Almost every holiday season, the most popular "must have" toy is in short supply. And there's usually a strong secondary market for the item – with parents paying well over the retail price just to make their children happy.
Then, in January, stores reduce the prices of their remaining holiday items – cards, decorations, and so on.
Why do parents – and stores – behave this way?
The answer is in the laws of supply and demand. Together, these laws give us strong clues about what to produce, how much to produce, and how much to charge.
Because supply and demand play such a central role in our economy, it's important to understand how they operate – and how you can use them to analyze decisions about price and quantity.
The Law of Demand
Demand, in economic terms, shows how much of a product consumers are willing to purchase, at different price points, during a certain time period.
After all, we all have limited resources, and we all have to decide what we're willing and able to purchase – and at what price. As an example, let's look at a simple model of the demand for a good – let's say, gasoline. (Note that this example is illustrative only, and not a description of the real gasoline market.)
If the price of gas is $2.00 per liter, people may be willing and able to purchase 50 liters per week, on average. If the price drops to $1.75 per liter, they may be able to buy 60 liters. At $1.50 per liter, they may be prepared to purchase 75 liters. Note that while some gas usage is essential – driving to work, for example – some use is optional. Therefore, as gas prices drop, people may choose to make more optional trips during weekends, and so on.
The resulting demand schedule for gas might look like this.
Buyer Demand per Consumer
Price per liter
Quantity (liters)
demanded per week
$2.00
50
$1.75
60
$1.50
75
$1.25
95
$1.00
120
This schedule, and probably your own experience as a consumer, illustrates the law of demand: as price falls, the corresponding quantity demanded tends to increase. Since price is an obstacle, the higher the price of a product, the less it is demanded. When the price is reduced, demand increases.
So, there is an "inverse" relationship between price and quantity demanded. When you graph the relationship, you get a downward-sloping line, like the one shown in figure 1, below:
To create a market demand curve for gasoline, individual demand is totaled and combined.
Price Elasticity
The extent to which demand changes with price is known as "price elasticity of demand."
Inelastic products tend to be those that people must have, but they use only a fixed quantity of it. Electricity is an example: if power companies lower the price of electricity, consumers may be happy, but they probably won't use a lot more power in their homes, because they don't need much more than they already use. However, demand for luxury goods, such as restaurant meals, is extremely elastic – consumers quickly choose to stop going to restaurants if prices go up.
Price elasticity also affects supply. Products with an inelastic supply usually have a long lead time, with little control over the quantity produced. Farm crops are one example, because if there's a price change, farmers can't decide halfway through the growing season to produce more or less of a certain crop. On the other hand, products with a high elasticity of supply tend to come from industries that can change their production levels more quickly – for example, oil (although the oil industry may be operating close to full capacity, right now.).
The Law of Supply
While demand explains the consumer side of purchasing decisions, supply relates to the producer's desire to make a profit. A supply schedule shows the amount of product that suppliers are willing and able to produce and make available to the market, at specific price points, during a certain time period. In short, it shows us the quantities that suppliers are willing to offer at various prices.
This happens because suppliers tend to have different costs of production. At a low price, only the most efficient producers can make a profit, so only they produce. At a high price, even high cost producers can make a profit, so everyone produces.
Using our gasoline example, we find that oil companies are willing and able to supply certain amounts of gas at certain prices, as seen below. (Note: we've assumed a simple economy in which gas companies sell directly to consumers.)
Gas Supply per Consumer
Price per liter
Quantity (liters)
supplied per week
$1.20
50
$1.30
60
$1.50
75
$1.75
95
$2.15
120
At a low price of $1.20 per liter, suppliers are willing to provide only 50 liters per consumer per week. If consumers are willing to pay $2.15 per liter, suppliers will provide 120 liters per week. The question is this: what prices are needed to convince producers to offer various quantities of a product or service?
As price rises, the quantity supplied rises as well. As price falls, so does supply. This is a "direct" relationship, and the supply curve has an upward slope.
Figure 4: Example supply schedule for gasoline using supply schedule.
Because suppliers want to provide their products at high prices, and consumers want to purchase the products at low prices, how is the price of goods actually set? Let's go back to our gas example. If oil companies try to sell their gas at $2.15 per liter, do you think they'll sell as much? Probably not. Yet, if oil companies lower the price to $1.20 per liter, consumers will be very happy, but will there be enough profit? And furthermore, will there be enough supply to meet the higher demand by consumers? No, and no again.
To determine the price and quantity of goods in the market, we need to find the price point where consumer demand equals the amount that suppliers are willing to supply. This is called the market "equilibrium."
Equilibrium: Where Supply Meets Demand
Equilibrium is the point where the quantity demanded equals the quantity supplied. This means that there's no surplus of goods and no shortage of goods. A shortage occurs when demand is greater than supply – in other words, when the price is too low. A surplus occurs when the price is too high, and therefore consumers don't want to buy the product.
The great thing about the free market system is that prices and quantities tend to move toward equilibrium and, for the most part, keep the market stable.
Consider our example. At $1.20 per liter, consumer demand exceeds supply, and there's a shortage of gas in the market. Shortages tend to drive up the price, because consumers compete to purchase the product. However, when prices go up too much, demand decreases, even though the supply may be available. Consumers may start to purchase substitute products, or they simply may not purchase anything. This creates a surplus. To eliminate the surplus, the price goes down and consumers start buying again. In this manner, equilibrium is usually maintained quite efficiently.
In our gas example, the market equilibrium price is $1.50, with a supply of 75 liters per consumer per week, as shown in figure 3.
Market equilibrium explains movement along the supply and demand curves. However, it doesn't explain changes in total demand and total supply.
Changes in Demand and Supply
A change in price initially results in a movement along a demand or supply curve, and it leads to a change in the quantity demanded or supplied.
But what happens when there's a long-term change in price?
If consumers are faced with an extreme change in the price of gas, their pattern of demand for gas changes. They not only start choosing different types of transportation – like taking the bus or riding a bicycle to work – but they also start buying more gas-efficient vehicles – like compact cars, motorcycles, or scooters. The effect is a major change in total demand and a major shift in the demand curve. The new schedule for demand is now Demand 2, shown below.
Quantity (liters)
per week
Price per liter
Demand 1
Demand 2
$2.00
50
30
$1.75
60
40
$1.50
75
55
$1.25
95
75
$1.00
120
100
You can see this in the graph in figure 4, below. At each price point, the total demand is less, and the demand curve shifts.
Changes in any of the following factors can typically cause demand to shift:
Consumer income.
Consumer preference.
Price and availability of substitute goods.
Population.
With a shift in demand, the equilibrium point also completely shifts.
Demand 2
Demand 1
Supply
Quantity (liters)
per week
Price per liter
Quantity (liters)
per week
Price per liter
Quantity (liters)
per week
Price per liter
30
$2.00
50
$2.00
50
$1.20
40
$1.75
60
$1.75
60
$1.30
55
$1.50
75
$1.50
75
$1.50
75
$1.25
95
$1.25
95
$1.75
100
$1.00
120
$1.00
120
$2.15
The same type of shift can occur with supply. If the price of drilling for and refining gas increases, or if political events cause suppliers to decrease their output, the supply curve can move. The result is that for the same price, the quantity supplied will be either higher or lower than the current supply curve.
A common complaint with the oil and gas industry is that suppliers deliberately manipulate price by shifting the supply curve. The result is an equilibrium price that’s higher and at a lower quantity, as in the following example.
Demand 1
Supply 1
Supply 2
Quantity (liters)
per week
Price per liter
Quantity (liters)
per week
Price per liter
Quantity (liters)
per week
Price per liter
50
$2.00
50
$1.20
40
$1.20
60
$1.75
60
$1.30
50
$1.30
75
$1.50
75
$1.50
65
$1.50
95
$1.25
95
$1.75
85
$1.75
120
$1.00
120
$2.15
120
$2.15
Figure 6, below, shows the curves that result from this schedule.
When supply decreases, the supply curve shifts to the left. When supply increases, the supply curve shifts to the right.
Changes in supply can result from events like the following:
Change in production costs.
Improved technology that makes production more efficient.
Industry growth and shrinkage.
Key Points
Although the phrase "supply and demand" is commonly used, it's not always understood in proper economic terms. The price and quantity of goods and services in the marketplace are largely determined by (a) consumer demand and (b) the amount that suppliers are willing to supply.
Demand and supply can be graphed as curves – and the two curves meet at the equilibrium price and quantity. The market tends to naturally move toward this equilibrium – and when total demand and total supply shift, the equilibrium moves accordingly. It's an interesting relationship that determines much of what happens in a free market economy. If you understand how these factors influence pricing, supply, and purchasing decisions, it will help you analyze the market and make better price and supply decisions for your company.
Apply This to Your Life:
Consider these questions in relation to your life and business:
Are your production costs higher or lower than those of your competitors? What does this mean for your business if supply or demand curves shift?
Are you charging as much as you could for your product, particularly if demand is strong and supply is weak? Conversely, are you charging too much?
Are you paying too much for your inputs, particularly if demand for these inputs is weakening?
If demand for your inputs is likely to strengthen, or supply weaken, in the future, how can you protect yourself against this?
Are there any other questions you should be asking yourself as a result of knowing about supply and demand curves, equilibria, and shifts in supply and demand curves?
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