Demand and supply theory - Term Paper Example

Thus, for the exchange of interests (expressed in terms of goods and services) to occur, demand and supply has to exist, but at some costs. From the field of academia to industrial circles, the basic premises of supply and demand are integrated into the daily actions of the society. To be sure, the theoretical mastery of economics depends much on the understanding of the theory at hand (Gandolfi, Gandolfi, and Barash 5-6). The theory of demand and supply is, therefore, an organization principle that coordinates the production of goods and services (in quantities, often referred to as output) to satisfy societal needs through the market (price) mechanism.

Intuitively, the price mechanism functions in a perfectly competitive environment to maintain equilibrium of compensation to goods and services delivered by suppliers (supply side) and paid for by the consumers (demand side). The theory of demand and supply applies best to a theoretically free market structure in which no group of buyers or sellers holds the power to set market prices. Accordingly, the theory has two sides: the demand side and the supply side, which both function in the interest of the social needs.

For a given commodity delivered in the market for exchange, demand measures the quantity that buyers would be willing and able to acquire at a unit price (Gandolfi, Gandolfi and Barash 17). According to the theory, all consumers are rational decision makers who seek to maximize their utility by choosing the "best" bundle (in terms of quantity) of goods that their money (income) can buy (Silberberg and Suen 252–254). Noteworthy, the two units of measurements in the theory of demand are inversely related; a relationship that sums up the law of demand.

That is, ceteris paribus, any increase in the price of a commodity in a purely competitive market environment lowers the number of people (buyers) willing to buy the product. Higher product prices in this case may cause a massive shift by consumers towards more relatively cheaper substitute commodities; a scenario summarized in economics as price substitution effect. Conversely, consumers’ purchasing power acquired through a reduction in the price of a commodity offered for sale in the market increases their ability to buy the product with a possible consequential effect of a massive shift from other commodities considered expensive (income effect).

It is important to note that the changes in product prices as well as the quantities along the demand curve occur with all other determinants predominantly held constant (constrained utility maximization) (Samuelson 79). That is, there are many other factors such as income, tastes and preferences, prices of substitute goods among others that occasionally come into play to affect demand of a given product or service. A change in the amount of income, for instance, shifts the demand curve either to the left or right depending on whether the change in income is negative or positive respectively.

A sample shift in demand curve due to a decrease in income is shown in the diagram below. Supply on the other hand measures the quantity of commodities made available for exchange at a unit price in the market by sellers (Gandolfi,