Theory: Supply and Demand

Microeconomics: Supply and Demand

I can guarantee that at some point in your life you’ve heard someone say that ‘it’s all down to supply and demand’. Well they’re not wrong! In economics, the analysis of phenomena starts with the basic supply-demand analysis which is a fundamental yet extremely powerful tool that can be used with an array of relevant and interesting problems. Such problems include predicting changing market price and production, evaluating legislation and determining the effects things such as taxes.

Supply and demand curves are used to outline the market mechanism. In classical economics (without government intervention) supply and demand come together to determine both the market price and the market quantity of a product. It should now be noted what that supply and demand will turn out to be depends on their DETERMINANTS. Fluctuations of S & D occur over time and they represent their response to changes in economic elements.

We can therefore discuss the different determinants of supply and demand in different markets. Then, we can utilise supply and demand curves to comprehend an array of situations.

It is of paramount importance to understand that we can interpret how market price and quantity can be analysed by these curves both QUALITATIVELY and QUANTITATIVELY.

Supply-demand analysis therefore helps us to understand why prices change and how, and what happens when the government intervenes in the market.

To fully appreciate this analysis we need to understand the graphical concepts of the supply curve and the demand curve.

First, let’s take the supply curve. It represents the relationship between the quantity of a product that producers are willing and able to sell, and the price of the good ceteris paribus.

In the diagram above supply has shifted to the right, you say that there has been a change in supply when the curve shifts to the right and vice versa when it shifts left. You use the phrase ‘a change in the quantity supplied’ to refer to movements along the curve itself.

In the diagram above, the vertical axis represents the price of a good, measured in $ per unit i.e. the price that the sellers (firms/businesses/workers) receive for a given quantity supplied. The horizontal axis represents the total quantity supplied which is measured as the number of units in a given time period. Therefore, the S curve is the relationship between quantity supplied (Q, Q1) and the price (P). A salient point here is that the supply curve slopes upwards. This is because, as all firms are profit maximizers; the higher the price, the more that firms are willing and able to produce and sell. Expanding on from this, at a higher price firms may be more capable of expanding production by hiring more labor or having their current workers work overtime. Similarly, they may increase the scale of production in the long run by increasing the size of their capital stock. Moreover, a higher price is likely to attract new firms to the market. These newcomers could potentially face higher costs due to their relevant inexperience in the market.

There are other variable that affect supply in addition to price. These include:

1.  Production costs e.g. wages, interest charges, cost of raw materials
2. Conditions of production i.e. the state of technology
3. Expectations i.e. what the seller expects to sell in the future (based on future demand)
4. The number of suppliers in the market. If there is a greater number of firms in the market than before, then the supply curve will shift right because the curve itself is the sum of all the individual supply curves
5. Government intervention i.e. laws, taxes, regulation

Now, let’s take a look at the demand curve which is defined as the relationship between the quantity of a good that consumers are willing and able to buy, and the price of the good. Note that the demand curve slopes downwards which is opposite to the supply curve. This is because it represents the idea that consumers are more willing to buy more if the price is lower. If the price is lower, it allows those who couldn’t previously afford it to then buy it. As well it allows those who were already purchasing the good to consumer larger quantities of it.

Likewise to supply, demand depends on more things than just the price. These include:

1.  Income – for most goods, the greater the income level is then the greater the quantity demanded will be
2. Prices of related goods i.e. substitutes or complements
3. Tastes
4. Expectations

For an increase in demand, the demand curve shifts to the right to represent an increase in any of its determinants.

 
Developing on the determinant of prices of related goods. These refer to substitutes and complements. Two goods are said to be substitutes for each other when an increase in the price of one leads to an increase in the quantity demanded of the other. Two goods are said to be complements for each other when an increase in the price of one leads to a decrease in the quantity demanded of the other.

An obvious example of substitutes is beef and chicken because consumers are willing to shift their purchases from one to the other when prices change. An obvious examples of complements is cars and car fuel. Because they tend to be used together, a fall in the price of car fuel will increase the quantity demanded for cars.

So to conclude, the demand curve shifts to the right not only when income increases, but also when there are positive changes in taste for the product and also when the price of a substitute good has increased or the price of a complementary good has decreased. Finally, demand could even depend on the weather. The demand curves for skiing holidays will shift to the right when there are heavy snowfalls.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

Thanks for reading and if you have any queries please email me at:samandchrisshapley56@gmail.com or post a comment on the page itself and I’ll try to get back to you as soon as I can.