THE DETERMINANTS OF DEMAND

Many forces influence our decisions regarding the bundle of goods and services we choose to purchase. It is important for managers to understand these forces as fully as possible in order to make and implement decisions that enhance their firms’ long-term health. It is probably impossible to know about all such forces, let alone be able to identify and measure them sufficiently to incorporate them into a manager’s decision framework. However, a small subset of these forces is particularly important and nearly universally applicable. As stated above, the overall level of demand is determined by consumers’ incomes, their attitudes or feelings about products, the prices of related goods, their expectations, and by the number of consumers in the market. These are often referred to as the determinants of demand. Determinants of demand are the factors that determine how much will be purchased at each price. As these determinants change over time, the overall level of demand may change. More or less of a product may be purchased at any price because of changes in these factors.    

increase-and-decrease-of-demand

Such changes are shown by a shift of the entire demand curve. If the demand curve shifts to the right, we say that there has been an increase in demand. This is shown as a move from the original demand D1D1 to the higher demand D2D2 in Figure 3a. The original demand curve can be thought of as being the market demand curve for soft drinks. At a price of Rs. 15.00, given the initial level of demand, consumers would purchase 6,000 soft drinks. If demand increases to the higher demand, consumers would purchase 13,000 soft drinks rather than the 6,000 along the original demand curve.

A decrease in demand can be illustrated by a shift of the whole demand curve to the left. In Figure 3b, this is represented by a move from the original demand D1D1 to the lower demand D2D2. At the price of Rs. 13 initially 8,000 soft drinks are purchased, while following the decrease in demand only 7,000 soft drinks are bought.

It is important to see that these changes in demand are different from the changes in quantity demanded. We discussed how changes in price cause a change in quantity demanded. As price changes, people buy more or less along a given demand curve. Movement from A* to B* in Figure 4.1 shows the change in quantity demanded as price changes. It is not a shift in the whole demand curve, such as that shown in Figure 4.3a and 4.3b. When the whole demand curve changes, there is a change in demand. Some of the variables that cause a change in demand are changing incomes, changing tastes of consumers, changes in other prices, changes in consumer expectations, and changes in the number of consumers in the market etc. These variables that cause a change in demand are also known as shifter variables.

THE PRODUCT’S PRICE AS A DETERMINANT OF DEMAND

It has already been noted that consumers are expected to be willing and able to purchase more of a product at lower prices than at higher prices. In evaluating a demand or sales function for a firm or an entire industry, one of the first things a thoughtful analyst or manager will consider is the price of a product. If inventories have built up, a firm may consider lowering the price to stimulate quantity demanded. Rebates have become a popular way of doing this. Rebate programmes of one type or another have appeared for cars, home appliances, toys and even food products. Such rebates constitute a way of lowering the effective purchase price and thereby increasing the quantity that consumers demand without the negative repercussions of raising the price once the excess inventory is eliminated. Instead of raising the price back to its normal level, the firm simply allows the rebate programme to quietly come to an end. As has been stated above, this is called a change in quantity demanded. As the effective price falls, a greater quantity is demanded.

INCOME AS A DETERMINANT OF DEMAND

On the other hand, shifter variables, as the name implies cause the demand curve to shift i.e. there is a change in demand. Nearly all goods and services are what economists refer to as normal goods. These are goods for which consumption goes up as the incomes of consumers rise, and the converse is also true. In fact, it is rare to find a demand function that does not include some measure of income as an important independent variable. Goods for which consumption increases as the incomes of consumers rise are called normal goods. Goods for which consumption decreases as the incomes of consumers rise are called inferior goods.

This relationship between product demand and income is one of the reasons that so much national attention is given to the level of Gross Domestic Product (GDP) and changes in the rate of growth of GDP. The GDP is the broadest measure of income generated in the economy. In demand analysis, other more narrowly defined measures, such as personal income or disposable personal income, are often used; but these measures are highly correlated with GDP. Thus, looking at the changing trends in GDP is helpful for understanding what may happen to the demand for a product.

TASTES AND PREFERENCES AS DETERMINANTS OF DEMAND

We all like certain things and dislike others. A pair of identical twins brought up in the same environment may have different preferences in what they buy. Exactly how these preferences are formed and what influences them is not easy to know. Psychologists, sociologists, and social psychologists have a lot to offer in helping economists and other business analysts understand how preferences are formed and altered.

Even if we do not have a thorough understanding of preference structures, one thing is clear. Preferences and changes in preferences affect demand for goods and services. All have observed how such changes in tastes and preferences have influenced various markets. For example, consider the automobile market. In the United States, people appeared to have a preference for big, powerful cars throughout the 1950s and 1960s. During the 1980-90s, the preference structure started to change in favour of smaller, less-powerful, but more fuel-efficient cars. In part, the change in preference structure for cars may also have been related to lifestyle factors, such as being sportier and more concerned with resource conservation. Convenience factors, such as ease of driving and parking, may also have been important. Demographic changes, especially a trend toward smaller families, may have had some effect as well. In terms of the theory, the change in preference toward fuel-efficient cars will shift the demand curve for smaller cars to the right (see Figure 3a). On the other hand, social attitudes towards -smoking has changed and thus one would expect that the demand curve for cigarettes has shifted to the left (see Figure 3b ). Likewise, the growing awareness in respect of noise and environmental pollution has resulted in a decline in the demand for crackers during Diwali celebrations.

As much as we may like to think that we know our own minds and make our own purchase decisions without the influence of others, we are very likely influenced quite strongly by various peer groups, including the people with whom we work, classmates, roommates, the people with whom we socialize, neighbours, and so on. Our decisions about clothes, entertainment, college courses, food, and many other things are influenced by these peer groups.

From the business perspective, advertising is a key factor in the formation and alteration of consumers’ tastes and preferences. We can think of advertising as being either primarily informational or primarily transformational. Informational advertisements are designed to increase demand for a particular product by providing information about a product:, how it is used, how much it costs, where you can buy it, what attributes it has (size, weight, etc.). Newspaper advertisements often have the strongest informational component. They are designed to elicit direct purchase action on the part of consumers.

Transformational advertisements are designed to influence the image of a product or service. They attempt to enhance the satisfaction we get from a product by evoking positive images of how we will feel if we buy it. Think about television commercials for soft drink. How much usable information do they give you? Usually not much. They tell you the name of the product; associate its consumption with some reference group of happy, healthy-looking people (often famous people as well); and generally try to create a positive image in an attempt to alter your preference structure in favour of that soft drink. A single exposure to such an advertisement is not usually very effective, but repeated exposure to that advertisement and similar ones has been shown to influence consumer preferences.

In terms of measurement, this determinant of demand-tastes and preferences is the most difficult for an analyst to handle. It is hard to identify all the things that influence tastes and preferences, and often just as hard to measure those that are identified. Measures of advertising effort are sometimes used to help account for this determinant of demand.

OTHER PRICES AS DETERMINANTS OF DEMAND

How much consumers buy of a product may be affected by the prices charged for other goods or services as well. Figures 4a and 4b show the effect on the demand curve following a change in the price of a related good or service. Both graphs are self-explanatory. Earlier, it was noted that the rise in the price of gasoline during the 1970s had some effect on the demand for large versus small

cars in the United States. Gasoline and cars are complementary goods; they are used together and complement one another. When the price of gasoline rose, there were at least two effects on the automobile market. First, the higher price of gas increased the cost of driving, and thus reduced the total number of miles individuals tended to drive. Second, smaller, more fuel-efficient cars became more attractive relative to big cars.

This relationship can be stated in more general terms. Suppose that we observe two goods, A and B, and B is complementary to A. If the price of B goes up, we can expect the quantity demanded for A to be reduced. Why? Because as the price of goods B increases, its quantity demanded decreases according to the law of demand. But now, some individuals who would have purchased B at the lower price are no longer making those purchases. These same individuals now no longer have any use for A, because A was a good useful only in conjunction with B. Thus, the quantity demanded of A goes down as well. The reverse is also true: if the price of B falls, the demand for A will rise. It should be clear why business analysts are concerned not only about the effect that their product’s price has on sales but also with the effect of the prices of complementary products. 

demand-curves-for-substitutes-and-complements

What effect would you expect of an increase in the price of movie tickets to have on the demand for home VCDs and DVD players? These are substitute goods. That is, we assume that people view movie tickets and rented DVDs in much the same manner; some people would be willing to be entertained with either medium depending upon the price of the two mediums, the convenience of obtaining each, and so on. If the price of movie tickets goes up, we would expect the demand for DVD Players to rise as well. Why? If the price of movie tickets rises, fewer people attend theatre movies (according to the law of demand). But these same individuals still have a desire for entertainment and they view rented videos in much the same way as theatre movies. Some of them will now substitute rented video DVDs for the movies they would have attended in theatres, and this is seen as an increase in the quantity demanded of DVDs. In general, if we have two products, C and D, which are substitutes, we can expect that a rise in the price of C (or D) will cause the demand for D (or C) to go up.

Economists and other business analysts are, therefore, concerned with all other prices that may affect the products they are analyzing. The prices of both complementary and substitute products can be expected to influence demand. Later in this site, we will explain how a measure called the cross-price elasticity of demand can be helpful in determining whether two goods are complements, substitutes or neither. 

OTHER DETERMINANTS OF DEMAND

It would be a monumental task to identify everything that might have some influence on the demand for any product. So far, the four most important influences have been identified: a product’s price, income, tastes and preferences, and the price of complementary or substitute products. A number of others were identified in Demand and demand function page, which also affect demand. By now you will be able to establish the direction of the effect i.e. whether it will increase or decrease demand. For example, population growth obviously causes the potential demand for nearly all products to rise. In many cases, economists involved in analyzing the demand for particular products look at individual components of the population as determinants of demand. The changing age distribution, for example, may have differential effects on different markets. The growing proportion of people over 65 in the population has important ramifications for demand for such things such as healthcare products. Changes in other demographic characteristics and in the geographical distribution of the population may also be important. You may think of a variety of other effects on consumer demand as well.

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