Supply and Demand

Understanding the laws of supply and demand
are central to understanding how the capitalist economy operates.
Since we rely on market forces instead of government forces to
distribute goods and services there must be some method for
determining who gets the products that are produced. This is where
supply and demand come in. By themselves the laws of supply and
demand give us basic information, but when combined together the are
the key to distribution in the market economy… price.

What is demand?

Demand is comprised of three things.

• Desire
• Ability to pay
• Willingness to pay

It is not enough to merely want or desire an
item. One must show the ability to pay and then the willingness to
pay. If all three conditions are not me then the demand is not real.
This, by the way, is the purpose of advertising. While many may want
a product it is quite another to be willing to pay. Advertising
attempts to move a consumer from mere want to action. These day even
condition two may not stand in the way of a consumer. With the advent
of credit cards we are able to purchase products without the current
ability to pay. Many stores and car dealers even offer on the spot
credit though the interest rate may be quite high.

What factors alter your desire, willingness
and ability to pay for products? Some factors include consumer
income, consumer tastes the prices of related products like
substitutes for that product of items that may complement that
product.

Marginal utility – extra satisfaction a consumer gets by purchasing
one more unit of a product.

Diminishing Marginal
Utility: The more units one buys the
less eager one is to buy more. Think of diminishing marginal utility
this way. It is a hot summer day and your sweating bullets. You come
across a lemonade stand and gulp down a glass. It tasted great so you
want another. This second glass is marginal utility. But now you
reach for a third glass. Suddenly your stomach is bloated and your
feeling sick. That’s diminishing marginal utility!

There are two types of changes in
demand:

Changes in demand – change in the demand for a product that occurs
when price drops.

Changes in the Quantity
Demanded – change in the amount of a
product demanded regardless of price.

The difference is subtle but important. If
the demand of ice cream goes up in the summer it is because consumers
demand has truly increased, clearly it is hot. In the case the
business can most likely raise prices without suffering a drop in
sales. This is a change in quantity demanded. If sales of ice cream
were to increase in January as a result of a price cut, however, the
information we would be receiving is that the demand was artificially
manipulated. It really tells us that actual demand is low and that
extra efforts had to be made to increase sales. This is change in
demand.

When there is a change in amount purchased
(tied to demand) due to lower prices and surplus spending money it is
called the income
effect. Income effect basically
happens when salaries are on the rise.

Another economic phenomenon tied to demand
is Substitution
Effect. This states that as prices
drop consumers will buy more than usual at the expense of a different
product. Take a sale at the mall for example. If jeans are on sale
for a great price consumers will by extra jeans even if they had
previously planned to buy something else. This is that great deal you
just cannot pass up. What would the opportunity cost be? That item
you passed up and substituted for.

The Law of Demand:

quantity demanded in inversely
proportional to price.

Simply put, the higher the price, the lower
the demand and the lower the price, the higher the demand.

In numbers it would look like so:

Economists also like to look at things
graphically. It enables us to see the quantity and price on a
limitless scale. To do this we plot what is known as a demand curve. The
price is always on the vertical axis and the quantity is always on
the horizontal axis. If we were to plot our points and draw a demand
curve for the cookies it would look like this:

 The Law of
Supply-

Quantity supplied is directly
proportional to price.

Clearly the law of supply is the opposite of
the law of demand. Don’t these both make sense to you? Consumers want
to pay as little as they can. They will buy more as the price drops.
Sellers, on the other hand, want to be able to charge as much as they
can. They will be willing to make more and sell more as the price
goes up. This way they can maximize profits.

Numerically a supply schedule would look
like this:

The accompanying supply curve would be drawn
like so:

 

Market or Equilibrium Price

Now that we have covered both demand and
supply we have to combine both together. The place where what sellers
are willing to sell for and buyers are willing to buy for is called
market or equilibrium
price. This is the price the product
will sell for. Price is negotiation
between the buyers and the sellers.

To figure out price one has to law the
supply and demand next top each other.

When we then plot and draw both curves
together we are able to see the market price of the product.

 

The market price
for cookies in this graph is 30 cents. The quantity sold and bought
is 1100 cookies.

WHY PRICES ARE IMPORTANT IN A MARKET
ECONOMY

Prices are key ingredients in our economy
because they make things happen. If buyers want to own some items
badly enough, they will pay more for them. When sellers want to sell
some items badly enough, they will lower their prices. Prices play
such an important role in economic life that the United States is
often described as a price-directed market economy. Let us see
why.

1. Act as
Signals to Buyers and Sellers. One
of the things that prices do is carry information to buyers and
sellers. When prices are low enough, they send a “buy” signal to
buyers (consumers), who can now afford the things they want. When
prices are high enough, they send a “sell” signal to sellers
(retailers), who can now earn a profit at the new price.

2. Encourage
Efficient Production. Prices
encourage business people to produce their goods at the lowest
possible cost. The less it costs to produce an item, the more likely
it is that its producers will earn a profit.

Firms that are efficient will produce more
goods with fewer raw materials than firms that are inefficient.
Producers strive for efficiency as a way of increasing their profits.
While these efforts are in the best interests of the sellers, all of
us may benefit because we are provided with the things we want at
lower costs.

3. Determine
Who Will Receive the Things Produced. Finally, prices help to determine who will receive
the economy’s output of goods and services. The price that a worker

receives for doing a job is called a wage. The amount of this wage
determines how much the worker has to spend. What the worker can buy
with those wages will depend, in turn, upon the prices of the goods
and services the worker would like to own.

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