The Influence of Supply and Demand on Price

The Influence of Supply and Demand on Price

Changes in either supply or demand will move the market clearing point and change the market price for a good.

Introduction

The amount of a good in the market is the supply and the amount people want to buy is the demand. Consider a certain commodity, such as gasoline. If there is a strong demand for gas, but there is less gasoline, then the price goes up. If conditions change and there is a smaller demand for gas, due to the presence of more electric cars for instance, then the price of the commodity decreases.

The factors influencing supply include:

• Price – As the price of a product rises, its supply rises because producers are more willing to manufacture the product because it’s more profitable.
• Price of other commodities – There are two types: competitive supply (If a producer switches from producing A to producing B, the price of A will fall and hence the supply will fall because it’s less profitable to make A), and joint supply (A rise in one product may cause a rise in another. For instance, a rise in the price of wooden bedframes may cause a rise in the price of wooden desks and chairs. This means supply of wooden bedframes, chairs, and desks will rise because it’s more profitable. )
• Costs of production – If production costs rise, supply will fall because the manufacture of the product in question will become less profitable.
• Change in availability of resources – If wood becomes scarce, fewer wooden bedframes can be made, so supply will fall.

Factors influencing demand include:

• Income
• Tastes and preferences
• Prices of related goods and services
• Consumers ‘ expectations about future prices and incomes that can be checked
• Number of potential consumers

Supply and Demand As an Economic Model

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price). This results in an economic equilibrium of price and quantity.

The four basic laws of supply and demand are:

• If demand increases and supply remains unchanged, then it leads to higher equilibrium price and higher quantity.
• If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and lower quantity.
• If demand remains unchanged and supply increases, then it leads to lower equilibrium price and higher quantity.
• If demand remains unchanged and supply decreases, then it leads to higher equilibrium price and lower quantity.

Graphical Representation of Supply and Demand

Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the good, the standard graphical representation, usually attributed to Alfred Marshall, has price on the vertical axis and quantity on the horizontal axis, the opposite of the standard convention for the representation of a mathematical function.

Since determinants of supply and demand other than the price of the good in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as “shifts” in the curves). By contrast, responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.

Supply and Demand: The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

Equilibrium

Since the demand curve slopes down and the supply curve slopes up, when they are put on the same graph, they eventually cross one another. The point where the supply line and the demand line meet is called the equilibrium point.

In general, for any good, it is at this point that quantity supplied equals quantity demanded at a set price. If there are more buyers than there are sellers at a certain price, the price will go up until either some of the buyers decide they are not interested, or some people who were previously not considering selling decide that they want to sell their good. This process normally continues until there are sufficiently few buyers and sufficiently many sellers that the numbers balance out, which should happen at the equilibrium point.

Elasticity of Demand

Elasticity of demand is a measure used in economics to show the responsiveness of the quantity demanded of an item to a change in its price.

Elasticity of Demand: an Overview

Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price.

More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall.

Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as a Veblen good and a Giffen good, have a positive PED.

In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded.

The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.

Revenue is maximized when price is set so that the PED is exactly one. The PED of a good can also be used to predict the incidence (or “burden”) of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales data, and conjoint analysis.

Determinants

The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes (“wait and look”). A number of factors can thus affect the elasticity of demand for a good:

• Availability of substitute goods: The more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made. In other words, there is a strong substitution effect. If no close substitutes are available, the substitution of effect will be small and the demand inelastic.
• Breadth of definition of a good: The broader the definition of a good (or service), the lower the elasticity. For example, Company X’s fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist.
• Percentage of income: The higher the percentage of the consumer’s income that the product’s price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost. The income effect is thus substantial. When the goods represent only a negligible portion of the budget, the income effect will be insignificant and demand inelastic.
• Necessity: The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as in the case of insulin for those that need it.
• Duration: For most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy, or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic.
• Brand loyalty: An attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand.
• Who pays: Where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.