Supply and demand form the most fundamental concepts of economics. Whether you are an academic, farmer, pharmaceutical manufacturer, or simply a consumer, the basic premise of supply and demand equilibrium is integrated into your daily actions.
In any market transaction between a seller and a buyer, the price of the good or service is determined by supply and demand in a market. The law of supply and demand is a theory that explains the interaction between the sellers of a resource and the buyers of that resource. The theory is based on two separate “laws,” the law of demand and the law of supply. The two laws interact to determine the actual market price and volume of goods on the market.
Let’s discuss demand and supply in more detail.
Law of demand.
The law of demand states that if all other factors remain equal, the higher the price of a good, the fewer people will demand that good. In other words, the higher the price, the lower the quantity demanded.
The chart portrays the most basic relationship between the price of a good and its demand from the standpoint of the consumer. The higher the price of a good, the lower the number of interested buyers, since buyers want to save as much money as possible. Conversely, a cheap price will attract many buyers to the market, therefore, the quantity demanded will be higher. Thus, we see an inverse relationship.
Law of supply
Generally, the supply of a good and its price are directly proportional to each other and follow a linear relationship. As the price increases, the supply of that good also increases.
The supply line is seen from a seller’s perspective. When prices of a product increase, producers are willing to manufacture more of the product to realize greater profits. Likewise, falling prices depress production, as producers may not be able to cover their input costs upon selling the final good. Thus, we get a linear relationship.
By combining the two graphs, we can observe the point of equilibrium, where the supply and demand lines intersect. Tracing lines directly from the equilibrium point to the x- and y-axes will reveal the Price at equilibrium (Pe) and quantity at equilibrium (Qe), respectively.
It is crucial to note that the supply and demand structure does not always happen in real life. It is impossible to calculate Pe and Qe in real life since every individual buyer shows a different willingness to pay for goods, and every seller shows a different willingness to accept prices.
Producers seek to sell their products for as much as possible. However, when prices become unreasonable, consumers will change their preferences and move away from the product. A proper balance must be achieved whereby both parties can engage in ongoing business transactions to the benefit of consumers and producers.
Factors Affecting Demand are
Consumer preferences among different goods.
The existence and prices of other substitutes or complementary products can change demand.
Changes in conditions that influence consumer’s choices can also be significant, such as seasonal changes or the effects of advertising.
Changes in incomes of consumer can also be important in either increasing or decreasing the quantity demand.
Factors Affecting Supply are,
Supply is largely a function of production costs, including:
Labor and materials costs.
The physical technology available to combine inputs.
The number of sellers and their total productive capacity over the given time frame. and
Taxes, regulations, or additional institutional costs of production.
Furthermore, there are host of other real-life factors that interfere with the supply and demand model, such as:
The supply and demand model assumes perfect competition, which rarely occurs. In some markets, we see a single very powerful producer of goods. Since buyers are unable to find another place to purchase the goods, I forced them to accept whatever price the seller decides to set.
The practice is highly profitable for the seller and, in most cases, it is considered illegal.
Price floors are a minimum price put in place by the government to protect vulnerable sellers.
For example, the government might put in a place a price floor on farm goods such as potatoes. Thus, farmers will be guaranteed a certain amount of revenue and will be able to afford a living. The absence of a price floor may see the price of potatoes plummet to a very low equilibrium price and farmers go into bankruptcy.
We can think of subsidies as an alternative to price floors. Thinking back to the potato example, a subsidy will cover a certain portion of production costs for a farmer. Thus, the farmer will have fewer costs to cover and will capture more sales revenue. This will ensure that the farmer can still afford a living even if the equilibrium price of potatoes ends up being very low.
Government-imposed taxes to raise government revenue. A tax on buyers will mean that buyers will need to buy a good at a price above the equilibrium. However, the additional profits generated this way will be collected by the government rather than the seller to fund public infrastructure projects.