The law of supply and demand is the basis of a market economy. Without his understanding, it is impossible to explain how it functions. Therefore, it is from the study of the concepts of supply and demand that any course of economic theory begins. Since the type of management in most modern countries of the world is market, knowledge of this fundamental law will be useful to anyone. It allows us to understand that a reduction in the supply of goods leads to an increase in demand for its substitutes and a drop in complementary goods. But there are exceptions. This topic will be devoted to today's article.
Briefly
As a rule, the lower the price, the more consumers are willing to buy. So in simple words you can formulate the law of demand. The higher the price, the more manufacturers are ready to release the goods. This is the law of supply. Thus, we can conclude that, ceteris paribus, the lower the price of a product, the more consumers are willing to buy it and less produce producers. The law of supply and demand was first formulated by Alfred Marshall in 1890.
The law of supply and demand
The point at which the two curves intersect indicates the equilibrium volume of the product and its market price. In it, demand is equal to supply. This is a state of well-being. However, if this had always been the case, then the economy would not have developed, because crises are progressive in nature, although they bring significant socio-economic shocks.
But back to the demand. It represents the volume of goods that a consumer is willing to purchase at a given price level. The magnitude of demand reflects not just desire, but willingness to buy a certain amount of product. In addition to the price, it is also affected by the level of income of the population, market size, fashion, the availability of substitutes, inflation expectations. An exception to the rule of increasing demand while lowering market value are Giffen products, which we will dwell on below.
As for the offer, it characterizes not only the desire, but also the willingness of the manufacturer to offer his product for sale on the market at a given price level. This is due to the invariability of costs per unit of product, subject to increased profits. In addition to the price, the proposal is affected by the availability of substitutes, complements, the level of technology, taxes, subsidies, inflationary and socio-economic expectations, market size.
The concept of elasticity
This indicator characterizes the fluctuations in aggregate demand or supply caused by changes in the price level. If a decrease in the latter causes a greater percentage change in sales, then demand is considered elastic. That is, in this case, we can say that this is the degree of consumer sensitivity to the pricing policy of manufacturers.
However, you need to understand that elasticity can be associated with the level of income of customers. If the latter and the magnitude of demand change by the same percentage, then the coefficient under consideration is equal to unity. Economic literature often speaks of absolutely and completely inelastic demand.
For example, consider the consumption of bread and salt. Demand for these products is completely inelastic. This means that an increase or decrease in the price of them does not have any effect on the value of demand for them. Knowing the degree of elasticity is of great practical importance to manufacturers. There is no particular point in raising the price of bread and salt. But a sharp decrease in the price of goods with high elasticity of demand will lead to greater profits.
It is just so profitable to act in a highly competitive market, because buyers will instantly go over to the seller, whose products are cheaper. For products with low elasticity of demand, the considered pricing policy is unacceptable, since slightly changed sales volume does not compensate for lost profits.
The coefficient of elasticity of supply is calculated as the quotient of dividing the change in the quantity of goods produced by increasing or decreasing the price (both indicators should be expressed as a percentage). It depends on the characteristics of the release process, its duration and the ability of goods to long-term storage. If the increase in supply exceeds the increase in prices, then it is called elastic.
However, you need to understand that the manufacturer does not always have the opportunity to quickly rebuild. You can not increase the number of cars produced per week, although the price of them may well rise sharply. In this case, we can speak of an inelastic proposal. Also, the ratio under consideration will be low for goods that cannot be stored for a long time.
Graphic image
The demand curve shows the relationship between the price level in the market and the volumes of goods that consumers are willing to buy. This part of the graph displays the inversely proportional relationship between these values. The supply curve shows the relationship between the price level in the market and the volumes of goods that manufacturers are willing to sell. This part of the graph displays a directly proportional relationship between these values.
The coordinates of the intersection of these two lines reflect the equilibrium volume of the goods and the price that will be established on the market. This chart is sometimes called the “Marshall Scissors” because of its appearance. A shift of the supply curve to the right means that the producer has reduced costs per unit of goods. Therefore, he agrees to lower prices.
Cost reduction is often due to the introduction of new technologies or improved organization of production. The shift of the supply curve left-up, on the contrary, characterizes the deterioration of the economic situation. At each old price level, the manufacturer will be ready to produce a smaller quantity of goods. Reducing the supply of goods leads to an increase in demand for benefits-substitutes and a decrease in complementary products. But is it always that simple?
Independent benefits
This group includes goods whose cross elasticity of demand is equal to zero. These are the benefits that do not complement and do not replace one another. An example of such benefits is a car and bread.
Components
This group of goods includes goods that complement one another or are consumed simultaneously.
An example of complementary goods is a car and gasoline. These are complementary products. The cross elasticity of their demand is less than zero. This means that a reduction in the supply of goods leads to a decrease in the purchased volumes of another. Demand for complementary goods always changes in one direction. If the price of one of these products rises, then consumers begin to buy less of the other.
In the case of complementary goods, it cannot be said that a reduction in the supply of goods leads to an increase in demand for the second. Why do we need gas if we cannot afford to buy a car. Since these are complementary goods, an increase in the price of one of them leads to a reduction in demand for the other. And how does this affect the economy as a whole? The price was raised by sellers of one product, and a decrease in revenue was also observed among manufacturers of its components.
Substitutes
This group includes products that replace each other. Examples of substitutes are, for example, various brands of tea. Similar products have similar characteristics and satisfy the specific needs of customers. Their cross elasticity is greater than zero. This means that a decrease in the supply of goods leads to an increase in demand for its substitutes.
With a reduction in the price of one type of tea, many consumers will abandon their usual brand and switch to it if it meets all quality parameters.
Thus, similar products compete with each other, forcing manufacturers to seek to reduce the cost of their production. However, there are exceptions related to demonstrative behavior, which we dwell on.
Essentials and Luxury Goods
In a separate group there are so-called inferior or inferior goods. Their feature is that the demand for them decreases with an increase in income. The richer people are, the less they tend to buy them. A special case is the so-called Giffen effect.
Defective goods, however, are not essential goods. The latter are products for which demand is independent of income. Their share in waste decreases, but the absolute consumption itself remains the same. Their income elasticity is less than one. Separately, you need to consider luxury goods. Their consumption increases at a faster rate than income.
Giffen Products
This concept is associated, like the following, with the concept of price elasticity. This category of goods includes, for example, bread and potatoes for Russia, and rice and pasta for China. The Giffen effect explains why price increases can lead to higher demand.
Indeed, the increase in the cost of potatoes leads to hype in the market. Although it would seem more rational to abandon it in favor of, for example, pasta or cereals. However, in practice this does not happen.
