sense of the elasticity of the demand for their products can better predict how demand will change with price and other factors. With that information, they can develop the best business strategies to foster growth.
2. Buyers’ Income
The more money that consumers have in their pockets, the more they can afford to buy. So, it makes sense that a buyer’s income has a direct impact on demand. As income increases, so does demand. And as income decreases, demand for goods and services slides as buyers simply can’t buy as much.
Of course, demand doesn’t necessarily increase directly in tandem with income. If a buyer’s income doubles, that doesn’t necessarily mean that they will purchase twice the amount of a product. Buyers only want so much of a product – not an infinite amount.
As companies understand buyer income trends, they also need to understand how they relate to their specific product or service. Demand for some items increases more than others with regard to increasing buyer income.
3. Price of Related Goods – Substitute and Complementary
Demand also rises and falls inversely to price of related goods, and in opposition to price changes of competitive products. A product or service’s financial burden on the consumer can rise because of the price of things related to it, or because of the price of competitive products.
There are two different ways the price of related goods can impact demand – as substitute products or complementary products.
Substitute Products
Substitute products are those that can take the place of a product, such as a generic substitute for a name brand. And complementary products are related to the original product, or that buyers tend to buy in tandem with it, but that are different types of products.
When buyers have other options for their goods or services, the price of the alternative choices can have an impact on demand. After all, who wants to throw money away by paying more for the same thing? Typically, they would choose the lower priced product of two products that were otherwise the same.
The lower the price of a substitute item, the lower demand for the product. To compete against this force of demand, a company must either lower its price to attract the buyers or improve its product so that it is superior to its substitute.
Complementary Products
With complementary products, demand moves in opposition to price movements. If the price of a complementary product increases, the demand for a product declines, much as it would if its own price increased. This factor is like the law of demand, only it includes two products that consumers buy together instead of one.
We can find an example of a complementary product in car buying with respect to gas prices. Driving requires that you buy gas regularly. So, when the price of gas rises, consumers factor that into their car buying decisions and look for smaller cars that get higher mileage per gallon. When the price of gas falls, we see increased demand for larger vehicles like SUVs that use more gas.
4. Consumer Preferences
People’s tastes are a major driver of demand. Simply put, if people don’t want your product, they won’t buy it. If they do have a desire for it, they’ll want to buy more of it. So, the more popular and trendier an item is, the higher the demand is.
That’s why marketing often focuses heavily on increasing people’s desires for certain products. Advertisements try to make goods or services look enticing with rewards like a better lifestyle or reputation. They try to change consumer tastes so that demand for their goods increases.
5. Consumer Expectations
Everyone likes to make a good investment and no one likes to lose money. If consumers see the market for something picking up in the future, they will anticipate higher demand and higher prices.
If they believe the price of a product will increase down the line, they will be willing to pay more for it in the present and more people will want to buy it. That’s why consumer expectations can have a strong impact on demand.
Other Factors the Affect Demand
The determinants of demand described above are the basic driving forces behind demand that economists often use to calculate trends. However, there are many other factors that can affect demand as well.
For example, seasonal changes have a significant impact on demand for many kinds of consumer goods. Snow ski equipment is in higher demand in the winter and lower demand in the summer. And boating equipment is in higher demand in the summer and lower demand in the winter. Warm hearty food tends to be in higher demand in the winter and cool, and refreshing food is in higher demand in the summer.
Another factor that economists recognize affects demand is the number of buyers in the market. With more buyers in the market, demand increases. If more people can afford to buy a product, then they will increase demand simply with their numbers.
Similarly, if there are fewer buyers in the market for a product, demand will drop as there are simply not as many people there who want to buy it.
How Demand Relates to Supply
The relationship between demand and supply is also important to understand. You’ve likely heard of the law of supply and demand. We learned about the law of demand above that higher prices lead to lower demand and vice versa. Understanding the law of supply is critical to learning how these two economic principles are connected.
The law of supply essentially says that as a product’s price increases, producers will make of it so they can earn more money and maximize profits. As a prices decrease, companies tend to make less of a product because they are not making as much money.
The Bottom Line
Understanding how the forces of demand work is critical for anyone in business management, so that they can help the company drive sales growth. But everyone can benefit from having a general understanding at what’s behind demand and buying trends. Being aware of the forces are at work in our everyday life can help us be aware of our own actions and the impact of our actions.
As we’ve seen, countless factors can influence demand trends. The most common forces are price of goods and related goods, personal income of consumers, tastes and preferences, expectations and size of the market. Yet many forces, big and small, are at work when it comes to demand trends.
Demand is a result of the combined way that these factors are related to each other at any given time.