Economics Made Easy for All Series- Theories of Supply and Demand

Economics Made Easy for All Series- Theories of Supply and Demand

Supply and demand are the most fundamental concepts of Economics and form the backbone of a market economy. Let us understand these basic concepts.

Law of Demand

See the diagram. The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. The demand curve has a downward slope.

Law of Supply

See diagram. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. Unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because it increases revenue.

Price Determination

The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

Example

Let us imagine that the price of ball pen A is Rs 5 per piece. The quantity demanded at that price in a shop is 1000 per month. Now the price is reduced to Rs 4 per piece. The quantity demanded will increase to over 1000 per month. The demand will go on increasing and will become infinite at price zero. Now consider the situation from the perspective of the supplier. Assume that the cost of production for various manufacturers of ball pens varies from Rs 2 to 3.5 per piece. At Rs 5 per piece it is profitable for all the manufacturers to sell and hence the quantity of supply in the market is large. Once the price falls below Rs 3.5 some suppliers for whom the production cost was higher will stop production, being unprofitable, and produce some other product. As the price nears Rs 2 per piece all suppliers will be unwilling to sell and supply would become zero. At prices above Rs 5 more producers will enter the market since the profits are high and thus supply will increase.
 

Demand and Supply Equilibrium

See diagram. When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding. This equilibrium price is only a theoretical concept. In reality prices get determined by the demand and supply relationship somewhere near the equilibrium. Just analyse the price fluctuations of gold and crude oil to understand the play of market forces in determining it.
 

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