Law of Supply and Demand
Law of Supply and Demand
Law of Supply and Demand
• states that at higher prices, producers are willing to offer more products for sale than
at lower prices
• states that the supply increases as prices increase and decreases as prices decrease
• states that those already in business will try to increase productions as a way of
increasing profits
• states that people will buy more of a product at a lower price than at a higher price, if
nothing changes
• states that at a lower price, more people can afford to buy more goods and more of an item
more frequently, than they can at a higher price
• states that at lower prices, people tend to buy some goods as a substitute for others more
expensive
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.
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.
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.
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
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.
In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus,
there are too few goods being produced to satisfy the wants (demand) of the consumers.
However, as consumers have to compete with one other to buy the good at this price, the demand
will push the price up, making suppliers want to supply more and bringing the price closer to its
equilibrium.
Source: http://www.investopedia.com/university/economics/economics3.asp
Marginal utility is defined as the increase in utility as a result of consuming one more unit of the
good. It is the additional satisfaction, or amount of utility, gained from each extra unit of
consumption.
Although total utility usually increases as more of a good is consumed, marginal utility usually
decreases with each additional increase in the consumption of a good. This decrease
demonstrates the law of diminishing marginal utility. Because there is a certain threshold of
satisfaction, the consumer will no longer receive the same pleasure from consumption once that
threshold is crossed.
The law of diminishing marginal utility helps economists understand the law of demand
and the negative sloping demand curve. The less of something you have, the more
satisfaction you gain from each additional unit you consume; the marginal utility you gain
from that product is therefore higher, giving you a higher willingness to pay more for it.
Prices are lower at a higher quantity demanded because your additional satisfaction
diminishes as you demand more.
For example, say you go to a buffet and the first plate of food you eat is very
good. On a scale of ten you would give it a ten. Now your hunger has been
somewhat tamed, but you get another full plate of food. Since you're not as
hungry, your enjoyment rates at a seven at best. Most people would stop before
their utility drops even more, but say you go back to eat a third full plate of food
and your utility drops even more to a three. If you kept eating, you would
eventually reach a point at which your eating makes you sick, providing
dissatisfaction, or 'dis-utility'.
http://www.investopedia.com/
http://kr.mnsu.edu/~renner/supdem.htm
The market combines in exchange, both buyers and sellers. For economics it combines the
demand and the supply curve to determine price. This price is called an equilibrium price, since
it balances the two forces of supply and demand. An equilibrium price is the price at which the
quantity demanded is equal to the quantity supplied. The quantity supplied and demanded is also
referred to as the equilibrium quantity. Figure 5, shows both demand and supply determining
equilibrium price and quantity.
In figure 5, “A” is the equilibrium price and “Q” is the corresponding equilibrium quantity. At
the price “A” the quantity supplied and a quantity demanded are equal, and at the “Q” quantity,
demand and supply are equal.
If price were at “B” the quantity that suppliers would like to supply would be larger than
consumers would demand at that price, creating a surplus quantity. A surplus would create forces
among the many competitive suppliers to cut prices (supplier are all relatively small). Those
forces would push the price down to the equilibrium level at “A”.
If prices were at “C” the quantity that suppliers would like to supply, would be less than
consumers would demand at that price, creating a shortage. Because of the shortage and a
competition among consumers, prices would tend to rise. Only at “A” would there be no
tendency for the price to change, and “A” is the equilibrium price.
This graph represents the objective impersonal operation of the market. No one sets the price,
and if the consumers don’t like the price, they have no one to blame, and no recourse (over the
price). If suppliers don’t like the price, they in turn have no one to blame and no recourse (over
the price). This is seen by many as one of the strength of markets.
http://tutor2u.net/economics/revision-notes/as-markets-equilibrium-price.html
In this note we bring the forces of supply and demand together to consider the determination
of equilibrium prices.
Equilibrium means a state of equality or a state of balance between market demand and
supply. Without a shift in demand and/or supply there will be no change in market price. In
the diagram above, the quantity demanded and supplied at price P1 are equal. At any price
above P1, supply exceeds demand and at a price below P1, demand exceeds supply. In other
words, prices where demand and supply are out of balance are termed points of
disequilibrium.
Changes in the conditions of demand or supply will shift the demand or supply curves. This
will cause changes in the equilibrium price and quantity in the market.
Demand and supply schedules can be represented in a table. The example below provides an
illustration of the concept of equilibrium. The weekly demand and supply schedules for T-shirts
(in thousands) in a city are shown in the next table:
1. The equilibrium price is £5 where demand and supply are equal at 12,000 units
2. If the current market price was £3 – there would be excess demand for 8,000 units
3. If the current market price was £8 – there would be excess supply of 12,000 units
4. A change in fashion causes the demand for T-shirts to rise by 4,000 at each price. The
next row of the table shows the higher level of demand. Assuming that the supply
schedule remains unchanged, the new equilibrium price is £6 per tee shirt with an
equilibrium quantity of 14,000 units
5. The entry of new producers into the market causes a rise in supply of 8,000 T-shirts at
each price. The new equilibrium price becomes £4 with 18,000 units bought and sold
The demand curve may shift to the right (increase) for several reasons:
The reverse effects will occur when there is an inward shift of demand. A shift in the demand
curve does not cause a shift in the supply curve! Demand and supply factors are assumed to be
independent of each other although some economists claim this assumption is no longer valid!
1. A fall in the costs of production (e.g. a fall in labour or raw material costs)
2. A government subsidy to producers that reduces their costs for each unit supplied
3. Favourable climatic conditions causing higher than expected yields for agricultural
commodities
4. A fall in the price of a substitute in production
5. An improvement in production technology leading to higher productivity and efficiency
in the production process and lower costs for businesses
6. The entry of new suppliers (firms) into the market which leads to an increase in total
market supply available to consumers
The outward shift of the supply curve increases the supply available in the market at each price
and with a given demand curve, there is a fall in the market equilibrium price from P1 to P3 and
a rise in the quantity of output bought and sold from Q1 to Q3. The shift in supply causes an
expansion along the demand curve.
Important note:
A shift in the supply curve does not cause a shift in the demand curve. Instead we move
along (up or down) the demand curve to the new equilibrium position.
A fall in supply might also be caused by the exit of firms from an industry perhaps because
they are not making a sufficiently high rate of return by operating in a particular market.
The equilibrium price and quantity in a market will change when there shifts in both market
supply and demand. Two examples of this are shown in the next diagram:
In the left-hand diagram above, we see an inward shift of supply (caused perhaps by rising costs
or a decision by producers to cut back on output at each price level) together with a fall (inward
shift) in demand (perhaps the result of a decline in consumer confidence and incomes). Both
factors lead to a fall in quantity traded, but the rise in costs forces up the market price.
The second example on the right shows a rise in demand from D1 to D3 but a much bigger
increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and
an increase in the equilibrium quantity traded in the market.
http://www.econweb.com/MacroWelcome/sandd/notes.html
We list and explain four factors that can shift a demand curve:
1. Change in input costs: An increase in input costs shifts the supply curve to the left. A
supplier combines raw materials, capital, and labor to produce the output. If a furniture
maker has to pay more for lumber, then her profits decline, all else equal. The less
attractive profit opportunities force the producer to cut output. Alternatively, car
manufacturer may have to pay higher labor costs. The higher labor input costs reduces
profits, all else equal. For a given price of a car, the manufacturer may trim output,
shifting the supply curve to the left. Conversely, if input costs decline, firms respond by
increasing output. The furniture manufacturer may increase production if lumber costs
fall. Additionally, chicken farmers may boost chicken output if feed costs decline. The
reduction in feed costs shifts the supply curve for chicken to the right.
2. Increase in technology: An increase in technology shifts the supply curve to the right. A
narrow definition of technology is a cost-reducing innovation. Technological progress
allows firms to produce a given item at a lower cost. Computer prices, for example, have
declined radically as technology has improved, lowering their cost of production.
Advances in communications technology have lowered the telecommunications costs
over time. With the advancement of technology, the supply curve for goods and services
shifts to the right.
3. Change in size of the industry: If the size of an industry grows, the supply curve shifts to
the right. In short, as more firms enter a given industry, output increases even as the price
remains steady. The fast-food industry, for example, exploded in the latter half of the
twentieth century as more and more fast food chains entered the market. Additionally,
on-line stock trading has increased as more firms have begun delivering that service.
Conversely, the supply curve shifts to the left as the size of an industry shrinks. For
example, the supply of manual typewriters declined dramatically in the 1990s as the
number of producers dwindled.
Some Questions on Supply and Demand
The price of coffee would fall if there was a fall in demand and/ or an increase in supply
The demand for coffee could fall for various reasons such as
1. With the Aid of Supply and Demand diagrams explain the effect on the market for mobile phones if:
a) Improved technology producing mobile phones
b) An increase in taxes on mobile phones but an increase in advertising for phones with new features
2. What could explain a fall in the price of computers?
As the price increases, suppliers can earn higher levels of profit or justify higher marginal
costs to produce more.
2. Part of the reason that Michael Jordan earns millions of dollars each year while school teachers may earn
$30,000 is because
The supply of superstar basketball players is very low, while the supply of competent
teachers is much larger.
Demand for Michael Jordan's talents is very high since he can generate so much revenue for
a firm.
Consumers enjoy basketball to the point that they are willing to spend lots of money and
time attending games and watching commercials.
4. All the following shift the demand curve for automobiles to the right except:
6. What happens in the market for airline travel when the price of traveling by rail decreases?
a shortage results.
a surplus results.
9. If the demand curve shifts to the right, then we move up and to the right along our supply curve.
True
False
10. If the cost of making bicycles falls, the price goes down, causing the demand curve to shift to the right.
True
False