The Five Factors of Demand
The five factors of demand are:
1. The price of the good or service
2. The income of buyers
3. The prices of related goods or services
4. The tastes or preferences of consumers
5. Consumer expectations about whether the prices of the product will rise or fall in the future
For aggregate demand, the number of buyers in the market is the sixth factor.
Demand Formula or Equation
This equation expresses the relationship between demand and five specific factors:
qD = f (price, income, prices of related goods, taste, expectations)
As can be noted, this equation is not a straightforward equation like 2 + 2 = 4. It is not easy to create an equation that accurately predicts the quantity demanded by consumers.
Instead, this equation highlights the relationship between demand and its main factors. The quantity demanded (qD) is a function of five factors – price, buyer income, price of related goods, consumer taste, and consumer expectations regarding future supply and price. As these factors change, the quantity demanded also changes.
How Each Factor Affects Demand
The effect of each factor on demand is unique. For example, when the buyer’s income increases, it may also increase demand. The buyer has more money and is likely to spend it. However, when other factors increase – like the price of related goods, for example – demand may decrease.
Before analyzing the effect of each factor, it is important to note that these factors do not change in a vacuum. All factors are in a state of constant change. To understand how one factor affects demand, we must first assume that all other factors remain unchanged.
Price
The law of demand states that when prices rise, the quantity demanded falls. This also means that when prices fall, demand increases. People make purchasing decisions based on price if all other factors are equal. The quantity purchased at each price level is described in the demand table. It is then plotted on a graph to show the demand curve.
If the quantity demanded responds significantly to price, it is known as elastic demand. If demand does not change much regardless of price, this is considered inelastic demand.
Income
When income rises, the quantity demanded will also increase. When income falls, demand will also decrease. However, if your income doubles, you will not always buy double the quantity of a certain good or service. There is only a limited number of ice cream cones you wish to buy, regardless of your wealth. This is an example of “marginal utility.”
Marginal utility is a concept that states that each unit of a good or service is less valuable to you than the first. At some point, you will not want any more of it, and marginal utility will drop to zero.
The first cone of ice cream is delicious. You might want a second cone. But then, the marginal utility starts to decrease to the point where you do not want any more.
Prices of Related Goods
The price of complementary goods or services raises the cost of using the product you demand, so you will want something less. For example, when fuel prices rose to $4 a gallon in 2008, the demand for trucks and SUVs that consumed fuel in large quantities decreased. Fuel is a complementary good for these vehicles. The cost of driving a truck increased as fuel prices rose.
An 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. For this reason, Apple continually innovates with its iPhones and iPods. As soon as a substitute like a new lower-priced Android phone appears, Apple launches a better product. Then Android is no longer a substitute.
Taste
When
As public desires, feelings, or preferences change in favor of a particular product, the quantity demanded also changes. Similarly, when tastes conflict with it, this reduces the quantity demanded. Commercial advertisements try to increase the desire for consumer goods.
Expectations
When people expect the value of something to rise, they demand more of it. This helps to explain the housing asset bubble in 2005. Property prices rose, but people continued to buy homes because they anticipated prices would keep rising. Prices continued to increase until the bubble burst in 2007. New home prices dropped 22% from their peak in March 2007 of $262,200 to $204,200 in October 2010. However, the quantity demanded did not increase even as prices fell, and sales dropped from their peak in 2005 by 1.2 million homes to a low in 2011 of 306,000 homes.
So why didn’t the quantity demanded increase as prices fell? This is partly due to the broader economy experiencing a recession. People expected prices to continue to fall, so they didn’t feel an urgent need to buy a home. Record levels of foreclosures entered the market due to the subprime mortgage crisis. Demand for homes did not increase until people expected future home prices would also rise.
Number of Buyers in the Market
The number of consumers affects overall demand. As more buyers enter the market, demand increases. This is true even if prices do not change, and the United States saw this during the housing bubble in 2005. Low-cost mortgages and subprime mortgages increased the number of people who could afford to buy a home. The total number of buyers in the market increased. Demand for housing rose. When home prices began to decline, many realized they could not afford their mortgages. At that time, foreclosures were made. This reduced the number of buyers and led to a decrease in demand.
Frequently Asked Questions (FAQs)
What is the law of demand?
The basic law of demand states that as prices go up, demand goes down, and vice versa. It assumes no changes in the other four factors that determine demand.
What factors affect the elasticity of demand?
Two of the biggest factors affecting the price elasticity of demand are the availability of substitutes and whether the item is a necessity or a luxury. Over time, demand will always be more elastic than it is in the short term, as you have more time to find substitutes if the price remains high.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Victoria University. “Principles of Microeconomics. Chapter 3.3. Other Factors that Determine Demand.”
Congressional Budget Office. “Gas Prices and Car Markets.”
Census Bureau. “Average and Sale Prices of New Homes Sold in the United States.”
Census Bureau. “New Home Sales, Historical Time Series, Download ‘Houses Sold’ XLS. Use the ‘Sold Annually’ tab.”
Federal Reserve History. “Subprime Mortgage Crisis.”
California State University Northridge. “Microeconomics.”
Source: https://www.thebalancemoney.com/five-determinants-of-demand-with-examples-and-formula-3305706
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