What are Supply and Demand?
Supply and demand are the forces that drive the markets. Their interaction typically determines the prices of goods and services within an economic system.
- Supply refers to the amount of all goods and services produced by companies;
- Demand is the sum of all goods and services that consumers are willing to buy during a given period.
These two concepts are fundamental to understanding the dynamics that shape economic models, elucidating the mechanisms by which market prices are established through the interplay of buyers and sellers.
The Law of Supply and Demand Explained
The law of supply states that as the price of a good or service increases, the quantity supplied by sellers will also increase, assuming all other factors remain unchanged.
Conversely, the law of demand stipulates that as the price of a good or service increases, the quantity demanded by buyers will decrease, assuming all other factors remain the same.
These two laws interact to determine the equilibrium price, which is the price point at which the quantity demanded by buyers equals the quantity supplied by sellers. At that price point, the market is said to be in equilibrium.
The supply and demand model relies on several assumptions, including the following:
- Buyers and sellers are rational;
- They have access to the same information;
- No entry barriers exist for sellers;
- The goods that are being exchanged are identical.
Factors Affecting Supply and Demand
A variety of factors can shift the supply and demand curves. This causes both the equilibrium price and quantity demanded and supplied to change.
Some factors that could increase supply include:
- Improvements in technology – i.e. artificial intelligence (AI) – make production more efficient;
- Decreases in production costs like wages or raw material prices;
- Government subsidies and other similar incentives;
- New sellers entering the market.
Some factors that could decrease supply include:
- Shortages of raw materials, labor, or components;
- Rising production costs;
- Natural disasters that disrupt production lines;
- Strict regulations like price controls.
Meanwhile, some of the factors that could increase demand include:
- A deflationary environment that forces sellers to reduce their prices.
- Rising household incomes that result in greater purchasing power;
- New buyers coming to the market;
- A positive change in consumer preferences for a given product.
Factors that could decrease demand include:
- Price increases due to inflation or other factors;
- The availability of substitute goods of similar quality and utility;
- A decline in household income reduces purchasing power;
- New regulations that discourage consumption.
Changes in the equilibrium price and quantity ripple through the market as buyers and sellers adjust to the new conditions accordingly.
Importance of Supply and Demand
The dynamic system of supply and demand is important for several reasons:
- Determines Prices: The interaction between supply and demand forces sets prices for goods and services in a market economy.
- Influences Production: Prices determine what and how much companies can produce based on their profitability goals. Firms often opt to increase or decrease output based on profitability – i.e. return on investment (ROI).
- Reflects Availability: The supply and demand relationship affects the availability of goods and materials for both production and consumption. Product shortages result in higher prices, while surpluses lead to the opposite.
- Allocates Resources: Supply and demand forces guide the allocation of resources towards goods that are most valued by society through the price mechanism. Resources flow efficiently to where they are needed most.
- Maximizes Utility: Consumers seek to maximize satisfaction by buying more when prices are low and less when prices are high. This is called utility maximization.
- Incentivizes Innovation: Higher profits driven by supply and demand forces incentivize companies to innovate by developing new or better versions of the same goods that are currently in high demand.
The model of supply and demand is crucial for understanding product pricing and availability in free markets. It provides key signals and incentives that propel buyer and seller behaviors.
Equilibrium Price and Quantity
The equilibrium price and quantity is the point where the supply and demand curves intersect. At this point, the amount that buyers are willing and able to purchase exactly matches the amount that sellers are willing and able to offer.
The equilibrium can be visually depicted on a graph with the demand curve sloping down and the supply curve sloping up until they intersect. The price point at which the two lines cross indicates the equilibrium.
If the price is set higher than the equilibrium price, this will result in excess supply – also called a surplus. Producers are willing to supply more of the good than consumers are willing to buy.
If the price is set lower than the equilibrium price, it will result in excess demand – also called a shortage. Consumers want to purchase more of the good than producers are willing to supply.
At the equilibrium price, neither shortages nor surpluses occur. Shifts in supply and demand curves will cause the equilibrium price and quantity to change over time as well.
Determining Price Elasticity
Price elasticity refers to how sensitive the quantity demanded or supplied is to changes in the price of the good.
Both demand and supply are considered elastic when quantity changes significantly in response to price changes and inelastic when the quantity remains stable despite price fluctuations.
Price elasticity (PE) is calculated as:
PE = % Change in Quantity / % Change in Price
The coefficient measures the responsiveness of demand and can be interpreted as follows:
- If the coefficient is higher than 1, the demand is considered elastic;
- If the coefficient is 1, the demand has unit elasticity;
- If the coefficient is lower than 1, the demand is considered inelastic.
For example, let’s say that a 10% price increase causes an 8% drop in the quantity demanded of a given good. The elasticity coefficient is 0.8 (8% / 10%) in this case. This indicates that the demand for this good is inelastic.
When it comes to price elasticity for supply, the coefficients are interpreted in the opposite way:
- If the coefficient is higher than 1, the supply is considered inelastic;
- If the coefficient is 1, the supply has unit elasticity;
- If the coefficient is lower than 1, the supply is considered elastic.
Elasticity helps businesses understand how buyers and sellers may react to price adjustments. Raising prices on inelastic goods can increase revenues for businesses while increasing prices on elastic goods often reduce revenues.
The dynamic supply and demand model is fundamental to understanding and predicting market prices and availability. It provides key insights into consumer and firm behaviors.