The Law of Demand and Supply

ECONOMICS

The Law of Supply and Demand

Brief History:

The law of supply and demand was formulated by the famous British Economist Alfred Marshall, a striking example of how thought evolves in human science. From then on the frustration and urge to explain the phenomenon and of prices began.

Price as a Ratio

The labor theory, says, that prices depended on the relative amounts of labor expended on their production. According to the labor theory of value, price is nothing else but the ratio between units of the various commodities in exchange. And the advantage of this theory is that it highlights the essence of any price.

Cost Production Theory

the cost production theory of price is essentially the theory underpinning the mark-up methods of pricing followed by most retailers. Because it has appeals of simplicity.

But What about the Utility?

Prices have more to do with the satisfaction derived by the buyers from consuming the products that they purchase. Utility or the usefulness to the buyer or consumer is the determining factor for the price of a good. Satisfaction can be biological (taste),intellectual, psychic and psychological.

It takes two to tango

both cost of the production and utility determine the price of a commodity. In addition, cost of production (supply) and utility of the consumer (demand) are needed to explain the phenomenon of price.

The Law of Demand

States that the price of the commodity decreases, ceteres parebus (everything else unchanged) and the quantity of the product demanded increases. Thus, the quantity demanded change as the price changes. The quantity of demanded is measured over a specific period of time. The law of Diminishing Marginal Utility, is the satisfaction we derived out of the last good diminishes as we consume more of it. We also have the following terms 1. Income Effect, which talks about the ability of man to increase its consumption with the same nominal income, and the 2. Substitution Effect, which happens when a person shifts his choice due to the changes of another commodity.

Movement along the curve. For as long as there is no change in the relationship between price and quantity demanded, any change in the quantity demanded will be the result of the change in price.

Change or shift in demand. A change in demand refers to a shift in the demand curve, or completely new set of price-quantity relationship reflected on a new demand schedule. This shift take place when what we assumed earlier as constant or unchanged (ceteres parebus) actually changes.

Determinants of Demand:

1.Wealth (+)

2.Income (+)

3.Population (?)

4.Prices of Substitutes (-)

5.Prices of complements (?)

6.Consumers taste and preference (?)

7.Quality of the good (?)

8.Advertising and promotion (?)

9.Expectations of future price increases (?)

If income increase the quantity demanded will rise, and the entire demand curve will move to the right.

A leftward movement of the demand curve or schedule would reflect decrease in demand.

Change in the quantity demanded: involves only a shift of the entire demand.

Change in demand : involves only a movement of the same demand curve.

The Law of Supply

states that as the price of a commodity rises, the quantity of the product that sellers are able and will to sell also increases. The quantity supplied refers to the number of units offered for sale within a given period. The relationship between the quantity supplied and price is positive or the opposite of the demand curve.

Movement along the supply curve. Any change in price will result a change in quantity supplied. Demand will show something similar for the supply curve or schedule.

A rightward shift in the entire supply curve means more will be supplied at the same price.

A leftward shift means less will be supplied at the same price.

Non-price factors that affects quantity supplied:

1.changes in producers profit goals.

2.changes in prices of competing commodities.

3.changes in technology/productivity.

4.changes in prices of production inputs.

Equilibrium

Equilibrium is the key to understanding of many observed phenomena. Equilibrium price is what “clears” the market there is no excess quantity demanded or supplied.

CHANGES IN THE EQUILIBRIUM

The demands and supply curves constantly adjusting as a result of the dynamic nature of the economy.

SHORTAGES AND SURPLUSES

As the price of the product increases, more and more speculators may be attracted to the market, which leads to another round of price increase. Speculations can be harmful to the economy because of its psychological nature which has repercussions in on the economic process of the economic adjustments.

Concept of Elasticity

the ratio of the percentage increase in quantity to the percentage increase in what affects it.

PRICE ELASTICITY

the price elasticity of demand refers to the ratio between a percentage change in quantity demanded due to a corresponding change in price.

CLASSIFICATIONS OF DEMAND SCHEDULES:

1.UNITARY ELASTICITY, are those with numerical value equal to 1.

2.INELASTIC DEMAND ELASTICITY, are those whose elasticity are numerically less than 1.

if the increase of the quantity sold is less than proportionate to the decrease in price, he may end up a loser.

Price elasticity formula: e=ΔQ/Q

                                         ΔP/P

INCOME AND OTHER ELASTICITIES

Engel's law ( Ernst Engel, economist), the law maintains that as the income of a family increases, then the demand for food products increases at a slower rate. Such relationship introduces us to the concept of the Income Elasticity of Demand, which expresses the percentage change in which the quantity demanded corresponding to percentage change in income.

e=ΔQ/Q

    ΔP/P

the effect of a price change in quantity supplied tends to increase as the time period under which we analyze the adjustment to the price change lengthens.

What is the point in going trough all the the discussions regarding the elasticities of demand and supply?

The use of elasticity measure makes pricing decisions in many firms more rational and more truly profit-oriented.

This is the hand-out I prepared for my report in Economics. I hope this will lessen your burden whenever you will be assigned to report the said topic. God Bless!

Credits to the books I've used as a reference.

Basic Economics By: Bernardo M. Villegas & Victor A. Abola