Determinants of Demand

The knowledge of the determinants of market demand for a product or service and the nature of relationship between the demand and its determinants proves very helpful in analyzing and estimating demand for the product. It may be noted at the very outset that a host of factors determines the demand for a product or service. In general, following factors determine market demand for a product or service:

  1. Price of the product
  2. Price of the related goods-substitutes, complements and supplements
  3. Level of consumers income
  4. Consumers taste and preference
  5. Advertisement of the product
  6. Consumers expectations about future price and supply position
  7. Demonstration effect or ‘bend-wagon effect’
  8. Consumer-credit facility
  9. Population of the country
  10. Distribution pattern of national income.

These factors also include factors such as off-season discounts and gifts on purchase of a good, level of taxation and general social and political environment of the country. However, all these factors are not equally important. Besides, some of them are not quantifiable. For example, consumer’s preferences, utility, demonstration effect and expectations, are difficult to measure. However, both quantifiable and non-quantifiable determinants of demand for a product will be discussed.

1. Price of the Product

The price of a product is one of the most important determinants of demand in the long run and the only determinant in the short run. The price and quantity demanded are inversely related to each other. The law of demand states that the quantity demanded of a good or a product, which its consumers would like to buy per unit of time, increases when its price falls, and decreases when its price increases, provided the other factors remain’ same. The assumption ‘other factors remaining same’ implies that income of the consumers, prices of the substitutes and complementary goods, consumer’s taste and preference and number of consumers remain unchanged. The price-demand relationship assumes a much greater significance in the oligopolistic market in which outcome of price war between a firm and its rivals determines the level of success of the firm. The firms have to be fully aware of price elasticity of demand for their own products and that of rival firm’s goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price of its related goods. The related goods may be the substitutes or complementary goods.

  • Substitutes: Two goods are said to. be substitutes of each other if a change in price of one good affects the demand for the other in the same direction. For instance goods X and Y are considered as substitutes for each other if a rise in the price of X increase demand for Y, and vice versa. Tea and coffee, hamburgers and hot-dog, alcohol and drugs are some examples of substitutes in case of consumer goods by definition, the relation between demand for a product and price of its substitute is of positive nature. When, price of the substitute of a product (tea) falls (or increase), the demand for the product falls (or increases).
  • Complementary Goods: A good is said to be a complement for another when it complements the use of the other or when the two goods are used together in such a way that their demand changes (increases or decreases) simultaneously. For example, petrol is a complement to car and scooter, butter and jam to bread, milk and sugar to tea and coffee, mattress to cot, etc. Two goods are termed as complementary to each other. If an increase in the price of one causes a decrease in demand for the other. By definition, there is an inverse relation between the demand for a good and the price of its complement. For instance, an increase in the price of petrol causes a decrease in the demand for car and other petrol-run vehicles and vice versa while other thing’s remaining constant.

3. Consumers Income

Income is the basic determinant of market demand since it determines the purchasing power of a consumer. Therefore, people with higher current disposable income spend a larger amount on goods and services than those with lower income. Income-demand relationship is of more varied nature than that between demand and its other determinants. While other determinants of demand, e.g., product’s own price and the price of its substitutes, are more significant in the short-run, income as a determinant of demand is equally important in both short run and long run. Before proceeding further to discuss income-demand relationships, it will be useful to note that consumer goods of different nature have different kinds of relationship with consumers having different levels of income. Hence, the managers need to be fully aware of the kinds of goods they are dealing with and their relationship with the income of consumers, particularly about the assessment of both existing and prospective demand for a product.

For the purpose of income-demand analysis, goods and services maybe grouped under four broad categories, which ate: (a) essential consumer goods, (b) inferior goods, (c) normal goods, and (d) prestige or luxury goods. To understand all these terms, it is essential to understand the relationship between income and different kinds of goods.

  1. Essential Consumer Goods (ECG): The goods and services of this category are called ‘basic needs’ and are consumed by all persons of a society such as food-grains, salt, vegetable oils, matches, cooking fuel, a minimum clothing and housing. Quantity demanded for these goods increases with increase in consumer’s income but only up to certain limit, even though the total expenditure may increase in accordance with the quality of goods consumed, other factors remaining the same. Consumer’s demand for essential goods increases only until a particular income level. It tends to saturate beyond this level of income.
  2. Inferior goods: Inferior goods are those goods whose demand decreases with the increase in consumer’s income. For example millet is inferior to wheat and rice; coarse, textiles are inferior to refined ones, kerosene is inferior to cooking gas and travelling by bus is inferior to travelling by taxi. The relation between income and demand for an inferior good is under the assumption that other determinants of demand remain the same demand for such goods rises only up to a certain level of income, and declines as income increases beyond this level.
  3. Normal goods: Normal goods are those goods whose demand increases with increase in the consumer income. For example, clothing’s  household furniture and automobiles. Demand for such goods increases with the increases in consumer income but at different rates at different levels of income. Demand for normal goods increases rapidly with the increase in the consumer’s income but slows down with further increase in income. Up to certain level of income the relation between ­income and demand for all type of goods is similar. The difference is of only degree.Therefore, it is important to view the income-demand relations in the light of the nature of product and the level of consumer’s income.
  4. Prestige and luxury goods: Prestige goods are those goods, which are consumed mostly by rich section of the society, e.g., precious stones, antiques, rare paintings, luxury cars and such other items of show-off. Whereas luxury goods include jewellery, costly brands of cosmetics, TV sets, refrigerators, electrical gadgets and cars. Demand for such goods arises beyond a certain level of consumer’s income, i.e., consumption enters the area of luxury goods. Producers of such goods, while assessing the demand for their goods, should consider the income changes in the richer section of the society and not only the per capita income.

4. Consumer’s Taste and Preference

Consumer’s taste and preference play an important role in determining demand for a product. Taste and preference depend, generally, on the changing life-style, social customs, religious values attached to a good habit of the people. Change in these factors changes consumer’s taste and preferences. As a result, consumers reduce or give up the consumption of some goods and add new ones to their consumption pattern. For example, following the change in fashion, people switch their consumption pattern from cheaper, old-fashioned goods to costlier ‘mod’ goods, as long as price differentials are proportionate with their preferences. Consumers are prepared to pay higher prices for ‘mod goods’ even if their virtual utility is the same as that of old-fashioned goods. The manufacturers of goods and services that are subject to frequent change in fashion and style, can take advantage of this situation in two ways:

  1. They can make quick profits by designing new models of their goods and popularizing them through advertisement, and
  2. They can plan production in a better way and can even avoid over-production if they keep an eye on the changing fashions.

5. Advertisement Expenditure

Advertisement costs are incurred with the objective of increasing the demand for the goods. This is done in the following ways:

  • By informing the potential consumers about the availability of the goods.
  • By showing its superiority to the rival goods.
  • By influencing consumers choice against the rival goods, and
  • By setting fashions and changing tastes.

The impact of such effects shifts the demand curve upward to the right. In other words, when other factors’ remain same, the expenditure on advertisement increases the volume of sales to the same extent.

The relationship between demand and advertisement cost is based on the following assumptions:

  • Consumers are fairly sensitive and responsive to various modes of advertisement.
  • The rival firms do not react to the advertisements made by a firm.
  • The level of demand has not already reached the saturation point. Advertisement beyond this point will make only marginal impact on demand.
  • Per unit cost of advertisement added to the price does not make the price prohibitive for consumers, as compared particularly to the price of substitutes.
  • Others determinants of demand, e.g., income and tastes, etc., are not operating in the reverse direction.

In the absence of these conditions, the advertisement effect on sales may be unpredictable.

6. Consumers Expectations

Consumers’ expectations regarding the future prices, income and supply position of goods play an important role in determining the demand for goods and services in the short run. If consumers expect a rise in the price of a storable good, they would buy more of it at its current price with a view to avoiding the possibility of price rise future. On the contrary, if consumers expect a fall in the price of certain goods, they postpone their purchase with a view to take advantage of lower prices in future, mainly in case of non-essential goods. This behavior of consumers reduces the current demand for the goods whose prices are expected to decrease in future. Similarly, an expected increase in income increases the demand for a product. For example, announcement of dearness allowance, bonus and revision of pay scale induces increase in current purchases. Besides, if scarcity of certain goods is expected by the consumers on account of reported fall in future production, strikes on a large scale and diversion of civil supplies towards the military use causes the current demand for such goods to increase more if their prices show an upward trend. Consumer demand more for future consumption and profiteers demand more to make money out of expected scarcity.

7. Demonstration Effect

When new goods or new models of existing ones appear in the market, rich people buy them first. For instance, when a new model of car appears in the market, rich people would mostly be the first buyer, LED TV sets and Blu-Ray Drives were first seen in the houses of the rich families some people buy new goods or new models of goods because they have genuine need for them. Some others do so because they want to exhibit their affluence. But once new goods come in fashion, many households buy them not because they have a genuine need for them but because their neighbors have bought the same goods. The purchase made by the latter category of the buyers are made out of such feelings as jealousy, competition, equality in the peer group, social inferiority and the desire to raise their social status. Purchases made on account of these factors are the result of what economists call ‘demonstration effect’ or the ‘Band-wagon-effect’. These effects have a positive effect on demand. On the contrary, when goods become the thing of common use, some people, mostly rich, decrease or give up the consumption of such goods. This is known as ‘Snob Effect’. It has a negative effect’on the demand for the related goods.

8. Consumer-Credit Facility

Availability of credit to the consumers from the sellers, banks, relations and friends encourages the consumers to buy more than what they would buy in the absence of credit availability. Therefore, the consumers who can borrow more can consume more than those who cannot borrow. Credit facility affects mostly the demand for durable goods, particularly those, which require bulk payment at the time of purchase.

9. Population of the Country

The total domestic demand for a good of mass consumption depends also on the size of the population. Therefore, larger the population larger will be the demand for a product, when price, per-capita income, taste and preference are given. With an increase or decrease in the size of population, employment percentage remaining the same, demand for the product will either increase or decrease.

10. Distribution of National Income

The level of national income is the basic determinant of the market demand for a good. Apart from this, the distribution pattern of the national income is also an important determinant for demand of a good. If national income is evenly distributed, market demand for normal goods will be the largest. If national income is unevenly distributed, i.e., if majority of population belongs to the lower income groups, market demand for essential goods, including inferior ones, will be the largest whereas the demand for other kinds of goods will be relatively less.