Introduction to Supply and Demand

Supply and demand constitute the most basic concept of economics. Whether you are a scholar, a farmer, a pharmaceutical manufacturer, or a simple consumer, the basic premise of the balance of supply and demand has been integrated into your daily actions. Only by understanding the basic knowledge of these models can you master the more complex aspects of economics.

Explain the need

Although most explanations usually focus on explaining the concept of supply priority, for many people, understanding demand is more intuitive and therefore helpful in subsequent descriptions.

The figure above depicts the most basic relationship between the price of a commodity and its demand from the perspective of consumers. This is actually one of the most important differences between the supply curve and the demand curve. The supply diagram is drawn from the perspective of the producer, while the demand is drawn from the perspective of the consumer.

As the price of a commodity increases, the demand for the product (except for a few unknown circumstances) will decrease. To facilitate the discussion, we assume that the product in question is a television. If TVs are sold at a low price of $5 per unit, then a large number of consumers will buy them at a high frequency. Most people will even buy more TVs than they need, put one in each room, and maybe even some in the storage room.

Essentially, since everyone can easily afford TVs, the demand for these products will remain high. On the other hand, if the price of a TV set is $50,000, this gadget will be a rare consumer product because only the rich can afford it. Although most people are still willing to buy TVs, at this price, the demand for them will be very low.

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Of course, the above examples are all done in a vacuum. A pure example of a demand model assumes several conditions. First, there is no product differentiation-only one product is sold to every consumer at a single price. Second, in this closed scenario, the items in question are basic needs, not human necessities such as food (although having a TV provides a certain degree of utility, this is not an absolute requirement). Third, there are no substitutes for goods, and consumers expect prices to remain stable in the future.

Explain supply

The supply curve works in a similar way, but it considers the relationship between commodity prices and available supply from the perspective of producers rather than consumers.

When product prices rise, producers are willing to produce more products in order to achieve greater profits. Likewise, falling prices will inhibit production, because producers may not be able to pay for their input costs when selling the final product. Going back to the example of TV sets, if the input cost of producing TV sets is set at 50 US dollars plus variable labor costs, when the selling price of TV sets is below the 50 US dollars mark, production will be very unprofitable.

On the other hand, when prices rise, producers are encouraged to increase their activity levels to obtain more benefits. For example, if the price of a TV is $1,000, the manufacturer can focus on producing TVs in addition to other possible investments. Keeping all variables constant but increasing the price of TVs to $50,000 will benefit manufacturers and provide incentives to make more TVs. The search for maximum profit forces the supply curve to slope upward.

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A basic assumption of the theory is that producers play the role of price receivers. This input does not determine the price of the product, but is determined by the market, and the supplier only faces the decision of how much it actually produces at a given market price. Similar to the demand curve, the optimal scenario is not always the case, such as in a monopolistic market.

Find balance

Consumers usually seek the lowest cost, and producers are encouraged to increase output only at higher costs. Naturally, the ideal price consumers pay for goods is “zero dollars.” However, this phenomenon is not feasible because producers will not be able to continue operating. Logically, manufacturers seek to sell as many of their products as possible. However, when prices become unreasonable, consumers will change their preferences and stay away from the product. A proper balance must be achieved so that both parties can conduct continuous business transactions for the benefit of consumers and producers. (Theoretically, the optimal price that causes the producer and consumer to reach the maximum combined utility level appears at the price at the intersection of the supply and demand lines. Deviation from this point will lead to overall economic losses, usually called deadweight losses.

Law or theory?

The law of supply and demand is actually an economic theory popularized by Adam Smith in 1776. The principle of supply and demand has proven to be very effective in predicting market behavior. However, there are many other factors that affect the market at the microeconomic and macroeconomic levels. Supply and demand guide market behavior to a large extent, but it cannot directly determine it.

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Another way to view the laws of supply and demand is to treat them as guidelines. Although they are only two factors that affect market conditions, they are very important factors. Smith calls them the invisible hand that leads the free market. However, if the economic environment is not a free market, then the relationship between supply and demand will not be that big. In a socialist economy, the government usually sets prices for goods regardless of supply and demand.

This creates problems because the government is not always able to control supply or demand. This is obvious when looking at Venezuela’s food shortages and high inflation rate since 2010. The country tried to take over food supplies from private suppliers and establish price controls, but the result was severe shortages and corruption allegations. Supply and demand still have a great impact on the situation in Venezuela, but it is not the only factor.

For centuries, different market conditions have repeatedly explained the principle of supply and demand. However, the current economy is more globalized than ever before, and macroeconomic forces may be unpredictable. Supply and demand are effective indicators, but not specific predictive indicators.

Bottom line

The theory of supply and demand involves not only physical products such as televisions and jackets, but also wages and labor mobility. More advanced micro and macro economic theories often adjust the assumptions and appearance of the supply and demand curve to correctly explain the concepts of economic surplus, monetary policy, externalities, aggregate supply, fiscal stimulus, elasticity, and shortage. Before studying more complex issues, we must correctly understand the basics of supply and demand.


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