Question

Supply and demand is the foundation of the market economy and the basis of the study of economics.

1. Why supply and demand is considered as factors that make market economies work? Why supply and demand drives the market economy? Provide an example of the role of supply and demand in business decision making.
2. What is the difference between a movement along and a shift of the demand and supply curves? What are the factors that lead to shifts in supply and demand curves?

Answer 1

a) In a market there is exchange of goods and services. Quantity demanded is the amount of goods and services that buyers are willing to pay for. Quantity supplied is the quantity of goods and services that sellers are willing to sell. Equilibrium price and quantity is the point where demand equals supply.

In a market economy, the market price and quantity is determined by the interaction of quantity supplied and quantity demanded. The seller will look for the highest price, the buyer will look for the lowest price. The equilibrium price and quantity is determined by forces of supply and demand.

Adam Smith was an advocate of free market. According to him, if markets were left free and unregulated, the forces of demand and supply will result in the efficient allocation of resources. The quantity demanded will equal the quantity supplied. The market will settle at the equilibrium price and quantity level. The invisible hand will guide the market to the most efficient use of resources. The level of production, consumption and distribution of resources will promote total welfare.

For example, if consumers demand 200 units of a good at a price of $10 each, 150 units at a price of $15 and 100 units at a price of $20 each.

If the cost of production of the good is $10, and if the market price is $20, then producers will enter the market as there is economic pr ofit. As more and more producers enter the market, supply will increase and prices will fall. Ultimately, it will settle at an equilibrium market price where demand equals supply. This is how the invisible hand operates.

In business, pricing of goods and services is done by studying the demand for the goods and prices the buyers would be willing to pay.

b)

Demand

The law of demand states that there is an inverse relationship between price and quantity demanded, other things remaining the same.

Change in quantity demanded is the movement along the demand curve, whereas, change in demand is the shift in the demand curve due to change in determinants of demand.

A movement along the demand curve occurs when a change in quantity demanded is caused only by a change in price, and vice versa. A shift in a demand curve occurs when a good's quantity demanded changes even though price remains the same.

Factors causing shift in the demand curve:

• Size of the market: Demand will change or shift if the number of consumers for the product increases. The demand curve will shift to the right.
• Income of the consumers: Changes in income shifts the demand curve. Increases in income increases the demand for normal goods and decreases in income increase the demand for inferior goods. The demand curve will shift to the right.
• Increase in the price of related goods. If the price of substitute goods falls, then there is a shift in the demand. If price of large cars increase, then the demand for small cars will increase. Demand curve will shift to the right for small cars. In case of complements, as an example, if the price of gasoline increases demand for cars will fall. The demand curve for cars will shift to the left
• Tastes and preferences of consumers. Demand will depend upon the tastes and preferences of consumers. If there is a preference for health foods, then the demand curve for health foods will shift to the right.
• Expectations: If the consumers expect the prices to fall in the future, then demand curve will shift to the left.

Supply

The supply curve shows the relationship between the market price of the good and the quantity supplied at that price, other things remaining the same.

Change in quantity supplied is the movement along the supply curve, whereas, change in supply is the shift in the supply curve due to the above-mentioned factors.

Shifts in supply are caused by

• Changes in costs of production. Lower costs of product will shift supply curve to the right.
• Technological advances. Supply curve will shift to the right as more goods can be supplied.
• Prices of related goods. If prices of large cars increase, then supply of small cars will increase.
• Price expectations. If the suppliers expect the cost of production to go up in the future, they will increase in the prices of goods.
• Number of sellers. If there is an increase in the number of sellers, supply of goods will increase and prices of goods supplied will fall. If there is a decrease in the number of suppliers, the prices will go up as quantity of goods supplied will fall.
• Taxes and subsidies will also shift the supply curve. If there is an increase in taxes on goods sold, the prices will go up and quantity supplied will fall. If subsidies are given to producers, then prices will fall and quantity supplied will increase.