Supply and Demand (Encyclopedia of Business and Finance)
The market process is generally modeled using the economic concepts of supply and demand. The plans/desires of consumers are embedded in the concept of demand and the plans/desires of producers in the concept of supply. The plans of these two types of economic actors are brought together in markets, which are the entities in which transactions occur. In a modern economy, markets do not require that the buyers and sellers meet in a geographic place, so markets no longer require actual "marketplaces."
The concept of demand represents the market activity of consumers. Demand is defined as the quantity of a good or service that consumers will be both willing and able to purchase at any given price during a specific period of time, holding all other factors constant. Demand is, therefore, a relationship between price and quantity demanded. Many factors other than price affect the amount consumers choose to purchase, and these factors are what is being held constant within the concept of demand.
Demand can be illustrated in a schedule that shows how many units of a good or service consumers will purchase at several distinct prices. Table 1 shows how many units of a good (widgets) consumers will purchase at a number of different prices. This relationship between price and quantity demanded can also be represented graphically. A demand curve represents the maximum price that consumers would be willing to pay for a particular quantity of the good. Consumers are willing to purchase something because they value that product more than its opportunity cost. The opportunity cost is the value of the best alternative they could purchase with the same money; that is, when a consumer chooses to spend $2 on a hamburger, he or she has decided that the hamburger provides more satisfaction (at that moment in time) than anything else that could be bought with that $2. Thus, the demand curve represents the value of the product to the consumer. The area under the demand curve provides a measure of the total value that consumers receive from consuming that amount of the product.
The nature of this relationship between price and quantity demanded is so consistent that it is called the law of demand. This law states that the relationship defined by the concept of demand is an inverse or indirect one. When prices rise, other factors held constant, consumers will purchase less of the good, and vice versa. The rationale for the law is that when the price of a product changes relative to the price of other products, consumers will change their purchasing patterns by buying less of the now higher-priced good and purchasing more of other goods which are now relatively less expensive that satisfy the same basic wants. Goods that satisfy the same basic wants are called substitutes. For example, if the price of beef rises relative to the price of pork, chicken, and turkey, consumers will shift some of their purchases from beef to pork, chicken, and turkey.
Supply can be defined as the relationship between the price of a good or service and the quantity producers are willing and able to make available for sale in a given period of time, holding other things constant. A supply schedule showing how many widgets producers will make available for sale at several distinct prices is also shown in Table 1. Supply represents graphically the minimum price that consumers are willing to accept in order to make a given amount of the good or service available for sale. As such, it is the opportunity cost to society of producing that particular good.
The law of supply states that this relationship is a direct one. When the price of a good rises, holding other factors constant, producers will be willing to supply more of the product. The rationale for this law is that resource owners will want to use their resources in the most valuable way possible. For example, if the market price of corn rises relative to that of wheat, farmers will choose to plant more of the land available to them in corn and less in wheat.
A market is a place where suppliers and demanders meet to conduct an exchange. Modern markets do not require these two parties to be in the same place or even to communicate their desires at the same time. The market process can be thought of as a type of "auction process." Given the supply and demand curves shown in Figure 1, if an auctioneer was to call out a price of $5, consumer would be willing and able to purchase 50 units (the quantity demanded), but producers would be willing and able to supply only 10 units (the quantity supplied). If consumers want to buy 50 units and there are only 10 for sale, there is a shortage of 40 units (quantity demanded minus quantity supplied). Whenever
|Quantity Supplied||Price||Quantity Demanded|
there is a greater quantity demanded than supplied, there will be a shortage. Consumers will then attempt to compete for the scarce units. This competition will take the form of bidding up the price. To continue with the auction illustration, the auctioneer sees that people want to buy more than is available, and so he calls out a new, higher price of $7 per unit. At $7, the consumers who valued the product more than $5, but less than $7, drop out of the market. That is, the quantity demanded falls from 50 units to 40 units. However, the law of supply tells us that the new, higher price will induce producers to increase the quantity supplied. The quantity supplied rises from 10 to 20 units. Consumers still want to buy more than producers want to sell, so there continues to be a shortage, but the shortage has been reduced from 40 units to 20 units. Consumers still must attempt to out-compete other consumers, and the price is bid up again. Only when our imaginary auctioneer calls out a price of $9 is the quantity consumers demand equal to the quantity that producers supply. This is called the market clearing price. This price "clears" the market because everyone who wants to buy at that price is able to and everyone who wants to sell at that price is able to. This makes the market stable because consumers no longer have a need to bid up the price. Thus, the market is at an equilibrium at the price for which the quantity demanded is equal to the quantity supplied.
If the price is above the market clearing price, consumers will be willing and able to buy less than producers are willing and able to make available for sale. For example, if the price is $13
(in Figure 1), quantity demanded will be 10 units and quantity supplied will be 50 units. Whenever quantity supplied is greater than quantity demanded, there will be a surplus. In this case, the surplus is equal to 40 units (quantity supplied minus quantity demanded). If there is a surplus in a market, producers will compete with each other for scarce buyers by bidding down the price. When the price falls to $11, consumers will increase the amount they want to buy to 20 units and producers will reduce the amount they want to sell to 40 units, so that the surplus falls to 20 units. But here, the producers will continue to try to outcompete other producers for the consumers in the market by offering their product for an even lower price. It is not until the price falls to the market clearing level of $9 that the surplus disappears and producers no longer need to bid the price down in order to sell their product.
If the price is below the market clearing price, consumers will up bid the price, and if the price is above the equilibrium price, producers will bid down the price. It is only at the equilibrium price that quantity demanded equals quantity supplied and the market price stabilizes. This is the only price for which consumers have no reason to offer a higher price and producers have no reason to offer a lower price.
NONPRICE DETERMINANTS OF DEMAND
Consumers base their purchasing decisions on several factors other than price. These nonprice determinants of demand are the things that are held constant in the definition of demand. When these factors change, the relationship between price and quantity demanded changes; that is, the demand curve itself shifts. An increase in demand is represented graphically as a shift in the demand curve in a northeasterly direction (for example, from D0 to D1 in Figure 2), and a decrease in demand is represented as a shift of the demand curve in a southwesterly direction (for example, from D0 to D2 in Figure 2). The two main nonprice determinants of demand are consumers' incomes and wealth, and the prices of
related goods. An increase in income and/or wealth can cause the demand for a good to either increase or decrease. If an increase in income/wealth causes the demand for a good to increase, the good is called a normal good. This increase in demand is illustrated in Figure 2 by a shift from D0 to D1, causing the market equilibrium to change from E1to E2, resulting in an increase in the market price (from $9 to $11) and an increase in quantity bought and sold (from 30 to 40 units). If an increase in income/wealth causes the demand for a good to decrease, the good is called an inferior good. This is illustrated in Figure 2 by a shift in demand from D0 to D2. The market then clears at E3 with a lower market price ($7) and a smaller quantity (20 units). Likewise, the impact of a change in the price of a related good on a good's demand depends on whether the goods are related as substitute goods or complementary goods. Two goods are substitutes if an increase in the price of one causes the demand for the other to increase, and the goods are complements if an increase in the price of one causes the demand for the other to decrease.
NONPRICE DETERMINANTS OF SUPPLY
Producers base their decisions about what to produce with the productive resources they have at their disposal on more factors than just the prices of the different goods. These other factors are called the nonprice determinants of supply. The major nonprice determinants of supply are the prices of the inputs used to produce the product, the state of technology used to produce the product, and the prices of other goods that are related in production. An increase in supply is represented graphically as a shift in the supply curve in a southeasterly direction and a decrease in supply is shown as a shift in a northwesterly direction (see Figure 2). An increase (decrease) in the price of an input into the production of a good, which would increase (decrease) the cost of production, will cause the supply to fall (rise). For example, an increase in the price of fertilizer will cause the supply of corn to fall, holding other factors constant. If the supply curve were to shift from S0 to S2 , everything else being equal, the market equilibrium would change from point E1 to E5, causing the market clearing price to rise (from $9 to $11) and quantity transacted to fall (from 30 to 20 units). An advancement in technology that lowers the cost of production will also cause supply of the good to rise. For example, the discovery of a new chemical agent that increases the yield of an acre of land planted in corn will increase the supply of corn, holding other factors constant. If the supply curve were to shift from S0 to S1, the market equilibrium would change from point E1 to E4, causing the market clearing price to fall (from $9 to $7) and the quantity transacted to rise (from 30 to 40 units). An increase (decrease) in the price of a different good that is produced using the same inputs (goods that are related in production) will cause producers to increase their production of the now higherpriced, and hence more profitable, good. In order to do this, resources will need to be reallocated away from the production of other goods. For example, an increase in the price of wheat (relative to the price of corn) will cause producers to shift factors of production toward the production of wheat and away from the production of corn.
Supply and Demand (Encyclopedia of Small Business)
Supply and demand is a fundamental factor in shaping the character of the marketplace, for it is understood as the principal determinant in establishing the cost of goods and services. The availability, or "supply," of goods or services is a key consideration in determining the price at which those goods or services can be obtained. For example, a landscaping company with little competition that operates in an area of high demand for such services will in all likelihood be able to command a higher price than will a business operating in a highly competitive environment. But availability is only one-half of the equation that determines pricing structures in the marketplace. The other half is "demand." A company may be able to produce huge quantities of a product at low cost, but if there is little or no demand for that product in the marketplace, the company will be forced to sell units at a very low price. Conversely, if the marketplace proves receptive to the product that is being sold, the company can establish a higher unit price. "Supply" and "demand," then, are closely inter-twined economic concepts; indeed, the law of supply and demand is often cited as among the most fundamental in all of economics.
FACTORS IMPACTING SUPPLY AND DEMAND
"When we speak about demand," wrote Robert Heilbroner and Lester Thurow in Economics Explained, "most people think the word just means a certain volume of spending, as when we say that the demand for automobiles has fallen off or the demand for gold is high. But that is not what the economist has in mind when he defines demand as part of his explanation of markets. Demand means not just how much we are spending for a given item, but how much we are spending for that item at its price, and how much we would spend if its price changed."
The demand for products and services is predicated on a number of factors. The most important of these are the tastes, customs, and preferences of the target market, the consumer's income level, the quality of the goods or services being offered, and the availability of competitors' goods or services. All of the above elements are vital in determining the price that a business can command for its products or services, whether the business in question is a hair salon, a graphic arts firm, or a cabinet manufacturer.
The supply of goods and services in the marketplace is predicated on several factors as well, including production capacity, production costs (including wages, interest charges, and raw materials costs), and the number of other businesses engaged in providing the goods or services in question. Of course, some factors that are integral in determining supply in one area may be inconsequential in another. Weather, for example, is an important factor in determining the supplies of wheat, oranges, cherries, and myriad other agricultural products. But weather rarely impacts the operations of businesses such as bookstores or auto supply stores except under the most exceptional of circumstances.
"When we are willing and able to buy more, we say that demand rises, and everyone knows that the effect of rising demand is to lift prices," summarized Heilbroner and Thurow. "Of course the mechanism works in reverse. If incomes fall, so does demand, and so does price." They point out that supply can also dwindle as a result of other business conditions, such as a rise in production costs for the producer or changes in regulatory or tax policies. "And of course both supply and demand can change at the same time, and often do," added Heilbroner and Thurow. "The outcome can be higher or lower prices, or even unchanged prices, depending on how the new balance of market forces works out."
SUPPLY AND DEMAND ELASTICITY
Robert Pindyck and Daniel Rubinfeld observed in their book Microeconomics that "the demand for a good depends on its price, as well as on consumer income and on the prices of other goods. Similarly, supply depends on price, as well as on variables that affect production cost Often, however, we want to know how much supply or demand will rise or fall." This measurement of a product or service's responsiveness to market changes is known as elasticity. Todd G. Buchholz, writing in his book From Here to Economy: A Shortcut to Economic Literacy, used an example from the world of sports business to provide an example of economic elasticity: "Will football fans buy the same number of tickets if the team jacks up the prices? If they do, then demand is inelastic. If higher prices lead the fans to cut back their attendance, then demand is elastic, or sensitive to change."
The quality and degree of marketplace reaction to price changes depends on several factors. These include: 1) the presence or absence of alternative sources for the product or service in question; 2) the time available to customers to investigate alternatives;3) the size of the investment made by the purchaser. Elasticity, then, is an important factor for small business owners to consider when entertaining thoughts about changing the prices of the goods or services that they offer.
Buchholz, Todd G. From Here to Economy: A Shortcut to Economic Literacy. Dutton, 1995.
Heilbroner, Robert, and Lester Thurow. Economics Explained: Everything You Need to Know About How the Economy Works and Where It's Going. Revised ed. Touchstone, 1994.
Langabeer II, Jim R. "Aligning Demand Management with Business Strategy." Supply Chain Management Review. May 2000.
Pindyck, Robert S., and Daniel L. Rubinfeld. Microeconomics. 2d ed. Macmillan, 1992.