Microeconomics/Supply and Demand
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, for instance if everyone started using electric cars, or the commodity becomes more available, for instance a new oil field is discovered, then the price of the commodity decreases.
The availability of goods and services in the marketplace at any given point in time is defined as "supply". As we will see after, if the demand is greater than the supply, there is a shortage (more items are demanded at a higher price, less items are offered at this same price, therefore, there is a shortage). If the supply increases, the price decreases, and if the supply decreases, the price increases. This is called an indirect relationship, where if one variable goes up, the other variable goes down.
It is easy to see why this should be true; if 20 people have identical houses to sell, and only 15 people want to buy a house, then the buyers can pick the lowest price, so the sellers must try to satisfy the buyers. Of course, if the supply changes, and 5 sellers decide to stay, then there is one house for each buyer, and neither side can bully the other; each buyer will offer money for the house they want, and if the seller thinks it's not enough, he can refuse, since his house will probably be bought anyways. If 5 more of the sellers decide not to move, then the buyers need to offer more money, because the remaining sellers want to be able to sell their houses for as much money as they can, so they will pick the ten buyers who offer the most money.
The inverse is true as well; if the price of a home goes down, fewer people will sell, but if the price of a home goes up, more people will sell. This means that price and supply are closely linked, and changes in one are reflected in the other.
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 now.
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.
- 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.
A desire becomes demand when it meets the three important factors: having a strong desire, having the necessary purchasing power, and having the power to take decision to purchase.
Similar to supply, there is a relationship between price and demand; the more people want, the more it will cost, if the supply remains the same. To return to our example of houses, let's say there are 15 people selling houses, and 10 buying; the buyers have more influence on the sellers, and the prices will be low. If 5 more people decide to buy houses, then the price will go up, and if another 5 decide to buy one of these houses, the price will climb even further. Thus when demand is high, the price goes up and consequently the supply contracts; and when the demand is low, the supply expands while the prices go down.
The inverse here is true as well; if people will sell their house for less, they will find more people interested in buying. The reason why demand behaves this way is fairly obvious: people are more willing to buy more of a good, or buy the good more often if the good becomes cheaper. Likewise, when a good is on sale, or its prices drop, people will become more willing to spend money on it.
The way consumers behave can affect demand in many ways. Consumers gain satisfaction from the consumption of goods or services. This satisfaction is called utility.
The law of diminishing marginal utility is a theory in economics that says that with increased consumption, satisfaction decreases.
You are at a park on a winter's day, and someone is selling hot dogs for $1 each. You eat one. It tastes good and satisfies you, so you have another one, and another etc. Eventually, you eat so many, that your satisfaction from each hot dog you consume drops. You are less willing to pay the $1 you have to pay for a hot dog. You would only consume another if price drops. But that won't happen, so you leave, and demand for the hot dogs falls.
Consumer surplus is a term used to describe the difference between the price of a good and how much the consumer is willing to pay.
Back at the park, they are still selling hot dogs, but now for 80 cents. You are hungry, so you are willing to pay $1 for a hot dog, but since the price is cheap, you buy two. For each hot dog, you get 20 cents of consumer surplus
The income effect occurs when the incomes of consumers change.
You are still in the park, and someone is still selling hot dogs for $1. But over the weekend, you got a pay rise, and have more money in your pockets! But there's another hot dog stand selling hot dogs for $1.50 on the other side of the park. You have two choices;
- Buy more of the $1 hot dogs, because you can afford to.
- Go to the other side and buy the $1.50 hot dogs, because you believe they are of better quality, and you can afford to buy them now you've had a pay rise. In this case, the $1 hot dogs have become what we call an inferior good (a good for which demand falls as income rises).
The substitution effect is similar.
On another day in the park, there is the same $1 hot dog stand. But, on the other side, the rival hot dog stand now sells hot dogs for only 50 cents. You are more likely to go to that stand because it is cheaper.
A curve that shows the relationship between the price level of a good and the quantity of the good demanded at that price is called the demand curve (at any given point in time). Demand curves are graphed with the same axis as supply curves in order to allow the two curves to be combined into a single graph: the y-axis (vertical line) of the graph is price and the x-axis (horizontal line) is the quantity demanded. Demand curves usually slope downward because people are willing to buy larger quantities of a good as its price goes down. That is, low prices mean high quantities. Turning the relationship around, as price increases, the quantity demanded decreases.
Since the demand curve slopes down and the supply curve slopes up, if they are put on the same graph, they eventually cross one another. Graphically, this consists of superimposing the two graphs that we have; at the point where the two lines, the supply line and the demand line, meet, is called the equilibrium point for the good. To return to our example of houses; in the end, if the equilibrium point for the house price is $60,000, everyone who wants to buy on that price will find a house, and everyone who wants to sell on that price will find a buyer.
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 houses. 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.
Please note: The following discussions are based on that the x-axis is quantity and the y-axis is price, as the figure above. Also note, the curves need not be straight in a real situation.
Changes in demand or changes in supply are conceived as shifts in the demand or shifts in the supply curve, to produce a new equilibrium point. The new price and quantity of the equilibrium point should fit commonsense ideas of what happens when demand or supply changes.
- demand increases. For a given price, there is more demand. The down-sloping demand curve, where there is more quantity demanded as price decreases - is shifted in which direction ? It is shifted to the right, because for a given quantity, a higher price can be obtained. If the supply curve is not changed, then the right-shifted down-sloping demand curve will intersect at a higher price/quantity equilibrium point, and this is shown easily by sketching a second down-sloping curve next to, and to the right of, the original down-sloping demand curve.
- supply increases. For a given price , there is more quantity supplied. The up-sloping supply curve, where there is more quantity willing to be supplied for higher prices, is shifted to the right, because more suppliers are willing to supply at a lower price, causing quantity to increase for a given price. Drawing a second up-sloping supply curve to the right of the original up-sloping supply curve, will show that new equilibrium point gives a lower price and higher quantity for the same down-sloping demand curve.
- demand decreases. The demand curve is shifted to the left, and there is both a decrease in quantity and price at the equilibrium where it now intersects with the upsloping supply curve.
- supply decreases. The supply curve shifts to the left, and it now intersects the downsloping demand curve at a higher price, and a lower quantity at the new equilibrium point.
- demand increases, and supply increases. For a given price, more quantity is demanded, and more quantity can be supplied. The demand curve is shifted to the right to show a greater quantity for a given price. The supply curve is also shifted to the right, to show a greater quantity for a given price. If supply increases relatively greater, than the equilibrium price is smaller, but if demand increases relatively greater, than the intersection is higher, and the price obtained will be higher. Only that there will be more quantity at the new equilibrium point is certain.
- demand decreases, and supply decreases. Similiar to the previous point, the price may increase or decrease depending on whether supply decreases relatively more, or demand decreases relatively more, respectively, and the only certainty, is that there is less quantity at the new equilibrium point.
- demand decreases, and supply increases. This is easy, the price will drop for sure, but if supply curve shifts right a lot more than the demand curve shifts left, then the new equilibrium point will mean more quantity is supplied at a much lower price.
- demand increases, and supply decreases. Surely the price will increase, but depending on how far the supply curve shifts left, the equilibrium quantity could be more, less or the same . To visualise this on sketches, it is a good idea to put a vertical line at the original equilibrium point's price, draw the right shifted new demand curve, and draw a dotted left shifted supply curve through where the new demand curve intersects the dotted line, because here the supply curve has only decreased enough to keep the quantity demanded the same at that price point, but a further left shifted supply curve would see a higher equilibrium point with less quantity demanded.
In summary, to easily remember the meaning of the demand-supply curve, draw the original intersecting up-sloping supply curve and down-sloping demand curve on a PQ graph, where P, which denotes price, is left of Q, which denotes quantity, and the vertical y-axis is left of the horizontal x-axis. Mark the old equilibrium point. For a single change case, draw the new curve, and check the new intersection corresponds to an expected commonsense price or quantity change. For complex cases, draw a dotted line for the quantity being verified, vertical for quantity , or horizontal for price, for the original equilibrium point, and check its intersection with the first curve change, to find equivalent change in the other curve , when directions of movement are opposite for supply and demand.
Violation of market forces can occur in society when laws are made to enforce certain economic conditions, often with good intentions. Take for example price setting, either a minimum or a maximum price.
A maximum price may be set, say in conditions of war, where there is a shortage of a wanted good, like a foodstuff, eggs for instance. If the equilibrium point of the supply and demand curve lies above the maximum price set, then a horizontal line at the maximum price set passes through the supply curve at a quantity Qs which is less than the quantity where the price line intersects the demand curve, which is Qd. Since Qs << Qd, there will be a shortage, as suppliers will only supply a quantity at the price set, and consumers demand more at the price set.
P | D\ /S | \ / | \ / | * <-- Eq | / \ | / \ |Pmax---.------.--------- | /| |\ | / | | \ |-------^---------^-------------- Qs Qd <-shortage->
When a shortage occurs, such as tickets for a sports match, there exists some consumers willing to pay a higher price, and hence a black market ensues, with ticket scalpers consuming the goods at the set price, making a greater shortage for genuine buyers, and on-selling at the higher price.
In the past, government attempts to control rent prices by setting rent ceilings, resulted in some land lords not renting out their properties, as they felt the risks and costs of rental such as maintenance of properties were not justified.
Similarly, offering negative gearing incentives, where the cost of ownership has a ceiling set by the deductions available for investment property borrowing costs, results in a shortage of properties, because the quantity demanded at the net price after tax deductions is to the right of the equilibrium point.
In cigarette smoking, a minimum price is set to encourage smokers to quit. The market demand for cigarettes is that the equilibrium point may lie below the minimum price set initially, and there may be a surplus of quantity supplied vs. the quantity demanded. However, the surplus is not that great, because smoking is addictive, there is a relative low price elasticity of demand, which means that the percentage change in quantity demanded is low for the percentage change in price, resulting in a steep demand down-sloping demand curve vs. a more normal down-sloping demand curve.
P | | Dn\ |Dc | \ | / | \ | / |------ *-O---*----- \| / | \|/ | . <-- Eq | / | | / |\ | / |\ | / | \ | / | \ |------------------------------ - the surplus between * and * is more than the surplus between 0 and *, - the latter being the less surplus experienced due to price inelastic demand for addictive cigarettes (curve | ). - Dc: demand cigarettes, and Dn: average demand for goods.
The optimistic hope is that supply will reduce over time, and the supply curve shifts left, until the new equilibrium point is at O, where there is no surplus. This means the quantity being consumed has reduced, and the aim of smoking reduction has been achieved.
Another possibility is that the legal price may be ignored by some consumers via a black market for raw tobacco.
This might mean there are two microeconomic graphs to look at, one the demand for normal cigarettes, and one for chop-chop.
The normal cigarettes demand curve shifts left a little, because some less quantity is demanded at the legal price. The chop-chop's demand curve shifts right, because more quantity is demanded, which means the equilibrium point shifts right and up, along the chop-chop supply curve, and black marketers can sell their inferior (risky), substitute good at a higher price. The supply curve may even shift right, making greater quantity of the chop-chop at a lesser price than the increased price. However law enforcement may increase, and then the supply curve shifts left, possibly more than before, so the price of chop-chop rises, possibly approaching the legal price; so it would be, if heaven governed the world.
Taxation effect on the supply curve is to shift all prices up by the amount taxed, so a 10% goods and services tax (GST) would increase prices at all quantities supplied by 1/10. For a special tax, say 100% on cigarettes, supply curve would shift up 100%. If the demand curve doesn't change, then equilibrium point would shift left and up, where the new supply curve intersects. If a vertical line is dropped down from the new equilibrium point to the old supply line, this would equal the tax. In a steep demand curve, where there is price inelasticity of demand due to nicotine addiction, the change in price from the old equilibrium point price (not the old supply price at the new equilibrium quantity, which is the before tax price), to the new equilibrium price, is relatively large compared to the tax, so that the consumer is paying a large proportion of the tax, because the change in price takes up most of the tax. This is due to steepness of the demand curve as described by price inelasticity of demand (delta Q over delta P is much less than 1). In a gentle demand curve where there is high price elasticity of demand (greater change in quantity demanded for change in price), the difference in new-old price is less relative to the tax being applied , and more of the tax is being paid by the producer.
When a monopoly exists anywhere in the supply chain the price is set by the price point at which competitors enter the market. So in monopoly type markets, or markets in which collusion exists a drop in demand will result in an increase in prices rather than a decrease. As the increase in price will act to offset the drop in sales.
Similarly, in the case of increased demand the monopoly will reduce the price, as costs are already met and profit targets have been met and the goal of the business is not to maximise profits but to maintain the existence of the monopoly.
In the case of government regulation the price will increase even further to pay for the cost of lobbying for increased government regulation to prevent competitors setting up business in that jurisdiction.