Economic Theory of Demand and Supply - Essay Example

Due Economic Theory of Demand and Supply Human beings generally live in environments where their requirements are always constrained; that is, never perfectly guaranteed. Accordingly, people from all over the world end up engaging in a symbiotic relationship kind of to ensure the availability of the resources in short supply. The specialization of production as well as the market institution of trade antedates the science of economics that currently lies at the heart of modern economies. It is perhaps fair to say that the science of economics basically studies natural institutions of human behavior. People specialize in the production of goods and services -- or more existentially, as dictated by their environment, heredity, and/or fate in order to alleviate human suffering [their own existence included]. In the process of pursuit of own self-interests to satisfy needs and wants, individuals succumb to the unintended, invisible market forces that compel others to react by supplying necessities to make life even better in an engagement that leaves interactive parties better off as oppose to having excesses of what one produces in abundance, thus the very essence of efficient allocation of resources in the society studied in microeconomics (Stead and Stead, 2009, p.42). Economists are in agreement that prices and quantities are descriptively the most observable attributes of individual interests that interact within a market structure to facilitate mutually beneficial exchanges as envisaged by Adam Smith (Friedman, 2009, p.145). 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 of demand and supply (Gandolfi, Gandolfi, and Barash, 2002, pp. 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 moderates the exchanges to the point where goods and services delivered by suppliers (supply side) and paid for by the consumers (demand side) always tends towards a state balance with reference to the compensation packages received by either side. The dynamics of demand and supply applies best to a theoretically free market structure where no group of buyers and/or sellers holds the sway over the resultant market prices. As allude to in the above preliminary introduction, the existence of a market structure is sustained by demand and supply, with both functioning to service the numerous interests of the society. For a given commodity delivered in the market for exchange, demand measures the quantity that buyers/consumers would be willing and able to acquire at a unit price (Gandolfi, Gandolfi and Barash, 2002, p.17). In that very description, two influential factors are apparent: taste and ability to buy; expressed in one’s estimation of the importance of a good or service at a specific price and sufficiency of one’s wealth/income to offset the costs involved [price quoted] respectively. That is to say, as descriptively affirmed by economic theory, all consumers are rational decision makers who seek to maximize their utility [well-being, satisfaction, happiness, etc.] by choosing the "best" bundle (in terms of quantity) of goods that their money (wealth/income) can buy (Silberberg and Suen, 2001, pp. 252–254). Either way for both factors, price sticks out as the common denominator/factor. Noteworthy, the two units of measurements in the theory of demand [price and quantity] 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 quantity of a product that people (buyers) are willing to acquire. 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, 1947, p.79). That is, the simple demand curve, as seen in the diagram above, implies that price is the only factor which determines demand, which is usually not the case. Captured already are many other factors such as income, tastes and preferences, prices of substitute goods, expectations among others 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 decrease in income, for instance, with all other factors held constant, shifts the demand curve to the left as shown in the sample 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, Gandolfi, and Barash, 2002, p.22). Unlike the consumers striving to maximize their utilities, sellers (businesses/firms) endeavor to maximize profit. In other words, suppliers strive to make available goods and services in amounts that best help them get the highest attainable profit, thus the law of supply. Typically, product prices are directly proportional to the product quantities supplied; ceteris paribus, suppliers feel more motivated to make goods and services available as prices surge upwards as shown the diagram below: It is, in fact, more profitable for firms (producers) to increase their production capacities to the right of the supply curve as opposed to producing quantities leftwards. Nonetheless, production further to the right depends on other factors other price increases projected in the diagram just above. The level of knowledge base and the amount of capital available to firms will always constrain production further to the right. Just like in the demand curve, prices only determine the changes in supply along the supply curve. The level of technology, the price an input in production, prices of substitute products among other factors which are fairly stable in the short term, do change in the long run, resulting in the destabilization of prices and quantities made available to consumers in the market, basically shifting the supply curve either to the left or right depending on the magnitudes of the changes. An increase in the level of technology, ceteris paribus, shifts the supply curve to the right as shown below: As mentioned above, both the demand and the supply sides [consumers and suppliers] are all MAXIMIZERS; both have preferences of reaping MORE rewards to less. However, the constraints on both sides serve to curtail limitless compensation of rewards [utilities and profit respectively] towards a compromise. The point where the interests of both sides meet to strike a compromise [3p, 70q in the diagram below] is often referred to as the Market Equilibrium in economic theory, giving Equilibrium Price and Equilibrium Quantity as determined by the market forces of demand and supply (Carbaugh, 2013, pp. 42-44). Basically, a market is in equilibrium when at a given price of a product its ‘market demand’ equals its ‘market supply’ (Agarwala, 2009, p. 31). Operative mechanics of the theory of supply and demand “self-rights/self corrects” in case of a move away from the equilibrium; that is, firms, for instance, will not be able to sell/clear their stock if the selling price is deemed by consumers/buyers to be higher than their willingness to pay, which in effect means a depressed demand (Agarwala, 2009, p. 32). The condition that results when firms supply more of product at a given price in excess of demand by the consumers is what is referred to as a surplus, illustrated by the diagram below: As noted in the diagram, a price above equilibrium, P2 for instance, attracts more suppliers into the market and/or motivates existing firms to step-up their production capacities, thus, the increased supplies to Qs; causing a surplus of Qs-Q*. At a price above the equilibrium, say P2, only a handful of consumers would be willing to pay, and so demand drops (Friedman, 2009, p.17; Hirschey, 2008, p. 131). With the entry of more suppliers joining an already motivated industry, the production level overpowers the existing demand, making it harder for the market to clear. Accordingly, the ensuing competition for customers prompts a reduction in price towards its original level at P*. Similarly, a price, say P1, below the market equilibrium price demotivates firms, with well-grounded ones fringing their quantities delivered in the market as others quit the industry altogether (Hirschey, 2008, p. 131). The condition that results is a market in deficit of goods and services, with consumers now demanding more at that very given price P1 in excess of the amounts that the remaining suppliers cannot actually meet, thus, a shortage as shown in the diagram below: Since firms/producers are profit maximizers, they will increase the prices in order to get the most out of the excess demand; a trend that continues until the market stabilizes to its original position P*. References Agarwala, S. K. (2009) Principles of Economics, New Delhi: Excel Books. Carbaugh, R. J. (2013) Contemporary Economics: An Applications Approach, New York: ME Sharpe, Inc. Friedman, M. (2009) Price Theory, New Brunswick, NJ: Transaction Publishers. Gandolfi, A., Gandolfi, A. and Barash, D. (2002) Economics as an Evolutionary Science: From Utility to Fitness, New Brunswick: Transaction Publishers. Hirschey, M. (2008) Fundamentals of Managerial Economics, Mason, OH: South-Western Thompson Learning. Samuelson, P. A. (1947) Foundations of Economic Analysis, Cambridge: Harvard University Press. Silberberg, E. and Suen, W. (2001) The Structure of Economics: A Mathematical Analysis (3rd ed.), Boston: Irwin/McGraw-Hill. Stead, J. G. and Stead, W. E. (2009) Management for a Small Planet (3rd Ed.), New York: ME Sharpe, Inc. Read More