Supply, Demand and Price

The most basic laws in economics are the law of supply and the law of demand. Indeed, almost every economic event or phenomenon is the product of the interaction of these two laws. The law of supply states that the quantity of a good supplied rises as the market price rises, and falls as the price falls. If all Belarusian companies producing TV-sets, for example, raised the prices on their product all of a sudden, it certainly means that the Belarusian market would be overstocked with domestic TV-sets of “Vityas” and “Horizont”. Conversely, the law of demand says that the quantity of a good demanded falls as the price rises, and vice versa. (Economists do not really have a “law” of supply, though they talk and write as though they do. They are the same things, actually, looked at from different view points.)

Supply and demand are regulated through a price mechanism. Price in economics and business is the result of an exchange and from that trade we assign a numerical monetary value to a good, service or assets. It is commonly confused with the notion of cost as in “I paid a high cost for buying my new plasma television”. Technically, though, these are different concepts. Price is what a buyer pays to acquire products from a seller. Cost concerns the seller’s investment (e.g., manufacturing expense) in the product being exchanged with a buyer. (Have you ever thought buying a cheap article of clothes at a discount that its actual cost might have been much higher than that?) For marketing organizations seeking to make a profit the hope is that price will exceed cost so the organization can see financial gain from the transaction.

One function of markets is to find “ equilibrium ” prices that balance the supplies of goods and services and demands for them. In this connection economists often talk of “demand curves ” and “supply curves. ” An equilibrium price (also known as a “market-clearing” price) is one at which each producer can sell all he wants to produce and each consumer can buy all he demands. Naturally, producers always would like to charge higher prices. But even if they have no competitors, they are limited by the law of demand: if producers insist on a higher price, consumers will buy fewer units. Our mentioned above TV-set producers would not benefit much raising the price as the consumers would have to do without their TV-sets or choose those made by other producers. The law of supply puts a similar limit on consumers. They always would prefer to pay a lower price than the current one. In our case Belarusian buyers could prefer even buying those of much worse quality made by little known producers. But if they successfully insist on paying less (say, through price controls), suppliers will produce less and some demand will go unsatisfied, and in some families a TV-set might be passed from one generation to another as a family rarity!

Markets in which prices can move freely are always in equilibrium or moving toward it. For example, if the market for a good is already in equilibrium and producers raise prices, consumers will buy fewer units than they did in equilibrium, and fewer units than producers have available for sale. In that case producers have two choices. They can reduce price until supply and demand return to the old equilibrium, or they can cut production until the quantity supplied falls to the lower number of units demanded at the higher price. But they cannot keep the price high and sell as many units as they did before. If ordinary people were aware of the principle of equilibrium in economy, they would understand why the heads of most producing companies in the world were taking unpopular measures during the global financial crisis in 2008-2009.

Why does the quantity supplied rise as the price rises and fall as the price falls? The reasons really are quite logical. The consumers buy fewer units than producers have available for sale. First, consider the case of a company that makes a consumer product (in our case a TV-set). Acting rationally, the company will buy the cheapest materials (not the lowest quality, but the lowest cost for any given level of quality). As production (supply) increases, the company has to buy progressively more expensive (i.e., less efficient for the company) materials or labour to keep the demand (otherwise the buyer would prefer another producer), and its costs increase. It charges a higher price to offset its rising unit costs.

In a perfect economy, any market should be able to move to the equilibrium position instantly without travelling along the curve. Any change in market conditions would cause a jump from one equilibrium position to another at once. If the overall standard of the buyer's living falls the consequences for the producer may be dramatic. Or in the case when the supply decreases all the buyer's money turns to be worthless and it finally leads to inflation and further even to more global social and political changes, as it happened in the former USSR at the end of the 1980's. Unfortunately, in real economic systems markets don't behave in an ideal way, and both producers and consumers spend some time traveling along the curve before they reach equilibrium position. This is due to asymmetric, or at least imperfect, information, where no one economic agent could ever be expected to know every relevant condition in every market. Ultimately both producers and consumers must rely on trial and error as well as prediction and calculation to find the true equilibrium of a market. But supply and demand curves can still serve as an excellent tool for making those kinds of predictions.

After the Concise Encyclopedia of Economics, http://www.econlib.org/library