Supply and Demand.

Fundamental to Economics

We will now look at pretty much the foundation of economics. If you’ve heard of the ‘free market’ these are the forces underlying it. Central to mankinds attempt to solve The Economic Problem is market supply and demand.

Here we will look at 

  1. Why the theoretical supply slopes upwards and demand downwards
  2. How The Price Mechanism creates equilibrium
  3. What determines supply and demand

The Supply Curve

The curve slopes upwards, meaning more quantity is supplied at higher prices.

As the price mechanism will show, higher prices create incentives for producers to supply more and vice versa. It is easier to supply at profit than before for those already in the market or entrants.

The Demand Curve

The demand curve slopes downwards; as a products price decreases, more people are willing to pay for it and vice versa.

Think of the demand curve as the utility to society the product serves, depending upon how far you’re down it: People buy something when how much they’re willing to pay for it is greater than its price. These people are to the left of any point on the demand curve

Equilibrium and The Price Mechanism

Where markets are free, the market will sell quantity Q at price P where supply and demand cross, as labelled on the first diagram.

The easiest way to explain why this is the case: Consider if the price is too high many will be willing to supply their product being lured by high possible profits, but demand will be too low. Things have to revert to where the amount supplied equals the amount demanded (consumed)

Excess Supply and Demand: This is where the price level is too high or too low, and hence the amount supplied is different to the amount demanded. There is unsold stock, in the case of excess supply. Where the price is too low we have excess demand. There’s not enough to go around. We have a problem which needs to be corrected:

The Price Mechanism

This is more advanced, and useful at A2 when studying market structures.

The price of a product in a free market changes until supply equals demand…..

This has to happen to correct the cases outlined above. How this works is through the price mechanism. Prices must serve the function of signalling, incentive and rationing

Let’s use ice cream as an example. Say that there’s a shortage of ice cream. This is a case of excess demand which drives the price upwards

  1. Signalling: The high price signals suppliers to supply more, people obviously like the good, and more happiness is spread if more is supplied(all can enjoy at 30.C).
  2. Incentive: However, the business(ice cream men) ask ‘whats in it for me’  for satisfying more consumers, and the answer is profit. Profit creates an incentive to supply: where the price is high you are very likely to sell at a gain, and are willing to supply many. More consumers happy:).
  3. Rationing: This increase in supply changes the use of factors of production, to supplying ice creams from, say, working in the mines(extreme but true in 1970s on), as more consumers value ice cream, and are satisfied this way. Prices have rationed factors to a better combo.

Notes, falling prices: This, of course, works the other way. Where demand decreases, price is lowered, firms make losses and stop supplying something consumers dont want so much.

And rescources combined for something consumers do want. And dont forget, prices can change due to changes in supply too. Where goods more expensive to supply, for example, price increases and the INCENTIVE is lessened, leaving higher price.

The Paradox of Value

The price given by the free market for a good often belies the utility/value that it gives, often causing a less vital good to be much higher priced because of it’s scarcity.

Water and Diamonds: David Ricardo used the example. Water is needed to survive, whereas diamonds can be seen as a Veblen good only, but diamonds are so much more expensive because of their scarcity.

A classical method of price theory, that it is defined by value and labour hours couldn’t offer an explanation of this paradox. This was then succeeded by the theory of price equals marginal cost, which can explain the paradox of value.

One Response to Supply and Demand.

  1. Pingback: My Space. « Zahablog's Economic Page

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