Concepts and Theories of Supply, Demand and Price

Economics Coursework Paper

Introduction

This essay looks at the fundamental elements of economics. Economics covers the area of human activity that deals with how people provide for their material wellbeing. It looks at the complex sets of transactions that take place around the world every day. These transactions decide on the global allocation of raw materials and capital. It also looks at the decisions individuals make when they decide how to prioritise their needs and wants and how to spend their money. It can vary in scale from how one person or family will organise its activities to how nations and societies should or can be organised. Economics therefore deals with an enormous subject matter; it offers a way of understanding practically all human activity at any level of detail. The way in which it can do all this, and still remain united as a single science, is to adopt various principles which will apply to a school child buying his lunch, multinational companies merging on the stock market, or nations competing for trade. In this paper I will look at some of these principles and how they relate to various examples.^[1]

Supply, Demand and Price

You would be correct to assume that economics is interested in the price of things. While this is the main issue for most economic actors such as individual consumers, companies or countries, for economists, this is neither where the story begins nor ends. It is in fact just one of many details that will fit in to an overall economic picture. It is a well known fact that house prices usually rise. It is just as well known that computer prices keep falling. Economics explains these price movements by looking at and understanding their respective markets.

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The methods used to analyse a market are; understanding the motivations of the various participants in the market; the factors that control how much the consumers in the market wish to buy; the factors that control how much sellers wish to sell; how the price is set; and the institutional structures that also influence the price. When looking at markets in this way, the various actors in the market, or agents, are assumed to be rational, that is that they want to maximise their gains or get the best deal possible. This is known as ‘maximizing utility’ in economics.

When speaking of demand, we are not concerned with how much of a product is actually bought, but of how much the consumers in the market would like to buy. The amount demanded is expressed as a flow, which means we look at how much of a product is demanded over a particular period, and at a particular price. For example, if milk costs £1 per litre, there is a demand for 1 litre of milk per day, or 365 litres of milk per year. In basic demand theory, there are a number of factors that can go into increasing or decreasing the amount demanded. For example, if you advertise the health benefits of milk, the consumer may decide to drink more. Also if there was a shortage of orange juice, consumers might drink more milk to make up for the difficulty of getting orange juice. Making milk cheaper will also increase the demand for it. Therefore, demand is something that can altered and, to an extent, controlled by the seller.

One of the key functions of economics is to narrow down and explain the various factors that will effect demand, supply and price. Economists wish to be able to measure exactly how these three variables will interact. If they can do this effectively, they will be able to manipulate the three so as to arrive at a level of supply, and a price, that will maximise the profit, or utility, for the producer. And the reason they can do this is because of the one certainty of economics, which is that the consumer will also be seeking to maximise his utility under the options available to him.

Demand and Price

While it may be impossible to know exactly when and how much a given consumer will feel like drinking with his breakfast each morning, there are things we can no. One of them is that, in general, the lower the price of a product, the more of that product will be demanded, assuming all other things remain equal. This principle is so dependable it is known as the law of demand. This is because all wants can be satisfied by a number of products. For example, if you are hungry at school, you will have a want, namely lunch. This want can be satisfied by a sandwich, an apple, a bag of crisps, a chocolate bar, etc. Even if you look at the sandwich, you can have ham, cheese, salad etc. The chocolate bar can be a Snickers, Mars, Twix etc. If you suddenly double the price of cheese sandwiches while everything else remains the same, the demand for cheese sandwiches will go down. Some people will still buy the same amount of cheese sandwiches, others will buy less cheese sandwiches and opt for other types of sandwiches or maybe and apple or chocolate bar, and some will completely stop buying cheese sandwiches. No one will buy more cheese sandwiches than they did before. Therefore, as price increases, demand will continue to decrease.^[2]

Economists can demonstrate this using a demand schedule. This shows the demand for a product at various prices.

Example of a demand schedule

The demand schedule will then be used to plot a graph, or demand curve. The price will appear on the Y-axis and the quantity demanded on the X-axis. This curve will show the complete relationship between demand and price.

Example of a demand curve

This above schedule and demand curve show how demand for milk will vary according to price. As the price increases from £0.50 per litre to £3.00 per litre, the consumer decreases the amount they drink each day from 1.4 litres to just 0.2 litres.

This example shows a relatively simple relationship between price and demand. In real life, there are many more factors at work that will dictate the demand for a product. While price is certainly one very important variable, the demand will also depend on the price of other alternative products. So if the price of orange juice for example were suddenly to increase, you would probably notice an increase in demand for milk, even though the price of milk did not change. That is because orange juice is an alternative product to milk. Also, if consumers were to get richer, they would be willing to buy more milk, or pay more for the amount they wanted, and again this would have a significant effect on the demand curve. Similarly, if consumer’s tastes were to change this would effect the demand curve. So if the milk producer was to start advertising the health benefits of milk this might increase demand even though there was no change in price. In practice there are actually an infinite number of variables that will effect the demand for a product, but this does not mean that the basic law will not always hold. No matter how attitudes to a product, for example milk, change over time, it will always be the case, according to the law of demand, that an increase in price will lead to a decrease in demand and vice versa.

Supply

Simply finding the demand curve for a product is however not enough. You might expect that it would make good business, as well as common sense, to decide your supply based on current market demand. If consumers want 1 litre of milk per day, and they are willing to pay £1 per litre, and say there are 1,000 consumers in the market, then why not simply produce 1,000 litres of milk per day. Well first of all, we can see that this tells us nothing about the profits of the producer. If you found out milk costs £1.50 a litre to produce, would you still recommend that the producer try to sell 1,000 litres at £1 per litre? Obviously not, therefore our picture is incomplete as it takes no account yet of the suppliers side of the bargain.

The economic hypothesis that explains supplier behaviour is that if all other things remain equal, the quantity that they are willing to produce is positively related to the product’s own price, or the higher the price, the more they are willing to produce. This is basically because increasing production costs money, and the more you increase production, the more it costs, so firms will only increase production for as long as the price they can get for the product justifies the increased cost of production.

Just like when measuring demand, a supply schedule is used to compare different price levels with different levels of production.

Example supply schedule

The supply curve shows the different amounts the producer would be willing to supply at different prices. As can be seen, the supply increases as price increases.

Example of a supply curve

Using these two graphs, economists can find the most efficient price for milk in this market. For example, if milk was priced at £0.50 per litre, consumers would be willing to drink 1.4 litres per day, but the producer would only be willing to supply 0.41 litres per day. Clearly there is waste at this price. Likewise, if the price was set at £3.00 per litre, the producer would be happy to supply 4.66 litres to each consumer, however they would only be willing to buy 0.2 litres per day. So a balance must be found somewhere in between. To find this point, economists will plot both the supply and demand curves on the same graph and find the point at which they intersect. This is the most profitable and efficient level at which to set production and price.

The graph below shows that in this market, the supply and demand curves intersect at the price of £1 per litre of milk. This is therefore the level at which the price would settle under normal market conditions.

Price Elasticity

The value of being able to analyse markets in this way, and understand how the price will settle is not solely theoretical. Businesses want to use this information to maximise profits. Therefore, theories on how to manipulate the above graphs are extremely important. One aspect if this is known as price elasticity. This is the theory that will explain how changes in price affect the quantity demanded. In the above example, the consumers would be willing to drink 1.4 litres of milk per day if it cost £0.50. Imagine if you could get the same consumers to continue demanding this quantity of milk at a cost of £3.00 per litre. This would mean a huge difference in profits for the producer. While it may not be possible to affect this change, having a greater understanding of the demand curve will allow detection of greater profit potential. Likewise, if you identify the causes for supply variation with changes in price, you may be able to improve the efficiency of your own business and move the point of intersection of supply and demand curves to a more profitable position.

The change in demand with price is known as price elasticity of demand. The change in supply with price is known as price elasticity of supply.

Elasticity cannot simply be judged by looking at the curves on graphs. This is because the shape of the curve depends as much on the scale of the graph as on the responsiveness of the demand or supply to changes in price. Therefore, elasticity is measured by a mathematical ratio. This is the percentage change in quantity demanded divided by the percentage change in price that caused it.

If you get a value for price elasticity of demand of zero this means that the quantity demanded does not change at all as the price changes. Such products are known as perfectly inelastic. There are very few products that would give this result. Even products such as bail to get out of jail pending trial will depend on the consumers ability to pay, and taxes, which supposedly offer no choice to the consumer, are also somewhat elastic as tax evasion has been shown to increase as tax rates rise. If the value is a fraction, between zero and 1, the quantity demanded will change but at a lower rate than the price changes. This is known as inelasticity. So if you were to increase the cost of the good by 50%, demand would decrease, but by less than 50%. This is generally observed in products that are deemed vital or necessary to people, but which are supplied without much competition. It is most typical in monopolies. So for example, if there is only one electricity or phone company, an increase in prices will lead to less usage, but people cannot wholly stop using such goods and so the usage will only decrease by a small amount. Likewise, goods such as housing, basic foods, or fuel, even though there may be a variety of providers, will generally be of low elasticity because people are forced to buy a certain amount of these products no matter what the price may be. In these situations, it is common to find government regulation to guarantee fairness of the market. If the elasticity is 1, then the demand and supply change at the same rate as price. This is known as unit elasticity. An elastic good will be one where the value will be greater than one. This means that the quantity demanded will change by more than the price changes. So for example, if there were two identical farms selling identical apples, both located next to each other, and both sell apples for 10p each, you might expect that 50% of customers will go to each farm. However, if one of the farmers was to increase his price to say 12p per apple, the vast majority of customers will now go to the other farmer. He will lose more than 20% of his customers for a 20% rise in price. This is most likely in markets of high competition. If the value for elasticity is infinity, then the product is perfectly elastic. There is only one acceptable price. Purchasers will buy everything you have at one price, but if you increase it by even the tiniest fraction, they will buy none at all. This exists in theory, and in some highly automated and computerised financial markets. Computers will dictate prices according to precise calculations and then will not deviate from this.

Market structures

The above explanation for elasticity shows the nature, and ultimate difference in the characters of different markets. One way you can classify various markets is by the price elasticity they will give. It may seem surprising that the huge differences between the New York stock exchange and school children spending their pocket money in a sweet shop, or between modern capitalism, Soviet style communism, and primitive barter based trading systems comes down to the issue of price elasticity, but this is one way of classifying markets and judging the degree to which they are similar or dissimilar. A person shopping for bread in the old Soviet Union, and a person waiting to be granted bail by a judge may appear to be in very different circumstances, but according to this market view, their position economically is very similar, they will accept what they are told, with little regard to price. However, future’s traders in global financial centres, spending billions or ever trillions of dollars every day, are revealed to have a lot in common with children in a sweet shop, weighing the various combinations of price and utility that different choices will provide them. They will ruthlessly abandon a product that doesn’t pull its weight on their cost/ utility calculation.

Conclusion

Using these few principles that lie at the foundation of economics, and a few simple examples, we can see how economic principles can explain a huge variety of social situations and human interactions. This is why economics claims to be able to offer an understanding of all human activity and why some criticise its growing influence as painting a false or inappropriate picture of humanity. While economic principles can be applied to children making friends, people acting with kindness or religions offering comfort and guidance, the question is not whether economics can provide answers, but whether the answers it provides are appropriate.

Bibliography

Lipsey & Chrystal, Economics, 10^th ed. 2004, Oxford University Press

Grant, Stanlake’s Introductory Economics, 7^th ed. 2003, Longman

Footnotes

^[1] Lipsey & Crystal, p. 40

^[2] Grant, p. 77