Determinants of demand

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Definition

Determinants of individual demand

The determinants of individual demand of a particular good, service or commodity refer to all the factors that determine the quantity demanded of an individual or household for the particular commodity. The main determinants of demand are:

  1. The (unit) price of the commodity.
  2. The tastes and preferences of the individual or household.
  3. The prices and nature of substitute goods, i.e., goods whose consumption can replace the consumption of the given good. The cheaper and better the substitute goods, the less the demand, ceteris paribus. This is termed the substitution effect.
  4. The prices and nature of complementary goods, i.e., goods for which increased consumption makes the consumption of the given good more worthwhile. A drop in the price of complementary goods leads to an increase in demand, ceteris paribus.
  5. The disposable income that the household has. More specifically, the fraction of household income that it is generally willing to spend on that or related commodities. An increase in income leads to an increase (or at any rate, no decrease) in demand for most goods. This is termed the income effect. Goods for which the income effect is reversed are typically inferior goods. For these good, demand may drop with a rise in income.
  6. Expectations of future prices. This is particularly important for durable goods for which there is no urgency to purchase. In general, if future prices are expected to be lower, demand is less for a given price, because a person decides to delay the purchase. If future prices are expected to be higher, demand may be higher for a given price, because a person prefers to buy now before the good becomes too expensive.
  7. The surrounding circumstances, such as climate, weather, crime levels, that have an effect on the desirability of possessing the good. This is sometimes folded under tastes and preferences -- however, surrounding circumstances could change without any change in tastes and preferences.

The demand curve (specifically, the individual demand curve) is a plot with quantity demanded on the horizontal axis and price on the vertical axis, keeping all other parameters constant (i.e., ceteris paribus).

Determinants of market demand

The market demand curve for a commodity is obtained by adding up the individual demand curves for all economic actors in the market. Thus, each of the determinants of individual demand is also a determinant of market demand. However, aggregating a particular determinant of individual demand across the market (through some method such as taking an average) does not necessarily capture all the information about that determinant since the distribution across the market also matters. Broadly, there are three kinds of factors that affect market demand:

  1. The size of the market. ceteris paribus, a larger market means more demand, and a more outward market demand curve.
  2. The various determinants of individual demand, averaged across all economic actors in the market.
  3. The distribution of each of the determinants of individual demand across all economic actors in the market.

Determinants of change in demand

Effect of unit price

Unit price has a direct effect on the quantity demanded but not on the demand curve (which is a plot of quantity demanded against individual price). The relationship is studied by studying the demand curve. The most important feature of this relationship is the law of demand, which asserts that an increase in unit price leads to a decrease in quantity demanded.

Other determinants

The cause of a change in quantity demanded, either at the individual or market level, is usually a change in one of the determinants of demand. Given below is a comprehensive table of examples:

Determinant of demand Individual or market? Nature of change Effect on quantity demanded ceteris paribus and hence on demand curve Measure of sensitivity
Tastes and preferences individual increase in preference positive, hence expansion of demand curve
Tastes and preferences individual decrease in preference negative, hence contraction of demand curve
Price of substitute good individual increase in price positive, hence expansion of demand curve see cross-price elasticity of demand, also substitution effect
Price of substitute good individual decrease in price negative, hence contraction of demand curve see cross-price elasticity of demand, also substitution effect
Nature of substitute good individual better substitution ambiguous. Demand could shift between the two substitutes depending on the relative prices.
Nature of substitute good individual worse substitution ambiguous. Demand could shift between the two substitutes depending on the relative prices.
Price of complementary good individual increase in price negative, hence contraction of demand curve see cross-price elasticity of demand
Price of complementary good individual decrease in price positive, hence expansion of demand curve see cross-price elasticity of demand
Nature of complementary good individual increase in complementarity positive (generally), hence expansion of demand curve
Disposable income individual increase in income positive (usually), hence expansion of demand curve see Engel curve and income-elasticity of demand. Goods for which this is true are termed normal goods. Exceptions are termed inferior goods.
Disposable income individual decrease in income negative (usually), hence contraction of demand curve see Engel curve and income-elasticity of demand. Goods for which this is true are termed normal goods. Exceptions are termed inferior goods.
Expectations of future prices individual increase in future price expectation positive, hence expansion of demand curve
Expectation of future prices individual decrease in future price expectation negative, hence contraction of demand curve
Environmental need for good individual increase in environmental need positive, hence expansion of demand curve
Environmental need for good individual decrease in environmental need negative, hence contraction of demand curve
Market size market increase in market size positive, hence expansion of demand curve