BASICS OF DEMAND AND SUPPLY - Nischl R B

 

BASICS OF DEMAND AND SUPPLY

Supply and demand form the most fundamental concepts of economics. Whether you are an academic, farmer, pharmaceutical manufacturer, or simply a consumer, the basic premise of supply and demand equilibrium is integrated into your daily actions. Only after understanding the basics of these models can the more complicated aspects of economics be mastered.

DEMAND: Although most explanations typically focus on explaining the concept of supply first, understanding demand is more intuitive for many, and thus helps with subsequent descriptions.

 As the price of a good increase, the demand for the product will—except for a few obscure situations—decrease. For purposes of our discussion, let's assume the product in question is a television set. If TVs are sold for the cheap price of Rs.5 each, then a large number of consumers will purchase them at a high frequency. Most people would even buy more TVs than they need, putting one in every room and perhaps even some in storage.

Essentially, because everyone can easily afford a TV, the demand for these products will remain high. On the other hand, if the price of a television set is Rs.50,000, this gadget will be a rare consumer product as only the wealthy will be able to afford the purchase. While most people would still like to buy TVs, at that price, demand for them would be extremely low.

Of course, the above examples take place in a vacuum. A pure example of a demand model assumes several conditions. First, product differentiation does not exist—there is only one type of product sold at a single price to every consumer. Second, in this closed scenario, the item in question is a basic want and not an essential human necessity such as food (although having a TV provides a definite level of utility, it is not an absolute requirement). Third, the good does not have a substitute and consumers expect prices to remain stable into the future.

SUPPLY: The supply curve functions in a similar fashion, but it considers the relationship between the price and available supply of an item from the perspective of the producer rather than the consumer.

When prices of a product increase, producers are willing to manufacture more of the product to realize greater profits. Likewise, falling prices depress production as producers may not be able to cover their input costs upon selling the final good. Going back to the example of the television set, if the input costs to produce a TV are set at Rs.50 plus the variable cost of labor, production would be highly unprofitable when the selling price of the TV drops below the Rs.50 mark.

On the other hand, when prices are higher, producers are encouraged to increase their levels of activity to reap more benefit. For example, if television prices are Rs.1,000, manufacturers can focus on producing television sets in addition to other possible ventures. Keeping all variables the same but increasing the selling price of the TV to Rs.50,000 would benefit the producers and provide the incentive to build more TVs. The behavior to seek maximum amounts of profits forces the supply curve to be upward sloping. (See: Understanding Supply-Side Economics.)

An underlying assumption of the theory lies in the producer taking on the role of a price taker. Rather than dictating prices of the product, this input is determined by the market and suppliers only face the decision of how much to actually produce, given the market price. Similar to the demand curve, optimal scenarios are not always the case, such as in monopolistic markets.