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Supply and Demand

Demand

Let's suppose I went into business making sandwiches and selling them on a street corner. I might find that if I sold them at 2.00 per sandwich, I could sell 100 of them in a day. Fair enough! It then occurs to me that I might be able to make more money if I charged 2.50 for the sandwiches, so the next day I put the price up to 2.50 and see what happens. However, at that price I find that I can only sell 80 of the sandwiches in a day.

What is happening is that fewer people are willing to pay the higher price - only the very hungry ones. If I then put the price up further, to 3.00 say, then I would sell even fewer of the sandwiches, probably about 60. Similarly, if I dropped the price below 2.00, then more people would be willing to pay the price, and I would sell more sandwiches.

We can represent this relationship using a graph, with the horizontal axis (X) representing the quantity of sandwiches that we sell, and the vertical (Y) axis representing the price that we charge. In graphs showing quantity versus price, you will almost always find the axes this way round, as it helps to maintain consistency.

In that diagram I have drawn the relationship between price and quantity sold as a straight line. In real life it would be some curve, probably a complicated one, which depended on the weather, how many other sandwich sellers there were in the neighbourhood etc. Questions of this type that appear in economics papers tend to involve straight lines, so I suggest that we stick with them.

Demand is defined as follows:

Demand is the quantity of any item or service that consumers want to buy at any conceivable price.

This means that Demand is really an equation rather than a single number. It tells us how the market changes as we alter the price. The concept of Demand is different from that of Quantity Demanded, but the difference is a subtle one:

Quantity demanded is the quantity of any item or service that consumers want to buy at any particular price.

So, while Demand defines the behaviour of the market at any price you care to mention, quantity demanded refers only to particular price values.

Moving the Demand Curve

You notice, that I refer to the line as a "Demand curve", even though it is a perfectly straight line. The relationship that the line shows us is the relationship between the price and the quantity demanded assuming all other factors remain constant. As soon as other factors change, then the line moves, either to the right or the left.

This is best explained with an example. Suppose the demand curve above refers to a type of coffee produced by our company. If a rival company decides to launch a new brand of coffee, particularly if it is accompanied by a massive public promotion, then demand for the original brand of coffee will fall. Effectively, people may decide that the price for our coffee is too high and they will switch their loyalties. We may decide to hit back by reducing the price, and this may well win back some of the deserters.

Effectively, the demand curve has moved to the left. At any given price, the quantity demanded has fallen, and this has the effect of moving the demand curve. Any factor that tends to persuade potential customers (such as a medical report in the press stating that drinking coffee causes cancer) not to buy our product will have this effect.

The movement of the curve is shown in the diagram on the right. The black line (marked Dold) represents the old value of the demand. After the change in the market, the new demand is represented by the red line (Dnew).

Of course, the opposite could happen. One of our rivals may go out of business, or contract their operations for some reason, or even decide that they can put their prices up (the fools!) This would cause demand for our brand of coffee to increase, and we would either sell more jars of coffee at the price we now charge, or we would put the price up and sell the same number of jars as we do today. Effectively, the demand curve would move to the right (the opposite way to that shown in the diagram above). The same thing would happen if we received some favourable publicity, such as a famous rock-star stating in an interview that he only drinks our brand of coffee.

We refer to rival brands of the same products as substitute goods:

Substitute goods/services are those which act as possible alternatives to a product or service.

Examples of substitute goods are butter and margarine, emulsion paint and wallpaper, ballpoint pens and fountain pens, black taxis and unlicensed minicabs.

When the demand curve for a product moves, we must also consider the effect that it will have on complementary goods. These are products and services whose market is linked to that of the first product - they naturally "go together" with the first product, such as coffee and coffee-whitener, toothpaste and toothbrushes, photocopier paper and toner cartridges for photocopiers.

Complementary goods/services are those that tend to be sold alongside or in conjunction with any product or service.

Generally speaking, as the demand for a product or service increases, so does the demand for complementary products or services, and the demand for substitute products or services goes down. As the demand for a product or service decreases, so does the demand for complementary products or services, and the demand for substitute products does up.

Supply

Now let's consider the other half of the equation - supply. On this graph, we will plot a line indicating how many items a manufacturer or retailer is prepared to supply at a given price. You might think that any manufacturer would set the price depending on costs and profits and then go at full speed to produce as many of the items as possible.

In fact, manufacturers make a decision before they start as to how many items they are going to produce. If they think that they can sell these items at a high price, then they will make and supply more of them (they have a good chance of making a profit). If they don't think that they can sell the items for a high price, then they probably won't supply many of them.

We can plot a similar line to the one that we saw before for the supply side of the process. This time the line slopes upwards to the right, meaning that retailers will stock more of an item on their shelves if they charge a larger price for them. At higher prices, they have an incentive to supply more.

Effectively, supply is defined as follows:

Supply is the quantity of an item or service that sellers are prepared to provide at each conceivable price.

Again, there is a difference between "Supply" and "Quantity supplied". Supply refers to the equation itself, telling us how many of the item the company is prepared to supply at any price, but as soon as we talk about a particular price, then we refer to the quantity supplied.

Equilibrium Price

Now we shall put both those lines on the same graph, again with quantity along the horizontal axis and price up the vertical axis:

You can see that the two lines cross at a point, called the Equilibrium Point (meaning the "balance point"). The price and the quantity both demanded and supplied will settle down at this point.

At the equilibrium point, the quantity of the item that people demand exactly matches the quantity that the retailer will supply. We say that the market clears at this point. If you prefer it in the form of an equation,

Supply = Demand

In this case, the equilibrium price is about 2.80 and at that price, the company is prepared to provide and sell 72 items. Of course, the quantity of the items demanded is also 72 items, so all the items on offer are bought.

The reason that markets have a tendency to stabilise at the equilibrium point is that both the customers and suppliers are motivated by self-interest (greed). If the price is set too high by the suppliers, then they find that they have produced more goods than they can sell (supply is higher than demand). Effectively, they have a surplus which they can't sell, a situation termed as excess supply:

Excess Supply occurs when supply is higher than demand.

The only way to get rid of this surplus of goods is to reduce the price in the hope that people will be willing to buy the goods at the lower price. Similarly, if the price is below the equilibrium price, then the demand for the product is great and can't be fulfilled. The suppliers find that they run out of the product, a situation known as excess demand:

Excess Demand occurs when demand is higher than supply.

In this case, the suppliers have a good incentive to supply more. However, this encourages the price to rise. If consumers are willing to pay more for an item or service than they have to, this is referred to as a situation of consumer surplus:

Consumer surplus measures the difference between what a consumer is willing to pay for an item/service and what he/she has to pay for it.

In this way, prices below the equilibrium price tend to rise, and those above it tend to fall.

This diagram illustrates the situations of excess demand and excess supply:

Price Elasticity of Demand

There are times when we want to know how elastic a market for a particular item is. A market is said to be elastic if a small change in price would produce a relatively large change in the number of the items that people want to buy. (Effectively, decreasing the price would cause the number of items sold to "stretch", and increasing the price causes the number of items sold to "shrink" - just like a piece of elastic!) If the number of items doesn't change much when the price is increased or decreased, then we say that the market is inelastic.

The graph on the right shows an example of an elastic market. In this case, the graph shows how many packets of washing powder a retailer will sell for any given price. The graph shows that the consumers have little loyalty to the brand of washing powder - if the price increases just a little bit, lots of people stop buying that particular brand of powder and switch to something equally good which is a little cheaper. The reason that the market for this brand of powder is elastic is that there are several competitors, whose products are just as good, and it is easy to change from one brand to another.

Here is another graph. This time it shows the market for first-class stamps. There is only one company in the whole of Britain which is allowed to manufacture first-class stamps, and that is the Post Office, so if you want a stamp, you have no choice other than to get it from them (or possibly from a newsagent, who buys the stamps from the Post Office anyway).

This means that the Post Office have a captive market - they can increase the cost of a stamp without the fear that people will buy their stamps from somebody else. Of course, a few people would stop sending letters if the price went up (they might send E-mails instead), but an increase in price would only lead to a small drop in the number of first-class stamps required. This is an example of an inelastic market.

How do we measure the elasticity of a market? We define a measure called the Price Elasticity of Demand, which compares a change in price with a change in quantity demanded:

Price Elasticity of Demand (P.E.D.) =
Percentage change in quantity demanded
Percentage change in price

The P.E.D. is almost always negative. This is because when the price drops, the quantity of items demanded rises. When the price rises, the quantity of items demanded rises. Effectively, one and only one of the two terms in that fraction will be negative, i.e. it will be a negative number divided by a positive one, or a positive number divided by a negative one. Either way, you will end up with a negative answer.

Let's try it with an example. Suppose the price of chocolate buttons is 0.85 per packet, and at that rate, the retailers sell 140 packets per month. Then, they decide to reduce the price by 17p (i.e. 0.17) and they find that the number sold increases to 154 packets per month.

The change in price is -17p (note the negative sign as the price has decreased).

As a percentage, this is
- 0.17
0.85
x 100 = - 20%

The change in quantity is 154 - 140 = 14 packets (positive this time).

As a percentage, this is
14
140
x 100 = 10%

Price Elasticity of Demand (P.E.D.) =
10%
-20%
= - 0.5

Note that there is no percentage sign (%) on the P.E.D. We could, consider the same question the other way round, assuming that the retailers started with the lower price and then increased it. This time the price starts at 68p (0.68) and increases by 17p to 85p (0.85). The number of packets sold drops, from 154 packets per month to 140.

The change in price is 17p (This is positive as the price has increased).

As a percentage, this is
0.17
0.68
x 100 = 25%

The change in quantity is 140 - 154 = -14 packets (negative to represent a decrease).

As a percentage, this is
-14
154
x 100 = - 9.09% (to 2 decimal places)

Price Elasticity of Demand (P.E.D.) =
- 9.09%
25%
= - 0.3636

N.B. Please note that the Price Elasticity of Demand formula produces a different number depending on which point you regard as the starting point and which you regard as the finishing point. It is therefore not simply a measure of the slope of the graph.

An elastic market has a P.E.D. which is more negative than
-1.

An inelastic market has a P.E.D. between 0 and -1.

A unit-elastic market has a P.E.D. of exactly -1.

What's so special about a unit-elastic market?

The true significance of a market situation where P.E.D. = 1 becomes apparent when we consider the revenue that a company will receive. The revenue is defined as the money that the company receives by selling a certain number of goods at a given price. For instance, if a company sells 400 items at 35p each, then the revenue = 400 x 0.35 = 140. Revenue is not the same as profit, as it does not take into account the cost of producing the items or any tax that has to be paid.

We already know that as the price per item increases, the quantity of those items demanded will decrease. Although an increase in price would tend to increase the revenue, a decrease in demand will tend to decrease it. In fact, the revenue reaches a peak at a certain price and quantity demanded and drops off on either side of it.

Here's an example. The table below shows the quantity of an item sold for given prices between 0.20 and 2.00 per item. I have added a column indicating the revenue, found by multiplying the price and quantity figures, and another column indicating the P.E.D. Each figure in the P.E.D. column is based on the current price and quantity figures, and the next one along, so there is one fewer entry in this column than in the other columns.

Price
Quantity
Revenue
P.E.D.
0.20
400
80
-0.1
0.30
380
114
-0.158
0.40
360
144
-0.222
0.50
340
170
-0.294
0.60
320
192
-0.375
0.70
300
210
-0.467
0.80
280
224
-0.571
0.90
260
234
-0.692
1.00
240
240
-0.833
1.10
220
242
-1
1.20
200
240
-1.2
1.30
180
234
-1.444
1.40
160
224
-1.75
1.50
140
210
-2.142
1.60
120
192
-2.667
1.70
100
170
-3.4
1.80
80
144
-4.5
1.90
60
114
-6.333
2.00
40
80

You can see that the revenue reaches a maximum value at the same point that the P.E.D. reaches the value -1. Check the figures for yourself if you want. At prices above 1.10 per item, demand is price elastic and a fall in price would lead to an increase in total revenue. At prices below 1.10 per item, demand is price inelastic, and an increase in price would lead to an increase in total revenue.

Price Elasticity of Supply

This is a similar measure to Price Elasticity of Demand, except that it measures the elasticity of supply. It is defined by a similar equation to the one above:

Price Elasticity of Supply (P.E.S.) =
Percentage change in quantity supplied
Percentage change in price

Because supply curves always slope upwards to the right, the P.E.S. is always positive. Again, we can apply the terms elastic, inelastic and unit-elastic to supply:

An elastic supply has a P.E.D. which is greater than 1.

An inelastic supply has a P.E.S. between 0 and 1.

A unit-elastic supply has a P.E.S. of exactly 1.

Government Regulation

Occasionally, governments will step into the market and impose artificial restrictions on both prices and quantities of goods. They may impose a price ceiling to prevent the prices of goods rising above a certain level. Alternatively, they may impose a floor by supporting prices to prevent them falling below a certain level. The effect of this is to freeze the market at some point apart from the equilibrium point.

A good example is the British economy during the Second World War. Due to imports to Britain being reduced, the quantity of food and basic groceries such as soap and boot polish was reduced. This led to an increase in demand (people desperately searched for the few remaining goods that were on sale). The natural effect of this was to increase prices - shops realised that they could charge more for food as there was a severely limited supply.

The government was faced with an economy where prices were going through the roof and the food was rapidly running out. They responded in two ways:

The first step prevented the price from moving either up or down, and the second step prevented the demand from moving up. Of course, governments can only control the legal economy. There is always a "black market" economy of goods sold illegally, which is not subject to government control. Throughout the war, goods were still available on the black economy, although the prices of those goods were much higher than those of the legal market.


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