Supply and Demand are the most fundamental concepts of economics and the backbone of
market economics.
Demand refers how much (quantity) of a good or service is that people are able or willing to
buy.
Quantity demanded (the amount people wish to buy) refers to how much of a good or service is
desired by buyers at a specific price.
The Law of Demand- Price and quantity demanded have an inverse relationship. When price
increases the quantity demanded decreases, and as price decreases the quantity demanded
increases.
Notice that price is depicted on the y axis while quantity is depicted on the x axis.
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As you can see the demand curve is a downward sloping curve.
Price 2 is higher than price 1 and as a result the quantity
demanded for the widget has dropped.
Think about it, if you were interested in purchasing a new pair of
jeans and assuming all things are the same would you be more or
less able/willing to buy a pair of jeans at $40 or $80? The answer
is most likely $40 but why?
An absolute key assumption in the law of demand is that nothing else that could have an impact
on the demand for the product has changed expect for its price.
Reasons that explain the law of demand.
1. Substitution effect- we all have choices. Perhaps a person was planning on buying a pair of
jeans for $40 and they saw the price was $80 and as a result they bough a pair of khaki
pants instead.
2. Income effect- Change in purchasing power. - Maybe you thought the price was $40, an
you only brought enough money to buy a pair of $40 jeans, now you can’t buy any.
Conversely, maybe you brought enough money to buy 1 pair of $80 jeans and to your
delight you saw that the jeans were on sale for $40. Now you are able or willing to buy 2
pairs.
3. The law of diminishing maximum utility- see next page
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Demand is a measure of the buyer’s marginal utility or marginal benefit.
Law of Diminishing Marginal Benefits- A law of economics stating that as a person increases
consumption of a product - while keeping consumption of other products constant - there is a
decline in the marginal utility that person derives from consuming each additional unit of that
product.
Imagine you spent the entire day swimming and playing on the Ocean City beach. It is now
dinner time and you are absolutely starving. You decide to stop at Mack and Manco’s and get a
slice of pizza. You buy a slice for $2.00. As you are eating your slice you think to yourself,
“wow this is so good I would have paid $3.00 for this slice.” You decide to go back and buy
another slice. As you are enjoying you second slice you think, “This wasn’t as good as the first
slice but it was worth $2.00.” You head back to buy one more slice you think, “I’m full and I
don’t want to spend more money on a slice, maybe I would if it was a only dollar.”
1st slice > $2.00
2nd slice = $2.00
3rd slice < $2.00
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We can graphically depict the law of diminishing marginal utility. Notice the downward slope.
Price
$3
Marginal Cost
$2
$1
Marginal Benefit
Slice 1
Slice 2
Slice 3
Quantity
Brainstorm a list of businesses that consider the diminishing marginal utility of the customer
when determining their pricing a portion size.
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To summarize, the law of demand states that price and quantity demanded (the amount people
wish to buy) have an inverse relationship. As price increases the amount that people wish to
buy drops and as price decreases the amount that people wish to buy increases. This produces
a downward curve and is caused by three things; the substitution effect, the income effect
(changes in purchasing power), and the law of diminishing marginal utility.
Supply represents how much the market can offer.
The quantity supplied refers to the amount of a certain product that producers are able and
willing to supply at a certain price.
The law of supply states that price and the quantity supplied (amount producers want to
produce at a certain price) have a direct relationship. As the price for the good or service
increases, suppliers are more willing to supply it. And as the price for the good or service
drops, less suppliers want to produce it.
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Quantity supplied is a trade-off between labor and leisure. Additionally it’s a measure of
opportunity cost in the sense that when a supplier use resources to produce one produce they
give up on producing another.
Consider for a moment that someone is planning paying someone to cut their grass. He decides
to put an add sign in the paper. Of the two ads which will generate the more interest? Why?
Mow my lawn for $10
Mow my lawn for $40
$40 dollars of course!! Because there are more people who are willing to give up their leisure
or another job for $40 dollars as opposed to $10.
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in
demand or price. So it is important to try and determine whether a price change that is caused
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by demand will be temporary or permanent.
Up to this point we have looked at the relationship between price and demand and also price
and supply. Now let’s consider the relationship between supply and demand.
If the supply is greater than the demand prices will drop.
If the supply is less than the demand prices will rise.
If the supply is equal to the demand the prices will remain steady at equilibrium.
Consider for a moment a C.D. was just released by a new rock group. Based on information
from previous sales and other factors in the market, they decided to produce 10 C.D.s and at the
price of $20.
It turns out that the C.D. was a hit and 20 people demanded the C.D. Because the supply is less
than the demand the price will rise. Because the price rises the law of supply kicks in, as price
rises the quantity supplied rises as well.
Now the C.D. company produces 30 C.D.s to meet the demand. Now that the 20 people have
bought their CD, there are still 10 more C.D.s that nobody seems to want. Remember when
price increases suppliers want to supply more but at the same time as the price increases buyers
want to buy less. Now the supply is greater than the demand and the price begins to fall. As
price falls suppliers a want to supply less and buyers want to buy more.
If this sounds like a seesaw, well it sort of is, but the price will eventually stabilize and balance.
Supplemental Reading: How the Price System Works
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Think about water for a moment. Water
always seeks its own level. What does that
mean? Consider the water of a lake. By
itself, with no other forces besides gravity
acting on it, the water would be completely
flat-like a sheet of glass. Price is the same
way, it is always seeking it own levelequilibrium.
Equilibrium
When supply and demand are equal (i.e. when the supply curve and demand curve intersect)
the economy is said to be at equilibrium. At this point, the allocation of goods is at its most
efficient because the amount of goods being supplied is exactly the same as the amount of
goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the
current economic condition. At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are demanding.
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As you can see on the chart, equilibrium occurs at the intersection of the demand and supply
curve, which indicates no allocation inefficiency. At this point, the price of the goods will be P*
and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.
Similarly to perfectly level water, in the real market place equilibrium can only ever be reached
in theory, so the prices of goods and services are constantly changing in relation to fluctuations
in demand and supply.
Besides water what else can you think of that is naturally seeking balance? Would you consider
balance a natural state? Would you consider equilibrium price to be natural?
Disequilibrium:
Disequilibrium occurs when price or quantity are not equal to the equilibrium price or
equilibrium quantity.
Excess Demand- Excess demand occurs when prices are set lower than the equilibrium price.
As a result the lower price increases the quantity demanded while lowering the quantity
supplied. Resulting an in inefficient outcome where the quantity demanded exceeds the
quantity supplied. The result is a shortage.
Shortages are man-made, they are a result of pricing. Shortages should not be permanent
because the lowered prices will result in consumers competing with each other by offering
higher prices to buy the products. The resulting higher prices will incentivize suppliers to
increase the quantity supplied bringing the market closer to equilibrium. Shortages are not
permanent IF prices are allowed to adjust. But what happens if prices are not allowed to
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adjust?
If the government sets a price ceiling, below the equilibrium price, then the price will not be
able to reach its equilibrium point. A price ceiling is a price control that prevents prices from
rising above a set price.
Price ceilings are intended to keep prices
lower and more affordable but those who
create controls often fail to realize that
price ceilings are not immune to the
backs laws of supply and demand.
The quantity that consumers demand (Q d) exceeds the
amount that suppliers want to supply (Q s).= shortage
When the price is lower than the
equilibrium price, the quantity demanded
will increase, while the quantity supplied
will decrease resulting in a shortage.
Consider for a moment how you would react to hearing the news that the government is
placing a ceiling on gas prices. For the foreseeable future gas prices will be no higher than
$3.00 per gallon. You would probably fill up all of your family’s cars, the lawn mower, and
any container that would hold gas. But so would everybody else. No big deal except for one
problem.
The gas companies knowing that they cannot make as much money will send their gas
someplace else. Why would they sell it here for $3.00 when they can get more money
someplace else. Now there is a shortage of gas.
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Price ceilings and resulting shortages are not a new phenomena. For example,
In the sixteenth century price controls decided the fate of Antwerp, the most important city of
today's Belgium. From 1584, it was besieged by Spanish forces led by the Duke of Parma. For a
year smugglers risked their lives to get food into the city. Why? The prices were high and the
incentive for wealth was worth the risk. But as the prices rose the public became angry and
insisted that the leaders “do something!!”
The City Fathers of Antwerp answered the call by fixing maximum prices for food, with severe
penalties. The people of the city celebrated but the enforced low prices didn't force anybody to
economize. The unintended outcome was devastating, at first the city lived in high spirits but
soon all of the provisions were depleted.
The new price ceiling had an additional unintended outcome, predictably now that smugglers
couldn’t receive the just compensation for their risk, nobody was willing to bring in food to the
city.
Ironically, the price ceiling was more effective than
the blockade at preventing food from entering the city.
Within weeks of the creation of the price ceiling the
city surrendered.
What was worse for the people of Antwerp? Expensive food or no food?
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The story teaches us three lessons.
1. Both intended and unintended consequences must be considered when creating any policy
especially price controls.
2. Policy must be judged on its outcomes and not on its intentions or the rhetoric of the policy
maker.
3. History has proven that a price control often harms the very group of people that it was
intended to help.
Investigate. . .
Investigate a more recent price ceiling and report on its intended consequences and its outcomes.
One other note:
Students are often confused that price ceilings are drawn
below the equilibrium. Think of it like this, if a boy was
holding a helium balloon and he let it go outside, it would
go up, up, and up. But if he let that balloon go inside, it
would naturally rise until it was stop by the ceiling. If that
ceiling disappeared the balloon would instantly rise. Price
isn’t any different.
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Excess Supply
If the price is set too high, the quantity that suppliers wish to supply will exceed the amount
that consumers wish to buy. The result is a surplus.
Surpluses
Like shortages, surpluses are man-made, they are a result of pricing. Surpluses should not be
permanent because the higher prices will result in suppliers competing with each other by
selling their products at lower prices. The resulting lower prices will increase the quantity
demanded by the customers bringing the market closer to equilibrium. Surpluses are not
permanent IF prices are allowed to adjust. But what happens if prices are not allowed to
adjust?
The quantity that consumers demand (Q d) is less than the amount
Price floors are government mandated
price controls which keep prices above
the equilibrium price. Like price ceilings
the result is an inefficient allocation of
resources. This time the quantity supplied
is greater than the quantity demanded.
that suppliers want to supply (Q s).= surpluses
When prices are keep artificially higher than
they would naturally occur in the free market,
the law of demand and the law of supply make the
outcomes easy to predict. Higher prices lower the
quantity demanded, and higher prices increase the quantity supplied. Resulting in a surpluses.
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What public purpose does a price floor serve? Who wants the customer pay higher prices?
The suppliers of course.
Often price floors are created to help a specific group of suppliers. Price floors are most often
associated with agriculture products and other goods and services where competition could
result in significantly lower prices. Of course that is good for the customer, but unified interest
groups that lobby the government pay vast amounts of money to influence government to
create the floors.
The best example of price floors is minimum wage. In this case the worker is the supplier and
the firm is the customer.
Investigate:
Research Minimum wage laws in the United States.
Research intentions and outcomes- both intended and unintended.
How have minimum wage laws impacted the employment levels of unskilled workers?
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