Laws of Supply and Demand - Essay Example

ECO365: Laws of Supply and Demand Introduction The law of supply and demand forms one of the most basic and fundamental models for setting a price and productivity level. In its most basic form it states that as demand rises producers will raise their price, and as price rises they will produce more goods. Of course, taking this to its logical end would see producers continue to raise prices and more goods would be produced under the higher prices. However, the law is limited by other market forces such as a limited market, price ceilings, elasticity, shifts in the demand and supply curve, and equilibrium. In pricing a product, it would seem simple enough to calculate the costs and add a profit margin. However, "While costs form the basis for pricing decisions, they are only a starting point, with market conditions and other factors usually determining the most profitable price" (Gale, Cengage Learning, 2007, p.262). The laws of supply and demand and their associated curves are the instruments that economists employ to determine a price that will maximize profit. Key Points An important factor that impacts the law of supply and demand is that the law is reactive to the market. As was illustrated in the Atlantis apartments, raising prices would increase the revenue, but at some level the demand would drop. Likewise, if the prices rose and suppliers built more apartments the supply would reach saturation and there would be a surplus of units. The demand and supply would react to the market forces, rather than dictating the price. This reaction to the market is the search for equilibrium, which is the point that demand equals the supply. In a perfectly competitive free market, all the units at Atlantis would find renters that are willing to pay the maximum price that the owners could ask. Raising the price and people would move out, while lowering the price would still result in the desired occupancy, but at a lower revenue. The change in supply and demand differs from the shift in supply and demand. A change in demand may come about as a result in the change in price, where a lower price raises demand. However, increasing the potential customer base would shift the demand. More customers would mean more people would be willing to pay higher rent. Likewise, if an alternative product were introduced, such as the short-term lease, it would shift the supply curve. When the supply or demand curves shift, the equilibrium point changes with it. According to Colander (2007), "The firm plays the same role in the theory of supply that the individual does in the theory of demand. The difference is that whereas individuals maximize utility, firms maximize profit" (p199). Raising the production level changes the supply, but does not shift the curve. The firm will set the production level to maximize profits, not necessarily revenue. An illustration of supply and demand that can be seen in current events and the energy market is applicable to many workplace situations. The price of oil has spiked and dipped in response to market conditions as the price seeks equilibrium. As more customers came into the market (IE China and India), the demand curve shifted to the right, which raised prices. At the new higher prices, producers produced more to meet the demand. In addition, alternative fuels became more attractive and the result was a shift in the supply curve. Conservation additionally lowered demand. At some point, the supply outstripped the demand and prices fell to find the equilibrium point. The forces of alternative fuels, conservation, and an increase in production shifted the demand and supply and found a new price. In the simulation with Atlantis apartments, setting the price lower increased the occupancy rates and raised more revenue. However, the management had made a decision to run at a 15 percent vacancy rate. While filling these additional apartments increased revenue, there were also associated costs, such as maintenance. As production reaches a certain level, an increase may cost more than the revenue it generates. Selling an item at just above costs in an effort to increase sales and revenue can have a disastrous effect, and plotting the breakeven point can reveal the hidden downsides to increasing production (Tyler, 2003, p.25). It needs to be remembered that the firms goal is to maximize profits, not revenue or sales volume. Adjusting the price to reach the point of maximum profits is the task that faces the business economist. Setting the price too low leaves money on the table, and too high of a price loses sales. Another major contributing factor that influences the setting of price is the elasticity. Price elasticity of demand is the characteristic of demand that allows it to stretch or contract in the face of a changing price. If raising the price does not decrease demand, then the product is said to be demand inelastic. Products that are specialized, have no substitutes, or are a necessity in limited supply are often inelastic. However, if the demand directly reacts to a change in price, it is said to be elastic. Orange juice could be considered to be elastic. Doubling the price of orange juice would cut the demand in half. There are substitutes (grapefruit juice), several suppliers, and an ample supply. A new treatment for a previously incurable disease would be inelastic. No matter where the price was set, it would find the same demand. Demand elasticity is one more factor that a firm needs to consider when maximizing profits. In conclusion, the law of supply and demand is a simple theory that is complicated by the market variables. Demand and supply are reactive to the market and the price, and the economist must make educated projections about the markets reaction. While many examples of supply, demand, and price are illustrated as linear functions, they seldom are. As with oil, demand may fall off sharply as the price rises. Demand inelasticity may see no change in demand as prices move up or down. The equilibrium point will move in response to the current market, and is constantly readjusting as the supply and demand curves shift. New products, suppliers, substitutes, and uses all impact the demand and price, as the shifting price in turn motivates producers to enter or leave the market, once again shifting the curve. It is the task of the economist to track these functions and make educated projections that help the firm set a price and production level that will maximize their profits from their available resources. References Colander, D. (2008). Economics (7th ed.). Boston: McGraw Hill. Gale, Cengage Learning. (2007). Encyclopedia of Small Business (Vol. 1, 3rd ed.). Detroit, MI: Gale. Tyler, R. (2003). Getting even. PC Fab, 18-27. Read More