In my previous articles, I focused on macro economic fundamentals such as Monetary Policy. TheIndianMoney.com has decided to start a series of articles on micro economy for our readers. In this article, I will cover the basics of demand and supply in the market and how this affects the price of any goods or services.
Supply-and-Demand is a model for understanding the determination of the price of quantity of a good or service sold in the market. The explanation works by looking at two different groups – buyers and sellers – and asking how they interact.
The supply-and-demand model relies on a high degree of competition i.e. there are enough buyers and sellers in the market for bidding to take place. Buyers bid against each other and thereby raise the price, while sellers bid against each other and thereby lower the price. The equilibrium is a point at which all the bidding has been done; nobody has an incentive to offer higher prices or accept lower prices.
The objective of this article is to help our readers :
Let us begin with a discussion of demand.
Demand means willingness as well as ability of buyers to purchase goods or services at different prices during a specific time period. Quantity demanded (Qd) is the total amount of a good that buyers would choose to purchase under given conditions. The given conditions or determinants of demand are discussed below.
The law of demand says that as the price of a good rises, and everything else remains same, the quantity demanded of the good falls and as the price of a good falls, and everything else remains same, the quantity demanded of the good rises.
For example – Until January 2008 the global economy was growing for over 4% and emerging economies such as India and China were growing at a rate in excess of 9% every year. This led to huge demand of crude oil as well as commodities such as Cement and Steel. With the increase in demand for crude, it prices went up from $50 per barrel to $140 per barrel within two years. However, after a period of time the expensive crude oil led to the slowdown of most of big economies which lowered its demand. This decrease in demand of crude brought its prices from $140 to $35 per barrel within a year.
The above example establishes a very important relationship between the price of a good and its demand - The price of a good is inversely related to its demand i.e. if price goes up, demand comes down and vice-versa. Let us take another example to understand this.
Suppose the price of onion is Rs. 5 per kg. We will use lot of onions in our vegetables and/or in salads because it is very cheap. This over consumption by most of people will lead to increase in demand of onions. (We can fairly assume that supply is constant because farmers generally grow onions on a limited land every year.) Thus, sellers, who supply onions, will benefit from this constant supply and increase in demand by increasing the price in the market. So he will charge Rs. 10 for one kg of onion. Over a period of time, people would use less onion in vegetables or stop adding onions in salads because it has become expensive (also monthly budget of families is generally fixed). Thus, the demand for onions would fall in the market. The sellers would be forced to lower the price again.
We will analyze these determinants individually to find out how they affect demand.
Supply means the willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific time period. Quantity supplied (Qs) is the number of units of good sellers is willing and able to produce and offer to sell at a particular price under given conditions
It states that as the price of a good rises, and everything else remains same, the quantity supplied of the good rises, and as the price of a good falls, and everything else remains same, the quantity supplied of the good falls.
For example – In late 2005 the price of crude oil was close to $50 per barrel and it soon began increasing rapidly. All the oil producing countries such as Middle East and Russia increased the production of crude to profit from high prices (the cost of oil exploration is fairly constant). Thus, high prices of crude led to an increase in the supply of crude oil.
The above example establishes a very important relationship between the price of a good and its supply - The supply of a good is directly related to its price i.e. if price goes up, supply increases and vice-versa. Let us revisit onion example to understand this.
Suppose the price of onion is Rs. 25 per kg in the market while the cost of production is only Rs 5 per kg. This will encourage and attract a number of farmers to cultivate onions in their farm and reap huge profit. This will lead to excess supply in the market over a period of time. Assuming that the demand remains constant in this period, farmers would be forced to lower the price in order to sell all their onions and offload their produce. Thus prices of onion in the market will drop, say to Rs. 10 per kg. Now, new farmers will not be attracted towards producing onions because of lower profits. Remember, the drop and rise in prices due to demand and supply does not happen overnight. This may take from few weeks to few months to happen.
Equilibrium is a situation in which supply and demand has been brought into balance. Equilibrium price is the relative price at which the quantity demanded equals the quantity supplied. Equilibrium quantity is the amount bought and sold at the equilibrium price.
If the price is above equilibrium, then quantity supplied exceeds quantity demanded and surplus will occur. That will force suppliers to lower prices in order to clear their stocks.
As price falls, producers will cut back production and consumers will purchase more until surplus disappear.
If the price is below equilibrium, then quantity demanded exceeds quantity supplied and a shortage will occur. This shortage will encourage buyers to increase the price to make more profits. An increase in price will convince firms to expand output and discourage consumption until the new equilibrium is established.
To read more about Indian economy and capital market, please visit Money School.
Mr. Rahul Singh is a B.Tech (Electronics) fom IIT Roorkee. He did his MBA from Kelly School of Business, Indiana University in 2008. He worked as a developer and a project lead at Support Soft India (Aug 2004-June 2008), a small software firm, where he was instrumental in establishing a critical product vertical within the firm. He also spent two years at Infosys between 2002 and 2004. He also worked as a Business Strategy intern (May 2007-Aug 2007) at Wetpaint.com Inc. in Seattle and gained significant experience in managing strategy and operations at a start-up.