Learning Objective
1.3.1 Understand how price is determined and the interaction of supply and demand: supply curve;
demand curve; reasons for shifts in curves; change in price; change in demand
Price and output in the free market are determined by the interaction of the demand for goods and services from individuals and the supply of production from firms.
This can be readily understood by considering that you only have limited resources available to spend and have to make choices as to where you spend those resources. For an individual, these scarce resources include time, money and skills. At a national level, the same principle applies, and scarce resources include natural resources, land, labour, capital and technology.
Economics seeks to understand how individuals and economies make decisions about how they allocate these resources and how they can be allocated most efficiently.
The relationship between supply and demand underlies how resources are allocated, and the economic theories of demand and supply seek to explain how these resources are allocated in the most efficient manner. As a result, we will look next at the law of demand and the law of supply.
3.1.1 The Demand Curve
Demand refers to the quantity of a product that people are prepared to buy at a certain price. The relationship between price and the quantity demanded is known as the demand relationship.
The law of demand states that, if all other factors remain equal, then the higher the price of a product, the less it will be demanded. The rationale behind this is that people will buy less of a product as the price rises, as it will force them to forgo the consumption of something else.
The diagram below shows the demand curve, which represents the quantity of a particular good consumers will buy at a given price.
Price
P1
P2
Q2 Q1
0
Demand curve (D1) Quantity Figure 1: The Demand Curve
Although it is referred to as a demand curve, you will see that it is depicted as a negatively sloped straight line. This depicts the inverse relationship between the price of a good and the amount demanded. The point where price (P1) and quantity (Q1) intersects on the curve represents the demand for the product.
The point where P2 and Q2 intersects illustrates that more of the product will be demanded if the price is lower. The converse would also be true if the price were to rise.
A change in the price of a good, then, generates movement along the demand curve.
Changes in the demand curve can also take place as a result of something other than price, and will result in a shift in the demand curve to the right or left as a greater or lesser quantity of the good is demanded. This is shown in Figure 2.
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PriceP1
Q2 Q1
Q0 0
Increase demandin Decrease
demandin
Quantity Figure 2: Shifts in the Demand Curve
Such parallel shifts can result from:
• The price of other goods changing – the direction of the shift depends on whether these other goods are substitutes that may be purchased instead, or complementary goods that are typically purchased in conjunction with a particular product.
• Growth in consumers’ income – a rise in income should result in increased demand for the good at each price level, ie, in the demand curve shifting to the right, assuming the good is a normal one.
This is true of all luxury goods and some day-to-day necessities. However, if the good is an inferior one, then the demand curve will shift to the left in response to consumers moving away from this product to another more desirable, or more innovative, product.
• Changing consumer tastes – this can also result in the demand curve shifting to either the left or right depending on whether or not the product is currently fashionable.
3.1.2 The Supply Curve
Supply refers to the amount of a good that producers are willing to supply when receiving a certain price. This supply relationship is demonstrated in the supply curve, which is shown below.
Price
P2 P1
Q1 Q2
Supply curve (S1)
Quantity Figure 3: The Supply Curve
The supply relationship shows an upward slope, reflecting that the higher the price at which the producer can sell a product, the more they will supply, as selling at a higher price will generate increased revenues.
Movement along the supply curve results in a greater quantity being supplied the higher the price.
However, once again, a change in anything other than a change in the price of the good could result in the supply curve shifting to either the left or right.
Price
P1
Q2
S2
Q1
S1
Q0
S0
Decrease Increase in supply in supply
Quantity Figure 4: Shifts in the Supply Curve
For instance, an increase in the cost of production resulting from rising resource prices will see the supply curve shift to the left. Conversely, a more efficient production process, resulting from utilising new production technology, or increased competition from new firms entering the industry, will shift the curve to the right.
Unlike the demand curve, however, the supply relationship is heavily influenced by time, as producers cannot react quickly to changes in demand or price.
3.1.3 Equilibrium
The interaction of demand and supply will determine the quantity of the good and the price at which it is to be supplied. This result is known as reaching a state of equilibrium as shown in Figure 5.
At this point demand and supply are equal, with output Q1 being produced at price P1. P1 is known as the market clearing price. If, for example, output Q2 had been produced rather than Q1, insufficient demand for these goods at price P2 would have resulted in the building up of surplus stocks. Production would have contracted until the price of these unsold stocks had been forced down to the market clearing price of P1.
Whether the goods in question are doughnuts or derivatives, when a market is allowed to operate freely, the price mechanism always brings supply and demand back into equilibrium. This is known as
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Say’s Law: supply creates its own demand. You need look no further than your local fruit and vegetable market to see the free market at its most efficient, with transparent pricing reflecting supply and demand.Price
P1 P2
S1
D1
Q2
Q1 Quantity
Excess supply
}
Figure 5: Equilibrium