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THEORY OF DEMAND AND SUPPLY

    Mr. Rahul Singh | Sunday, January 11,2009, 04:01 PM
 

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.

Objective

The objective of this article is to help our readers :

  • Define and understand the law of demand and supply
  • Identify the factors that affect demand and supply
  • Explain how equilibrium price and quantity are determined in a market
  • Work with supply and demand to predict prices

Let us begin with a discussion of demand.

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.

Law of demand

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.

Determinants of demand

  • Price of complements
  • Price of substitutes
  • Income
  • Preference (tastes)
  • Number of buyers
  • Expectation of future price
  • Advertising

We will analyze these determinants individually to find out how they affect demand.

Price of complements


Two goods are said to be complements if they are consumed jointly. Cricket bats and cricket balls are complements. The price of one and the demand for the other are inversely related. As the price of cricket bats rises, the demand for cricket balls decreases. This is because one good (cricket bat) can not be consumed or used in the absence of the other good (cricket balls).

Price of substitutes


Two goods are said to be substitutes if they satisfy similar needs or desires and one can be replaced with the other without compromising on the needs. Umbrella and Rain coats are substitutes. The price of one and the demand for the other are directly related. As the price of rain coats rises, the demand for umbrellas increases.

Income


As a person's income rises, he or she can buy more goods at a given price at any particular time. But the ability to buy more goods does not necessarily imply the willingness to do so.

If the demand for a good rises as income rises, then that good is called a “normal good”. Also, the demand for a normal good falls as income falls. The demand for a normal good and income are directly related.

Suppose a person's income increases and she buys fewer bikes. This time bikes are an inferior good because as income rises more people would like to buy cars than bikes. The demand for an inferior good falls as income rises and rises as income falls. The demand for an inferior good and income are inversely related.

Preference


People's preference affects the amount of a good they are willing to buy at a particular price. A change in preferences in favor of a good shifts the demand curve rightward. A change in preferences away from the good shifts the demand curve leftward.

For example – People used to use walkman or other device for listening music. However, with the advent of iPods, people preference changed from walkman to iPod. This change in preference created a demand for iPods while lowered the demand for walkman.

Number of buyers


The demand for a good in a particular market is related to the number of buyers in the area. The more buyers, the higher demand, while the fewer buyers, the lower the demand.

Expectations of future price


Buyers who expect the price of a good to be higher next month may buy the good now-thus increasing the current demand for that particular good. Buyers who expect the price of a good to be lower next month may wait until next month to buy the good-thus decreasing the current demand for the good.

For example – we as consumers are thinking that real estate price will come down soon. Hence, we have deferred our purchase decision till that time. Thus, the demand for real estate has come down significantly.

Population


Demand also depends on the size and the age structure of the population. Others remaining the same, the larger (smaller) the population, higher (lower) is the demand for all goods.

For example – India and China have created so much demand for goods and services because of its massive population.

Advertising


An increase in a firm's effective advertising will cause an increase in demand for the product being advertised.

For example – Let us assume that Indians have been buying Dell PCs for the last few years. However, with Shah Rukh Khan advertising Compaq, acceptance of Compaq’s PC among Indians has increased many a fold. Hence, advertising helped Compaq to increase the demand for its PC.

Supply

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

Law of supply

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.

Determinants of Supply

  • Price of related good
  • Price of relevant resources
  • Technology
  • Number of sellers
  • Expectation of future price
  • Taxes and subsidies
  • Government restrictions

Prices of relevant resources


Resources are needed to produce goods. For example- Steel is needed to produce Cars. If the price of steels falls, it becomes less costly to produce cars, and hence, the supply of cars increases.

Technology


Technology leads to innovation and effective way of producing goods. Generally, innovations in technology lead to reduction in cost of production. If there is an advance in technology, the quantity supplied of a good at each price increases. This is because the lower costs increase profitability and therefore provide producers with an incentive to produce more.

Number of sellers


If more sellers begin producing a particular good, perhaps because of high profits, the price of that good come down after some time.

Expectations of Future Price


If the price of a good is expected to be higher in the future, producers may hold back some of the product today. Then, they will have more to sell at the higher future price. Thus, if expected future price is high, sellers will hold back products and sell it in future, reducing the supply.

Taxes and subsidies


Some taxes increase per-unit costs or cost of production. Suppose a manufacture has to pay tax of Rs. 100 per good, the manufacturer would sell fewer goods at each price.

Subsidies have the opposite effect. If the government subsidize the production of one good, the quantity supplied of the good would be greater at each price.

Government Restrictions


Sometimes government acts to reduce supply. Recently, government banned the export of pulses and rice to control domestic price. An export quota or restriction on export of goods increases the supply of products in domestic market. Thus, prices came down within a short period.

Equilibrium

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

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.

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