What is the law of supply and demand?
The law of supply and the law of demand are two separate laws that work together to determine the optimal price point of a product (rather than the market as a whole). As a general rule, if price increases, then supply will increase, and demand will decrease. If price decreases, then demand will increase, and supply will decrease Over time, supply and demand will eventually determine the market equilibrium price, or the price where supply equals the quantity demanded in the market.
Change in Demand – What Impacts Consumer Demand?
So why are price and demand inversely related? Why does demand decrease when price increases, and why would demand increase when the price decreases? Well, there are two fundamental reasons for why this is the case:
Substitution effect: If substitutes exist for a particular product, then consumers will switch to substitutes when the price increases. If the price decreases, then consumers will switch away from substitutes.
Income effect: If the level of income remains the same, then lower prices will increase demand. If prices are increased, then demand will decrease because the consumers income is the same and they no longer can afford the product.
However, there are other factors that can increase or decrease consumer demand for a particular product or group of products. As you read through these, think about how these apply to your own lifestyle.
Price change of related goods (substitutes or complements): If the price of a related good increases or decreases, this can impact the demand of related products. For example, if the price to play golf decreased then the demand for golf clubs could increase as more people would start golfing.
Number of buyers in the market: If the number of potential buyers in a market increases, then the demand will increase. For example, if the market is ages 25-30, and the population of that age group increases, then there will be more buyers in the market.
Changes in wealth or income level: If the wealth of the buying population increases or their income increases, then the demand for particular products would increase. If wealth decreases or their income decreases, then demand will decrease for a particular product and may shift to other products that are less expensive.
Consumer trends or preferences: Marketing and social media can significantly impact consumer trends or preferences for a particular product. Think about how trends in society increase or decrease the demand for certain products.
Consumer expectations: If consumers believe the price will increase or decrease, or that there will be a change in supply in the future, then these expectations can shift demand. For example, if a hurricane is expected to hit, then consumers will stock up on certain goods.
Change in Supply – What Impacts Quantity Supplied?
So why are price and quantity supplied directly related? Why does supply increase when price increases, and why would supply decrease when the price decreases? In general, sellers want to sell products that have higher prices in the market. Pricing is the main factor impacting quantity supplied.
If price stays the same, then what else impacts supply? There are several key factors that can result in a change in supply:
Change in production cost: If the cost to produce a product increases, then supply will decrease. However, if the cost to create a product (material or labor) decreases, then supply will increase. Production cost generally includes materials and labor.
Change in manufacturing methods: If a company develops new manufacturing methods that increase output without changing the cost, then supply will increase. This could be due to new technology or a more efficient manufacturing process.
Changes in price or demand of related goods: Similar to how changes in price impact demand, if there is a change in price or demand, this can impact supply. If the price of a related good increased, then demand for a product would increase, which reduces supply.
Forecasted changes in supply: If a company expects the market conditions to change, they may increase or decrease supply.
Changes in regulation: If regulation (taxes, laws, or subsidies) related to a product changes, then supply can be increased or decreased. For example, if the government increased taxes on alcohol, then demand could decrease, and supply would also likely decrease.
What is market equilibrium?
Supply and demand curves determine the equilibrium point, which is the market’s equilibrium or the market-clearing price. Supply and demand might fluctuate up and down, but eventually every product will find it’s market equilibrium.
How can government imposed pricing impact supply and demand?
The law of supply and demand is typically free from government intervention. However, the government may have the ability to impact supply and demand if certain regulations are in place. Two of the most common ways the government can impact supply and demand are by implementing a price ceiling or floor:
Price ceiling — Occurs when the government establishes a max price. If the price ceiling is below the equilibrium price, then the market will have supply shortages since demand will be greater due to the low price. Examples include rent or prescription drugs (e.g. price cannot exceed $2,500).
Price floor —Occurs when the government established a minimum price. If the price floor is above the market equilibrium, then the market will have excess supply since the price is greater than the demand. Examples include wages, tobacco, or alcohol.
Learn about the various types of elasticity measures in this link!
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