Demand And Supply
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Supply
and demand is perhaps one of the most fundamental concepts of economics
and it is the backbone of a market economy. Demand refers to how much
(quantity) of a product or service is desired by buyers. The quantity
demanded is the amount of a product people are willing to buy at a
certain price; the relationship between price and quantity demanded is
known as the demand relationship. 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. 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.
The
relationship between demand and supply underlie the forces behind the
allocation of resources. In market economy theories, demand and supply
theory will allocate resources in the most efficient way possible. How?
Let us take a closer look at the law of demand and the law of supply.
A. The Law of Demand
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. As a result, people will naturally avoid buying a product
that will force them to forgo the consumption of something else they
value more. The chart below shows that the curve is a downward slope.
A,
B and C are points on the demand curve. Each point on the curve
reflects a direct correlation between quantity demanded (Q) and price
(P). So, at point A, the quantity demanded will be Q1 and the price will
be P1, and so on. The demand relationship curve illustrates the
negative relationship between price and quantity demanded. The higher
the price of a good the lower the quantity demanded (A), and the lower
the price, the more the good will be in demand (C).
B. The Law of Supply
Like
the law of demand, the law of supply demonstrates the quantities that
will be sold at a certain price. But 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 selling a higher quantity at a higher
price increases revenue.
A,
B and C are points on the supply curve. Each point on the curve
reflects a direct correlation between quantity supplied (Q) and price
(P). At point B, the quantity supplied will be Q2 and the price will be
P2, and so on. (To learn how economic factors are used in currency
trading, read Forex Walkthrough: Economics.)
Time and Supply
Unlike
the demand relationship, however, the supply relationship is a factor
of time. Time is important to supply because suppliers must, but cannot
always, react quickly to a change in demand or price. So it is important
to try and determine whether a price change that is caused by demand
will be temporary or permanent.
Let's
say there's a sudden increase in the demand and price for umbrellas in
an unexpected rainy season; suppliers may simply accommodate demand by
using their production equipment more intensively. If, however, there is
a climate change, and the population will need umbrellas year-round,
the change in demand and price will be expected to be long term;
suppliers will have to change their equipment and production facilities
in order to meet the long-term levels of demand.
C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.
Imagine
that a special edition CD of your favorite band is released for $20.
Because the record company's previous analysis showed that consumers
will not demand CDs at a price higher than $20, only ten CDs were
released because the opportunity cost is too high for suppliers to
produce more. If, however, the ten CDs are demanded by 20 people, the
price will subsequently rise because, according to the demand
relationship, as demand increases, so does the price. Consequently, the
rise in price should prompt more CDs to be supplied as the supply
relationship shows that the higher the price, the higher the quantity
supplied.
If,
however, there are 30 CDs produced and demand is still at 20, the price
will not be pushed up because the supply more than accommodates demand.
In fact after the 20 consumers have been satisfied with their CD
purchases, the price of the leftover CDs may drop as CD producers
attempt to sell the remaining ten CDs. The lower price will then make
the CD more available to people who had previously decided that the
opportunity cost of buying the CD at $20 was too high.
D. Equilibrium
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.
As
you can see on the chart, equilibrium occurs at the intersection of the
demand and supply curve, which indicates no allocative inefficiency. At
this point, the price of the goods will be P* and the quantity will be
Q*. These figures are referred to as equilibrium price and quantity.
In
the real market place equilibrium can only ever be reached in theory,
so the prices of goods and services are constantly changing in relation
to fluctuations in demand and supply.
E. Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.
1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.
At
price P1 the quantity of goods that the producers wish to supply is
indicated by Q2. At P1, however, the quantity that the consumers want to
consume is at Q1, a quantity much less than Q2. Because Q2 is greater
than Q1, too much is being produced and too little is being consumed.
The suppliers are trying to produce more goods, which they hope to
sell to increase profits, but those consuming the goods will find the
product less attractive and purchase less because the price is too high.
2. Excess Demand
Excess
demand is created when price is set below the equilibrium price.
Because the price is so low, too many consumers want the good
while producers are not making enough of it.
F. Shifts vs. Movement For
economics, the “movements” and “shifts” in relation to the supply and
demand curves represent very different market phenomena:
1. Movements
A movement refers to a change along a curve. On the demand curve, a
movement denotes a change in both price and quantity demanded from one
point to another on the curve. The movement implies that the demand
relationship remains consistent. Therefore, a movement along the demand
curve will occur when the price of the good changes and the quantity
demanded changes in accordance to the original demand relationship. In
other words, a movement occurs when a change in the quantity demanded is
caused only by a change in price, and vice versa.
Like
a movement along the demand curve, a movement along the supply curve
means that the supply relationship remains consistent. Therefore, a
movement along the supply curve will occur when the price of the good
changes and the quantity supplied changes in accordance to the original
supply relationship. In other words, a movement occurs when a change in
quantity supplied is caused only by a change in price, and vice versa.
2. Shifts
A shift in a demand or supply curve occurs when a good's quantity
demanded or supplied changes even though price remains the same. For
instance, if the price for a bottle of beer was $2 and the quantity of
beer demanded increased from Q1 to Q2, then there would be a shift in
the demand for beer. Shifts in the demand curve imply that the original
demand relationship has changed, meaning that quantity demand is
affected by a factor other than price. A shift in the demand
relationship would occur if, for instance, beer suddenly became the only
type of alcohol available for consumption.
Conversely,
if the price for a bottle of beer was $2 and the quantity supplied
decreased from Q1 to Q2, then there would be a shift in the supply of
beer. Like a shift in the demand curve, a shift in the supply curve
implies that the original supply curve has changed, meaning that the
quantity supplied is effected by a factor other than price. A shift in
the supply curve would occur if, for instance, a natural disaster caused
a mass shortage of hops; beer manufacturers would be forced to supply
less beer for the same price.
