Derived Demand Defined

What Is Derived Demand?

Derived Demand is demand for a good or service that arises as a result of demand for another related good or service.

One example of derived demand may be demand for a certain size and configuration of smartphone case for a new smartphone that just came on the market.

The more popular that smartphone is, the higher derived demand there is for those smartphone cases.

How Derived Demand Works

Derived demand can’t exist on its own. Instead, it’s a force that exists in numerous types of value chains, such as, for example, the ripple effect created by demand for clothing produced by a certain designer.

If this demand increases, derived demand might also increase for complementary shoes, jewelry, ties, and handbags.

The demand for factors of production also increases as demand for a finished product increases.

For example, there might be an increase in the demand for spare parts of the machines used to build a new model of car if that car experiences increasing demand, which would put additional strain on production machinery, causing it to break down more frequently.

Customers don’t want more spare parts for the factory machinery—they want the car.

However, for the cars to be built, the machines must be in good working order.

So, the demand for spare parts for those factory machines increases.

3 Types of Derived Demand

Derived demand can be broken down into three types—raw materials, processed materials, and labor.

These components are known as the chain of derived demand.

  • Raw Materials: These materials are essential ingredients used in the production of a final good. Two examples of raw materials are crude oil for petroleum-based products and lumber for new homes constructions.
  • Processed Materials: The aforementioned smartphone case would be an example of the processed material type of derived demand.
  • Labor: On a more macroeconomic level, the demand for human labor is derived demand from most any type of business that needs manpower to create the product or service it wants to sell to a market. Without a demand for goods and services, there would be no demand for workers to create them.

Using Derived Demand in Investing

If demand for a final product increases or decreases, the derived demand for various components of the chain of derived demand decrease accordingly.

Many investors will use derived demand as the basis for an investing strategy.

For example, the demand for a certain automobile is tracked closely by quarterly sales figures, and if those automobiles use a certain type of wood in their interiors, an investor could invest money into assets related to the production of that wood.

This type of investing is known as a “pick-and-shovel” investment strategy.

This strategy is named after what happened during the California Gold Rush of the 1840s and 1850s, when companies that were selling picks and shovels were considered good investments because the demand for these tools was fueled by the demand for gold—not finding gold.

More Examples of Derived Demand

The demand for public transportation is driven by people needing to get to their places of employment—a need which is driven by their employers’ demand for labor… which itself is a derived from demand for a product that employee’s labor is used to make.

Another example of derived demand would be custom-designed desks.

The demand is initiated by the demand of consumers for custom-designed desks.

From that, derived demand is created for the labor that builds those desks and the materials used to build them.