Law of supply and demand

Introduction

Supply and demand forms a fundamental model in any competitive market and economy. Demand refers to the product quantity that buyers are willing and able to buy. Quantity demanded is therefore the demand of products and services that customers are willing to purchase at a particular price. Supply refers to the amount of products that services that products are willing to offer to the market. Quantity supplied is therefore the amount of products producers are willing to offer for sale at a certain price.

The correlation between price and quantity demanded and price and quantity supplied is known as demand relationship and supply relationship respectively. Price is therefore a function of demand and supply. In any free market economy, the demand and supply relationship forms the basis for efficient allocation of resources. This paper examines the laws of demand and supply and how they determine the market prices (Investopedia, 2009).

The laws of demand and supply

The law of demand holds that all factors constant, as product prices rise, the quantity demanded for that product falls. The reverse is true when the product price falls. This is because the amounts of goods and services buyers are willing and able to buy depend on their price, so as prices rise, the opportunity cost of purchasing such products also increase. This means that buyers would substitute the consumption of such products with more valuable products. The law of supply states that all factors constant, as product prices goes up, the quantity supplied rises. As shown in figure1, the relationship between quantity demanded (Q) and price (P) yields a negative slope.

This means that the higher the product price, the lower the quantity of the product demanded and vice versa. Unlike the demand law, the relationship between price and quantity supplied results into an upward slope as shown in figure1 by the supply curve, Supply (s). This means that as product prices become high, the quantity supplied increases because producers supply more taking advantage of the high prices and thereby making profit Investopedia (2009).

Equilibrium

The point of intersection between demand and supply curves is called the equilibrium point. At this point supply and demand are equal and the market forces are said to be at equilibrium. The allocation of goods and services is therefore efficient since the quantity demanded exactly equals quantity supplied. Producers are selling all the products supplied at an optimal price and consumers have access of products demanded at all times.

As can be seen from figure1, the point of intersection between demand and supply curves is called equilibrium where product prices and quantity demanded are denoted by PE and QE respectively. PE and QE  refers to equilibrium price and equilibrium quantity respectively. In a real market situation, the equilibrium is difficult to be maintained because of constant fluctuation of demand and supply functions.

As a result there is always disequilibrium where the quantity and demand deviates from QE and PE. This condition arises as a result of a number of factors such as excess supply and excess demand. These excesses results into a shortage or a surplus. A surplus results when the quantity supplied is greater then the quantity demand and a shortage results when the quantity demanded is greater then the quantity supplied (Investopedia, 2009).

Elasticity

Elasticity refers to the degree to which demand and supply functions adapt to fluctuations in price. It depends on products since basic consumer products are more vulnerable to price fluctuations than other products. This is because consumers never stop purchasing these products even when their prices increase. When a slight fluctuation in price of a product causes a sharp change in its demand and supply, such as product is said to have be highly elastic. On the other hand, products whose price fluctuations do not significantly affect changes in there demand and supply are said to be inelastic. Elasticity can be represented as an equation as shown:

Elasticity= (change in quantity/ change in price)

If changes in demand and supply are equal, elasticity is equal to one and the curve is said to be elastic. If the changes in price are greater than changes in quantity, elasticity is less than one and is said to be inelastic (Investopedia, 2009).

Monopolies

A monopoly is a market economy where there is only one producer and supplier of a product. In such a market, the prices of products can be dictated by the leaving the consumer with no choice and therefore utility cannot be maximized. Market entry in such a structure becomes difficult as there impediments such as high costs involved.

A government may create a monopoly in an industry such as the energy sector so that it has exclusive authority to control it. In a competitive market economy, there are several producers competing to satisfy the needs of consumers. This allows price changes to be determined by market forces such as changes in supply and demand. In such a market both consumers and producers participate in product price determination (Norton, 2008).

Government intervention

When market equilibrium becomes unfair, the government might intervene to correct any anomalies in the equilibrium. Such interventions might include declaring a ban on the production and consumption of particular products. Government can intervene through price ceilings and price floors. A price ceiling sets a maximum limit that a product can be charged in the market.

As shown in figure1, the ceiling price is set at PCE below the equilibrium price. As a result the quantity demanded becomes greater then the quantity supplied resulting into a shortage. A price floor refers to the minimum limit that a product can be charged. This is shown by PFL in figure1 and is set above the equilibrium price resulting into a surplus (Eisenkolb, n.d).

Conclusion

Supply and demand plays a central in price determination in any economy. In order to have a free market economy, monopolies and intervention from the government should be limited in order for the market forces to determine automatically the price of products that is acceptable to both the consumer and the producer. However, the government should only intervene to ensure the supply and demand laws are adhered to and to bring product prices as close as possible to the equilibrium price.

Reference:

Eisenkolb, H. (n.d). The Law of Supply and Demand. Retrieved March 7, 2009 from

http://ourworld.compuserve.com/homepages/ruetten/supply.htm.

Investopedia (2009).Economics Basics: Demand and Supply. Retrieved March 7, 2009 from

http://www.investopedia.com/university/economics/economics3.asp.

Norton, K.J. (2008). Microeconomics - Understand the Law of Demand and Supply. Retrieved March 7, 2009 from

http://ezinearticles.com/?Microeconomics---Understand-the-Law-of-Demand-and-Supply&id=1592955.