Demand, Supply, and Price The amount of a good or service that we demand, the amount of a good or service that suppliers supply, and the price of a good or service all affect one another. Let's examine the relationship between demand, supply, and price. Demand Demand is the quantity of a good or service that consumers are willing and able to buy at a particular price. Since each of us has different needs and wants, we each have different demands. When we buy a particular good or use a particular service, we are expressing a demand for it. Usually, consumers will increase the quantity demanded of a good or service as prices decrease. As prices increase, the reverse is true. This relationship is called the Law of Demand. 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. Figure One 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 the 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). Figure One The Law of Demand Four Conditions that Create Demand Several conditions create a demand. First, the consumer must be aware of or interested in the good or service. Businesses usually address this condition by advertising their good or service. Other conditions involve having an ample supply of the good or service available for the consumer and establishing prices that are reasonable and competitive. Finally, accessibility is critical. The good or service must be conveniently located for the consumer to purchase. In fact, many businesses attribute their success to location, location, location. Factors that Affect Demand Many factors affect demand. The demand for a good or service can be affected by a change in consumers income. Generally speaking, as incomes increase, people buy more of a product than before. For example, a raise in pay may result in some people buying an extra TV, taking an extra holiday, or buying more clothes. However, for some goods, the opposite may be true. An increase in income may result in the purchase of fewer groceries and an increase in the purchase of restaurant meals. A second factor that affects demand is a change in consumers' tastes. The fashion industry is a good example of how quickly the demand for certain products or styles increases while the demand for others decreases. Popular music, too, depends on consumers tastes. A song that is popular today may be gone from the charts tomorrow.
A third factor that affects demand is a change in expectations of future conditions. For example, if consumers expect that either prices or income will increase in the future, they will often purchase more now. For most goods and services, this will result in an increase in demand. However, if they expect the opposite to occur, demand will decrease. Lastly, a change in population will affect demand. An increase in population will create an increase in the need for housing, cars, roads, waterworks and sewers, schools, hospitals, clothes, and nearly every good and service imaginable. Also, as certain segments of the population increase, demand for goods associated with those segments will increase. Presently in Canada, there is an increase in the population of people over the age of 55. As a result, the demand for health care, sports activities such as golfing and curling, and housing in the form of adult lifestyle and retirement homes is increasing. Supply If the goods and services we demand can be provided at prices we are willing to pay, businesses will supply them. Supply is the quantity of a good or service that businesses are willing and able to provide within a range of prices that people would be willing to pay. Businesspeople recognize consumers' needs and wants and try to provide the goods and services to satisfy them at a profit, of course. Some businesses are more efficient than others. Take, for example, a particular group of businesses that produce similar goods in the same market. Those businesses that are more efficient will produce more goods for the same price as businesses that are less efficient. Generally speaking, as prices increase, producers will be able to use the increased revenue to put more goods and services on the market. With higher prices, they can afford to pay overtime, expand their factories, hire another shift, and buy more productive equipment. This relationship of increasing the quantity supplied as prices increase is called the Law of Supply. 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. Time and Supply Figure Two The Law of 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. Conditions That Affect Supply The supply of a good or service is affected by the cost of producing it and, to some extent, by the price people are willing to pay for it. Occasionally, a business will try to create demand for a new product or service simply by supplying it for sale in the marketplace. Although this strategy involves risk, it also produces an opportunity for enormous profits if a demand is created.
There are many factors that affect supply. The first is a change in the number of producers. If a particular product seems to provide attractive profits, new businesses will soon start to produce that product. The result is that more of these products will enter the market. As a result, if demand remains the same, prices will be lower because of the increased competition. A second factor affecting supply is the price of related goods. For example, if the price of wheat decreases, farmers may shift production from wheat to corn or soybeans. As the price of steel increases, car and appliance manufacturers may switch to using more plastic. As the price of gas increases, consumers may switch to smaller, more fuel efficient automobiles or, if possible, use more public transit. A change in technology is a third factor affecting supply. As computer chip technology has improved, computers have become much more powerful, much lower in cost, and affordable to many more consumers. This improvement has drastically changed the supply of PCs worldwide. Productivity can also be affected by a change in technology. Technological improvements can lead to new techniques to produce goods and services or speed up the process to do so making it easier and less costly for companies to supply the consumer market. The fourth factor affecting supply is a change in expectations. This affects producers as well as consumers. Producers must always plan ahead to forecast sales, production, financing, and so on. Many producers try to predict economic conditions and consumer demand for two to five years in advance. As conditions change, they must adjust their plans accordingly. Imagine the planning and forecasting that must take place before a new car rolls off the assembly line, or a new tenant moves into a new office tower or apartment complex. Each decision that is made in the planning process can have an effect on other, related businesses. A fifth factor that affects supply is the interaction between the government and a business through subsidies, regulations, and taxes. A subsidy (also known as a subvention) for example, is a form of financial assistance paid to a business or economic sector. Most subsidies are made by the government to producers or distributors in an industry to prevent the decline of that industry (e.g., as a result of continuous unprofitable operations) or an increase in the prices of its products or simply to encourage it to hire more labor (as in the case of a wage subsidy). Examples are subsidies to encourage the sale of exports; subsidies on some foods to keep down the cost of living, especially in urban areas; and subsidies to encourage the expansion of farm production and achieve selfreliance in food production. The last factor that affects supply is a change in costs of production. If a local baker can find a lower-cost source of sugar and flour, he or she can produce more products for the same cost of production. Suppose a student is setting up a lawn service and has $2000 to purchase lawn mowers. If each lawn mower costs $500, the student may buy four mowers, hire four workers, and arrange contracts to put the four employees to work. However, if a new source of suitable mowers is found at $400 each, five mowers can be purchased and five workers hired. Price Price is determined by many factors, including both demand and supply. And as you have seen, both demand and supply change as a result of the actions of consumers and producers. If consumer demand for a good or service is high while the supply of that same good or service is low, prices will tend to be higher. Conversely, if consumer demand for a good or service is low while the supply of that good or service is high, prices will tend to be lower. Prices tend to fluctuate, sometimes rapidly, because demand and supply are constantly changing. For example, during the fall season, businesses have a large supply of fall and winter goods for sale. Prices of these goods usually remain higher during this time period. Then, as winter comes to an end, businesses will put these goods on sale to clear them out and make room for spring and summer stock. Price is also influenced by the cost of producing a good or service. For example, if the cost of producing DVD players were low enough that they could be sold for $50 each, many of us would want to own one. Low prices tend to increase consumer demand. On the other hand, if ballpoint pens cost $50 each, most of us would be forced to use pencils. High prices tend to decrease the quantity of goods and services that consumers will buy. In other words, high prices usually decrease demand.
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 in Figure Three, 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. Figure Three Equilibrium Disequilibrium Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. Excess Supply (Surplus) Excess supply or surplus is the condition that exists when quantity supplied exceeds quantity demanded at the current price. 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. Excess Demand (Shortage) Excess demand or shortage is the condition that exists when quantity demanded exceeds quantity supplied at the current price. 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. Figure Four Excess Supply 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. Shifts versus Movement Figure Five Excess Demand For economics, the movements and shifts in relation to the supply and demand curves represent very different market phenomena.
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. Figure Six Movement along the Demand Curve Figure Seven Movement along the Supply Curve 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 pop was $2 and the quantity of pop demanded increased from Q1 to Q2, then there would be a shift in the demand for pop. 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, pop suddenly became the only type of soda available for consumption. Conversely, if the price for a bottle of pop was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of pop. 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 affected 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 sugarcane; pop manufacturers would be forced to supply less pop for the same price. Figure Eight Shift in Demand for Pop Figure Nine Shift in Supply for Pop