(2):

Determinants of Demand:

Background:

Demand drives economic growth. Businesses want to increase demand so they can improve profits.
Governments and central banks boost demand to end recessions. They slow it during the expansion
phase of the business cycle to combat inflation.

The Five Determinants of Demand

The five determinants of demand are:

1. The price of the good or service.

2. Income of buyers.
3. Prices of related goods or services. These are either complementary, those purchased along
with a particular good or service, or substitutes, those purchased instead of a certain good
or service.
4. Tastes or preferences of consumers.
5. Expectations. These are usually about whether the price will go up.

For aggregate demand, the number of buyers in the market is the sixth determinant.

Demand Equation or Function

This equation expresses the relationship between demand and its five determinants:

qD = f (price, income, prices of related goods, tastes, expectations)

It says that the quantity demanded of a product is a function of five factors: price, income of the
buyer, the price of related goods, the tastes of the consumer, and any expectation the consumer has
of future supply, prices, etc.

Price. The law of demand states that when prices rise, the quantity of demand falls. That also means
that when prices drop, demand will grow. People base their purchasing decisions on price if all other
things are equal. The exact quantity bought for each price level is described in the demand schedule.
It's then plotted on a graph to show the demand curve. The demand curve only shows the
relationship between the price and quantity. If one of the other determinants changes, the entire
demand curve shifts.

If the quantity demanded responds a lot to price, then it's known as elastic demand. If the volume
doesn't change much, regardless of price, that's inelastic demand.

Income. When income rises, so will the quantity demanded. When income falls, so will demand. But
if your income doubles, you won't always buy twice as much of a particular good or service. There's
only so many pints of ice cream you'd want to eat, no matter how wealthy you are. That's where the
concept of marginal utility comes into the picture. The first pint of ice cream tastes delicious. You
might have another. But after that, the marginal utility starts to decrease to the point where you
don't want any more.
Prices of related goods or services. The price of complementary goods or services raises the cost of
using the product you demand, so you'll want less. For example, when gas prices rose to $4 a gallon
in 2008, the demand for Hummers fell. Gas is a complementary good to Hummers. The cost of
driving a Hummer rose along with gas prices.

The 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. That's why Apple continually innovates
with its iPhones and iPods. As soon as a substitute, such as a new Android phone, appears at a lower
price, Apple comes out with a better product. Then the Android is no longer a substitute.

Tastes. When the public’s desires, emotions, or preferences change in favour of a product, so does
the quantity demanded. Likewise, when tastes go against it, that depresses the amount demanded.
Brand advertising tries to increase the desire for consumer goods. For example, Buick spent millions
to make you think its cars are not only for older people.

Expectations. When people expect that the value of something will rise, they demand more of it.
That explains the housing asset bubble of 2005. Housing prices rose, but people bought more
because they expected the price to continue to go up. Prices increased even more until the bubble
burst in 2006. Between 2007 and 2011, housing prices fell 30 percent. But the quantity demanded
didn't grow. People expected prices to continue falling. Record levels of foreclosures entered the
market due to the subprime mortgage crisis. Demand didn't increase until people expected future
prices would, too.

Number of buyers in the market. The number of consumers affects overall, or “aggregate,” demand.
As more buyers enter the market, demand rises. That's true even if prices don't change. That
was another reason for the housing bubble. Low-cost and sub-prime mortgages increased the
number of people who could afford a house. The total number of buyers in the market expanded.
This increased demand for housing. When housing prices started to fall, many realized they couldn't
afford their mortgages. At that point, they foreclosed. That reduced the number of buyers and drove
down demand.

Price

Tastes Income

Determinants
of Demand

Prices of
related
Expectation
goods and
Services
(3):

(a): Income elasticity of demand

Summary, Outcomes and Formula:

Income Elasticity of Demand (YED) is defined as the responsiveness of demand when a consumer’s
income changes. It is defined as the ratio of the change in quantity demanded over the change in
income. The higher the income elasticity, the more sensitive demand for a good is to changes in
income. This means that a very high-income elasticity of demand suggests that when a consumer’s
income goes up, consumers will buy a lot more of that good and, reciprocally, when income goes
down consumers will cut back their purchases of that good to an even higher degree. A very low
price elasticity implies that changes in a consumer’s income will have little effect on demand.

YED = (New Quantity Demand – Old Quantity Demand)/(Old Quantity Demand) / (New Income – Old
Income)/(Old Income)

YED= Income elasticity of Demand

TYPE ELASTICITY OUTCOME

Income Elasticity of Demand
for a Normal Good
Income Elasticity of Demand
for an Inferior Good
Income Elasticity of Demand
for a Luxury Good
Relatively Inelastic Income
Elasticity of Demand
Income Elasticity of Demand is
0 the good isn’t affected by a
A normal good has an Income Elasticity of This means the demand for
Demand > 0. a normal good will increase
as the consumer’s income
increases.
An inferior good has an Income Elasticity of This means the demand for
Demand < 0. an inferior good will
decrease as the consumer’s
income decreases.
Luxury goods usually have Income Elasticity which means they are
of Demand > 1 income elastic. This implies
that consumer demand is
more responsiveness to a
change in income. For
example, diamonds are a
luxury good that is income
elastic.
0 < Income Elasticity of Demand < 1 are This means that consumer
goods that are relatively inelastic. demand rises less
proportionately in
response to an increase in
income.
Income Elasticity of Demand = 0 means that the demand for
change in income.

Income Elasticity of demand computation & Conclusion:

{(25-20)/20/ (15,000 – 10,000)/(10,000)} = 0.25/0.5= 0.5 >1 - Income Elasticity of Demand for a
Normal Good - This means the demand for a normal good will increase as the consumer’s income
increases.
(b) Cross elasticity of demand

Summary and Formula:

The cross elasticity of demand is an economic concept that measures the responsiveness in the
quantity demanded of one good when the price for another good changes. Also called cross-price
elasticity of demand, this measurement is calculated by taking the percentage change in the quantity
demanded of one good and dividing it by the percentage change in the price of the other good.

 The cross elasticity of demand is an economic concept that measures the responsiveness in
the quantity demanded of one good when the price for another good changes.
 The cross elasticity of demand for substitute goods is always positive because the demand
for one good increases when the price for the substitute good increases.
 Alternatively, the cross elasticity of demand for complementary goods is negative.

Cross Price Elasticity of Demand Formula = (Q1X – Q0X) / (Q1X + Q0X) ÷ (P1Y – P0Y) / (P1Y + P0Y),

where

Q0X = Initial demanded quantity of good X,

Q1X = Final demanded quantity of good X,

P0Y = Initial price of good Y and

P1Y = Final price of good Y

The cross-price elasticity behaves differently based on the type of relationship between the goods
which are discussed below.

Substitute products: In case both goods which are perfect substitutes to each other resulting in
perfect competition, then an increase in the price of one good will lead to an increase in demand for
the rival product. For example, various brands of cereal are examples of substitute goods. It is to be
noted that the cross price elasticity for two substitutes will be positive.

Complementary products: If in case one good is complementary to the other good, then a decrease
in the price of one good will lead to an increase in demand for the complementary good. The
stronger the relationship between the two products, the higher will be the coefficient of cross-price
elasticity of demand. For example, game consoles and software games are examples of
complementary goods. It is to be noted that the cross elasticity will be negative for complementary
goods.

Unrelated products: In case there is no relationship between the goods, then an increase in the
price of one good will not affect the demand for the other product. As such, unrelated products have
a zero cross elasticity. For example, the effect of changes in taxi fares on the market demand for
milk.

Cross Elasticity of demand computation & Conclusion:

(160-100)/(160+100)/(50-40)/(50+40) = 0.23/0.11= 2.09

From the above, it may be concluded that, tea and coffee are substitute products.

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