All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Determinants of Demand
Why do I do what I do?
"Good executives create customers. Great ones create markets."

What influences the amount demanded?  To make life easy we will restrict our discussion to the situation in the output market where individuals like yourself are the demanders.  This should be easy for you since you are likely to be a demander - in fact I am willing to bet you have been in the position of being a demander today.  The demand for a good or service depends upon a number of factors that effect either the number of buyers or the behavior of the buyers. To convince yourself, think about what factors influence your decision to have pizza for dinner, the choice of gasoline for your car, or the number of automobiles sold in Montana in the month of January.  One answer is supplied by Shlomo Maital in his book Executive Economics: Ten Essential Tools for Managers where thirteen "forces that shape what people buy" are discussed.   The thirteen forces, for which Maital provides numerous examples, arranged alphabetically, are: aptness, bandwagons and bubbles, price, demographics, sensitivity to price (elasticity), fashion and fads, greed, habit, income, jazz, knowledge, loyalty, minds and money.  At this time we will not discuss all of these factors, but rather focus our attention on a few of the key factors.

An entrepreneur would tend to focus attention on aptness - the ability to identify a need and deliver an apt way of satisfying that need.  The growth of Sears from a remote North Redwood, MN railroad station agency run by Richard Sears to the Sears Watch Co. in 1886 and then to the national catalogue business offers a good example of aptness in identifying customer needs.  And as so often happens, chance plays a significant role. Demand for Sears' watches in the west 'exploded' when the railroads in 1906 divided up the US into time zones in an effort to run an efficient train schedule.  All of a sudden 7AM took on more meaning than sunrise and those living in rural America needed watches.  Once Sears realized the magnitude of rural demand for 'things', he established a catalogue business to supply these things and Sears was off and running.  In 1999 we could see another example in Amazon.com, a company that realized the www was a good place to sell books - and once they succeeded there, Amazon expanded to other products including CDs.

Marketers, meanwhile, would tend to focus attention on factors such as fashion, fad and demographics.  Products tend to have a life-cycle similar to that of people. There are the early years where you see substantial growth followed by a maturity phase with slow growth which often turns into a period of decline.  An example would be the consumer electronics industry where we saw the passage of 'in-industries' from black and white TVs to color TVs to VCRs...  Maybe next it will be flat panel TVs, high definition TV, or internet TV.  The same would be true if you looked at automobiles as we passed through the mini-van era to the sports utility vehicle, or women's fashion as we move from short to long to mid length skirts and then back again.  

When we talk about demographics we are talking about people - how many and who they are - what ages, ethnicity, gender, family status, income...  You will undoubtedly hear much talk about certain classifications - baby boomers, Generation X, Yuppies (young, upwardly mobile, professional adults), DINC (double income no children households), Yiffies (young individualistic freedom-minded few born between Kennedy's death and Watergate), Hispanics, elderly  - what their needs are and what impact they will have on markets.  For example, two economists, Mankiw and Neil, created quite a furor when they suggested that the housing market was driven by demographics and the aging of the baby boomers would result in a long-term decline for housing.  In 1998 the excitement surrounding the stock market after the Asian crises pummeled Asian stock markets produced a number of articles citing the impact of the baby boomer generation on the stock market - how it propped up stock prices in the late 1990s and how stock prices will fall once the boomers begin retiring and selling off their stock shares to support themselves in retirement.  In general, if there was an increase in the number of demanders as a result of an increase in population, then we would expect to see an increase in demand as these new buyers arrived in the market. 

Financial advisors who guide people's decisions regarding how to allocate their wealth and real estate investors should be well aware of bandwagons and bubbles - an effect similar to fads.  For reasons we will discuss later [investing for the 21st century], prices in asset markets tend to be very volatile - moving up and down with wide swings.  At the heart of the discussion is the bandwagon effect.  Individuals buy an asset because others are buying it, which leads to more people buying it ... As more people rush in to buy the asset, the price rises which brings more people into the market.  Once the price begins to fall, however, the process reverses itself and prices fall rather sharply.  In the diagram below, the red line would be what you would expect in a market where there was a bandwagon effect creating the price bubbles - steep increase in price followed by a rapid decreases in price. 

History is full of examples of speculative bubbles.  In New England and Japan there were bubbles in the real estate market in the 1980s that burst in 1988 in New England and in the early 1990s in Japan.  There was also the US stock market 'crashes' in October of 1929 and 1987 and the Asian stock market crashes in in 1997-98.  In early 1999 there was much talk about a speculative bubble in the market for internet stocks as share prices of companies with some tie to the  internet rose dramatically.  According to The Economist (1/30/1999), this is just the most recent example of a speculative bubble associated with the stocks of companies in emerging technologies - railroads in the 19th century, radio in the 1920s, and biotechnology in the 1990s.

The most obvious factor affecting demand would be price. As the price of a product changes you would expect this would have an impact on demand.  Because we would expect an increase in price to cause a decrease in demand we expect there to be a negative relationship between price and quantity demanded. 

There is also the question of how much demand responds to price - a topic in the discussion of elasticity.  An example would be Apple computers that were historically much easier to use than PCs.  The result was Apple could charge higher prices than the PCs and demand would not decrease much as a result of the higher prices.  As the PCs became easier to use, however, demand for Apple computers responded more to price which caused Apple to change its pricing strategy.  You would also put loyalty into the discussion of responsiveness.  Companies work very hard to convince people their product is special so they will not lose customers as they raise price above that charged by competitors.  If sellers cannot differentiate their product, then they are likely to be drawn into 'ugly' price wars which will benefit buyers by driving down prices.   This is what happened to Apple when they lost their 'specialness' - they lost the loyalty of their customers.

The Apple computer can also be used as an example of the impact of habit.  If you own an Apple computer you are likely to buy another one if yours suddenly is stolen or breaks since you are in the habit of doing your computing with a Mac.  If, however, you have more time to adjust - the summer between semesters at school - then you are likely to be able to adjust your buying more. A more updated spin on this effect would be switching costs- it costs a user to switch computer systems and this should reduce the tendency to switch brands. 

Income and wealth should also influence demand. When we are discussing demand we are talking about how much people are willing and able to buy so ability to pay affects demand.  If income falls, a buyer will be likely to cut back on his/her purchases and thus income and demand move in the same direction.  The same would be true if someone felt a little less wealthy.  An example of the income effect, one that causes many environmentalists to lose sleep over, would be China's demand for automobiles or electricity.  As China's economy grows and its people see their incomes rise, they can be expected to trade their bicycles in for autos.  The resulting increase in demand for autos is seen as raising substantially the amount of air pollution.  They will also want electricity to power the lights, televisions, refrigerators, and air conditioners that they will buy with their higher incomes. An example of the wealth effect would be the US economy in the late 1990s.  As the stock market boomed you could see the effect in rising housing prices and booms in spending on automobiles, vacations and just about everything else.

You would also expect demand to depend upon other prices - the price of substitutes and the price of complements.  If the price of Hondas increased, then you would expect to see an increase in demand for Toyotas or Fords - substitutes for the Hondas.  If the price of computers (hardware) decreased, then you would expect an increase in demand for software which is a complement to the machines. There is a negative relationship between demand and the price of a complement while there is a positive relationship between demand and the price of a substitute.

Finally, you would also expect expectations to matter - if you expect things to improve then you are likely to increase your demand. An example of this would be the home heating oil "crisis" in early 2000 in Rhode Island. The price of heating oil began to rise creating the expectation of further price increases.  These expected price increases prompted consumers to increase their purchases of oil before the price rose any further.  A second example would be the situation in Japan in the late 1990s.  Concerns over the future state of the economy, the Japanese people's expectations about their economic future, prompted many individuals to cut back on their spending. 

Note: Be sure you make the distinction between a change in quantity demanded caused by a change in the price and a change in demand caused by a change in any other factor. The difference shows up in the demand curves where a change in quantity demanded is a movement on a curve while a change in demand is a shift of the entire curve. 

• Price of the good
• Price of other goods
  • Complements
  • Substitutes
• Income and wealth
• Population
  • Size
  • Composition
• Tastes / Preferences
  • Fashion & Fad
  • Aptness
  • Habits
• Confidence
• Expectation / Bubbles

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