Supply and Demand and Price

Supply and Demand and Price Elasticity

The laws of supply and demand: An overview

In general, the basic principle of the law of demand is as follows: as the price of a good or service decreases, the level of demand for that good or service increases. In other words, someone thinking of buying a new pair of boots may hesitate or not be able to afford $150 for a pair of Uggs. But if the price of the boots decreases to $75, more people will be able to afford the boots, and purchasing them will seem more attractive. The opportunity cost for purchasing the item will be lower: now someone's entire clothing budget will not be sacrificed for the Uggs. Conversely, if the price increases to $200, demand will decrease as some people will not be able to afford them and others can find better uses for the extra $50 they now cost. "People will naturally avoid buying a product that will force them to forgo the consumption of something else they value more" (Economics basics, 2009, Investopedia). There are some exceptions to this principle, of course -- for some luxury items, added cost can give added appeal, such as in the case of a trendy Coach purse or sports car. Also, the law of demand only holds true if all other factors remain equal. For example, in today's current recession, the prices of goods have been going down in many areas, but because people have less disposable income if they have lost their jobs, even $75 may seem like far too much. The opportunity cost of $75 now seems greater.

The law of supply holds that as price increases, supply increases as suppliers respond to the increased price with a desire to produce more. Conversely, as their inventories pile up and suppliers decrease prices to get rid of their unwanted goods and services, they have less of an incentive to produce and increase the available supply. As with demand, the supply curve is the relationship between supply and demand at a particular point in time and external factors can affect the equilibrium point where supply and demand meet. Surpluses and shortages are an economic fact of life. A natural disaster might sharply reduce the supply of oil, a bumper crop might unintentionally increase the supply of tomatoes, or a change in technology might make it much cheaper to produce a good or service in greater quantities with the same production costs.

Changes in consumer taste or available alternatives can also shift the supply curve inward or outward. "The important thing to remember about markets is that there is almost always some form of time lag between the changes in either demand and supply and the ability of consumers or producers to react to the changes" (The market system, 2009, part 3). For example, new competing technology called an eventual fall in demand of video cassettes and an eventual reduction of the supply as a new equilibrium was reached. Now there are only a few VHS players and cassettes remaining on the market, while the amount of TiVo and DVR users has exponentially increased. But this took time as people replaced their systems and converted their libraries from one medium to the new medium.

The demand for some goods is more responsive to changes in prices than other goods. For example, food as a whole might seem like a very inelastic good -- people have to eat. But because there are so many substitute goods for a meal, within the category of food price is often very elastic -- consumers will respond to an increase in the price of restaurant meals by cooking at home.