Earlier in this series we defined goods and services, and we also used the concept of
specialization to rationalize that it is easier to purchase something that we need rather
than to learn how to produce it ourselves.
But how do we know what the price should be for a good or service?
The answer to this question is supply and demand.
These words refer to the amount of stuff that exists and how much consumers are willing
to pay for it.
By analyzing how the cost of something affects how much people are willing to buy it, one
can become able to predict how consumers will react to a change in price.
Let’s begin by looking at demand.
Demand is the relationship between the quantities of goods and services that consumers desire,
or demand to consume, and the prices those consumers are willing to pay for those goods
and services, at different quantities.
So demand has to do with the desire to buy something, and the ability to pay for it.
Both must be present.
Remember, we all want a lot, but we can’t have it all.
The law of demand states that when stuff is cheaper, consumers will buy more of it.
When stuff is more expensive, consumers will buy less of it.
In other words, the price of a good or service combined with your ability to pay for it will
determine your decision as a consumer whether or not to buy.
For example, would you buy a slice of pizza if it was $2?
Most of us would answer yes.
What if that same slice of pizza was $4?
Fewer of us would, perhaps just those who really love pizza.
Now, what if that slice of pizza was $20?
Very few of us would.
Perhaps we would buy it only if we were starving and knew that there would be no other opportunity
to buy food for a long time.
Now there are many variables which can influence demand.
One such variable is known as the substitution effect, which takes place when a consumer
reacts to a rise in the price of something by consuming less of that thing and more of
a similar alternative, which we can refer to as a substitute.
For example, when the price of pizza becomes more expensive compared with other foods,
consumers become more likely to buy a substitute food item, like tacos or hamburgers.
Another such variable is the income effect.
Rising prices make us all feel more poor.
When prices rise, we cut back on what we buy if our income does not go up.
When you buy less of something without increasing your purchase of other things, that is the
income effect.
So if the price of a slice of pizza goes from $2 to $3, you might buy only three slices
instead of four.
We can illustrate this in a demand schedule, which is a table that lists the quantity of
something that a person will buy at various prices in a market.
Sticking with the pizza example, in the first column we have the price of a slice of pizza,
from $1 all the way to $6.
And in the second column we have the quantity demanded, which might be five slices when
they are only a buck, and decreasing by one for every dollar increase in slices, in the
limit of $6 per slice, where it is deemed by the consumer to be too expensive to purchase.
Now, what if we plotted these numbers on a graph?
The result would be a downward sloping demand graph, also commonly called a demand curve.
This is just a graphical representation of a demand schedule, and can be a more useful
way of visualizing this data.
Ok, with demand covered, now let’s look at supply.
Supply is the amount of a good or service that is available.
So how do producers know how much to supply?
Well, according to the law of supply, producers offer more of a good or service as its price
increases and less as its price falls.
Economists use the term “quantity supplied” to illustrate how much of a good or service
a producer is willing and able to sell at a specific price.
Let’s stick with pizza for our example.
If the pizza shop is already making money selling lots of slices of pizza all day, the
promise of higher revenues generated by each sale motivates the pizza shop to make more
pizza.
Assuming that the price of pizza were to be set by some outside figure, if the price of
pizza rises, but the pizza shop’s cost of making pizza stays the same, the pizza shop
will earn a higher profit on each slice.
The owner of the pizza shop understands that making more pizza makes sense in order to
take advantage of the higher prices.
Now, perhaps the demand is so high that the pizza shop can’t even keep up with the necessary
supply.
Customers show up and by noon there is no more pizza.
This may lead to a change in either the price or the supply.
Similar to a demand schedule, a supply schedule shows the relationship between price and quantity
supplied for a specific good or service, or how much of a good or service a supplier will
offer at various prices.
Like a demand schedule, a supply schedule lists supply for a very specific set of conditions.
For example, let’s list the price of the pizza in the first column, again from $1 to
$6.
Then in the second column let’s list the slices that will be supplied per day, starting
with 100, and going up by 50 for each dollar increase in price.
Again we could plot these numbers on a graph, and the result would be an upward sloping
supply graph, commonly called a supply curve.
This is a graphical representation of a supply schedule.
When buyers and sellers come together in a market, supply and demand have a close relationship.
Supply and demand create an equilibrium in the market, which is the point of balance
at which the quantity demanded equals the quantity supplied.
If we draw the demand and supply curves on the same plot, we can identify the point where
the two intersect.
This is known as the equilibrium price.
At equilibrium, the market is stable, because all of the goods and services are consumed.
However, supply and demand constantly shift, causing prices to change.
Usually over time, supply and demand will move to new equilibrium levels, which is why
we tend to know the price of something when we are shopping.
So let’s move forward and look more closely at how both supply and demand can change.