Laws of Supply and Demand
The market price of a good is determined by both the supply and demand for it. In the world, today supply and demand are perhaps one of the most fundamental principles that exist for economics and the backbone of a market economy. Supply is represented by how much the market can offer. The quantity supplied refers to the amount of a certain good that producers are willing to supply for a certain demand price. What determines this interconnection is how much of a good or service is supplied to the market or otherwise known as the supply relationship or supply schedule which is graphically represented by the supply curve.
In demand the schedule is depicted graphically as the demand curve which represents the number of goods that buyers are willing and able to purchase at various prices, assuming all other non-price factors remain the same. The demand curve is almost always represented as downwards-sloping, meaning that as price decreases, consumers will buy more of the good.
Just as the supply curves reflect marginal cost curves, demand curves can be described as marginal utility curves. The main determinants of individual demand are the price of the good, level of income, personal tastes, the population, government policies, the price of substitute goods, and the price of complementary goods.
When a supplier’s cost changes for a given output, the supply curve shifts in the same direction. For example, assume that someone invents a better way of growing corn so that the cost of corn that can be grown for a given quantity will decrease.
Basically, producers will be willing to supply more corn at every price and this shifts the supply curve outward, an increase in supply. This increase in supply will cause the equilibrium price to decrease. The equilibrium quantity increases as the quantity demanded increases at the new lower prices. This causes the price and the quantity to move in opposite directions in a supply curve shift. Also, if the quantity supplied decreases at any given price the opposite will happen.
A sudden increase or decrease in the supply of a particular good is also known as a supply shock. A supply shock is an event that suddenly changes the price of a product or service. This sudden change affects the equilibrium price. The two types of supply shocks that exist are the Negative Supply shock and the Positive Supply shock. A negative supply shock, which is a sudden supply decrease, will raise the prices and shift the aggregate supply curve to the left. A negative supply shock can cause stagflation due to the combination of rising prices and falling output. Meanwhile, a positive supply shock, an increase in supply, will lower the price of a good and shift the aggregate supply curve to the right. A positive supply shock could be an advancement in technology which most certainly makes production more efficient which thus increases output. For example, a positive supply shock could be shown in the early 1990s when communication and information technology exploded which resulted directly in productivity increase, and an example of a negative supply shock would be that of the high oil prices associated with the Arab oil embargo of the early 70s is the classic example of this occurrence. Any other factor could also produce this effect. Such as if the sudden doubling of the Federal minimum wage and all being equal could cause a supply shock.
Occasionally, supply curves do slope upwards, for example, the backward bending supply curve of labor. As a worker’s wage increases, that worker is willing to supply a greater amount of labor since the higher wage increases the marginal utility of working. The backward bending supply curve has also been observed in non-labor markets such as the market for oil. During the 1973 oil crisis, many oil-exporting countries decreased their production of oil. Also in some cases, the supply curve can be vertical. This represents that the quantity supplied is fixed, no matter what the market price is. For instance, the surface area of the land of the world is fixed. It does not matter how much someone would be willing to offer for an additional piece, the extra piece cannot be produced, and vice versa, even if no one wanted the land, it still would exist. The land, therefore, has a vertical supply curve, giving it zero elasticity. It does not matter how much the change in price is, the quantity supplied will not change regardless.
One of the most important building blocks of economic analysis is the concept of demand. The most famous law in economics, and the one that economists are most sure of, is the law of demand. The law of demand states that when the price of good rises, the amount demanded falls, and when the price falls, the amount demanded rises. When economists refer to demand, they usually have in mind not just a single quantity demanded, but what is called a demand curve. A demand curve traces the quantity of a good or service that is demanded at successively different prices.
Some of the modern evidence for the law of demand is from econometric studies which show that all other things being equal, when the price of good rises, the amount of it demanded decreases. How do we know that there are no instances in which the amount demanded rises and the price rises? A few instances have been cited, but they almost always have an explanation that takes into account something other than price. Nobel Laureate George Stigler responded years ago that if any economist found a true counterexample, he would be “assured of immortality, professionally speaking, and rapid promotion.” And because wrote Stigler, most economists would like either reward, the fact that no one has come up with an exception to the law of demand shows how rare the exceptions must be. But the reality is that if an economist reported an instance in which consumption of a good rose as its price rose, other economists would assume that some factor other than price caused the increase in demand.
The main reason economists believe so strongly in the law of demand is that it is so plausible, even to non-economists. Indeed, the law of demand is ingrained in our way of thinking about everyday things. Shoppers buy more strawberries when they are in season and the price is low, such an event is evidence for the law of demand because consumers are only willing to buy the higher amount available at the lower in-season price. Likewise, when people learn that frost will strike orange groves in Florida, they know that the price of orange juice will rise. The price rises in order to reduce the amount demanded to the smaller amount available because of the frost, this is another example of how the law of demand exists in the market economy. We see the same point every day in countless ways. No one thinks, for example, that the way to sell a house that has been languishing on the market is to raise the asking price, because the number of potential buyers for any given house varies inversely with the asking price. Indeed, the law of demand is so ingrained in our way of thinking that it is even part of our language. Think of what we mean by the term on sale. We do not mean that the seller raised the price. We mean that he or she lowered it. The seller did so in order to increase the number of goods demanded.
Economists have struggled to think of exceptions to the law of demand, although marketers have found a solution. Economist Thomas Nagle points out that when one particular car wax was introduced, it faced strong resistance until its price was raised from $.69 to $1.69. The reason, according to Nagle, was that buyers could not judge the wax’s quality before purchasing it. Consumers believed that the quality of this particular product was so important that it was not worth having a bad product that could ruin a car’s finish. Consumers “played it safe by avoiding cheap products that they believed were more likely to be inferior.”
As for many non-economists, they have become skeptical of the law of demand. A standard example usually illustrated is that of a good whose quantity demanded will not fall when the price increases, such as water. How, they ask, can people reduce their use of water? But those who come up with that example think of drinking water or using it in a household, as the only possible uses. Even for such uses, there is room to reduce consumption when the price of water rises. Households can do larger loads of laundry, or shower instead of bathe, for example. The main users of water, however, are agriculture and industry. Farmers and manufacturers can substantially alter the amount of water used in production. Farmers, for example, can do so by changing crops or by changing irrigation methods for given crops.
There are many influences on demand such examples are that it is not just price that affects the quantity demanded, income as well affects it. As real income rises, people buy more of some goods, which economists call normal goods, and less of what is called inferior goods, such as urban mass transit and railroad transportation. That is why the usage of both of these modes of travel declined so dramatically because postwar incomes were rising and more people could afford automobiles. Environmental quality is a normal good, which is a major reason that Americans have become more concerned about the environment in recent decades. Another influence on demand is the price of substitutes. When the price of a car, let’s use the Toyota Tercel, for instance, rises and all else being equal the demand for Tercel falls while the demand for a Nissan Sentra, a substitute rises. Also important is the price of complements, or goods that are used together. When the price of gasoline rises, the demand for cars falls.
In conclusion, generally speaking, the Law of Supply states that when the selling price of an item rises there are more people willing to produce the item. Since a higher price means more profit for the producer and as the price rises more people will be willing to produce the item when they see that there is more money to be earned. Meanwhile, the Law of Demand states that when the price of an item goes down, the demand for it will go up. When the price drops people who could not afford the item can now buy it, and people who are not willing to buy it before will now buy it at the lower price as well. Also, if the price of an item drops enough people will buy more of the product and even find alternative uses for the product.