The theory of supply and demand

“Teach a parrot to say supply and demand and you have an economist. Discuss”
(Question in a higher education final degree examination.)

The concepts of supply and demand are central to the study of economics. The body of theory is substantial ” standard undergraduate text books such as Lipsey”s An Introduction to Positive Economics deal with the subject over several hundred pages.

Paper 4 requires the candidate to have an elementary understanding of supply and demand theory. It is important to understand basic concepts and then apply them to real-life situations. In doing so, some of the “nuts and bolts” of the theories may quite properly be overlooked. For example, the candidate may have to demonstrate an ability to analyse a situation using supply and demand curves without ever knowing – or needing to know – how the curves are actually derived from first principles.

Background

Some regard Adam Smith as the founding father of economics. His famous book “The Wealth of Nations” (1776) touched upon his perceptions of markets and how they operate. Writing of the price system, which is built on the theories of supply and demand, Smith stated that it was the “invisible hand which guides the actions of consumers and producers”.

Over a century later, Alfred Marshall proposed a more complex theory, focusing on micro-economic analysis. It was Marshall who first formally identified the determinants of supply and demand and then developed his concepts in diagrammatic form. The supply and demand curves used in micro-economics today depend directly on Marshall”s work.

In the inter-war years, John Maynard Keynes drew inspiration from the work of Marshall in formulating his “General Theory of Employment, Interest and Money”. His theory of effective demand (now more commonly referred to as aggregate demand) is a direct extension of micro-economic analysis to macro-economic theory.

Supply

Supply is the flow of goods and services brought to the market place by producers in a given time period.

Generally, the higher the price which can be obtained, the higher the quantity supplied. Economists represent the supply curve by measuring price on the vertical axis and quantity supplied on the horizontal axis, with the curve sloping upwards from left to right (Figure 1).

Determinants of supply

The supply to a market will not be constant. The flow is influenced by several factors, all of which may change over time.

Price:
As mentioned above, a higher price will prompt producers to supply more.

Prices of other goods and services:
Some goods and services display inter-dependency of supply. If the price of good A increases this may render the supply of a good whose price remains unchanged less attractive. An example of inter-dependency is gas bottles and gas heaters.

Costs of factors of production:
The factors of production (or productive resources) are the inputs to the production process. They therefore, directly influence the capability of producers to bring products to the market. These costs are those relating to land, labour, capital and the entrepreneur. If the cost of land increases, producers may shift production towards goods which rely less on land and more on other factors of production.

Technological innovation:
Advances in technology reduce the unit costs of production through economies of scale. This can increase supply capability at each price level.

Producers” objectives:
Micro-economic theory relies on an assumption of profit maximisation. In practice, producers can have many different objectives which distort our perception of how supply behaves. In addition, market supply can depend on a wider range of factors, including climate, action by the labour force and so on.

Demand

Demand is the flow of goods and services required by consumers over a given period of time. Generally, the higher the level of price, the lower the level of demand. The demand curve is therefore, usually represented as sloping downwards from left to right (Figure 2). There are exceptions to this. Some goods and services attract lower demand when the price falls, including many products where the price is a “badge” of exclusivity. These products are said to display a “downward-sloping demand curve”.

Determinants of demand

The determinants of demand are:

Price:
As mentioned above, the higher the price, the lower the level of quantity demanded.

Prices of other goods and services:
Some goods are substitutes for one another. If the price of one falls, the demand for the other should also fall as it becomes less attractive to the consumer. Holidays in Greece and Florida are good examples of this.

Some goods are complementary ” the demand for them moves in tandem. If the price of one of them falls, the quantity demanded of the other will rise. Examples of complementary goods are portable CD players and batteries.

Income:
This is the most important determinant of demand. Generally, as income increases, the quantity demanded should also increase. Again, there are exceptions to this. In poorer countries, there is evidence that some staple goods, such as rice, will become less popular even if their prices fall as incomes increase.

Tastes and preferences:
Consumer preferences have a major impact on the level of demand. These may be influenced by a wide range of factors, all difficult or impossible to quantify precisely.

Changes in tastes and preferences can be permanent or temporary. Consider products such as ten-pin bowling (hugely successful in the 1960s), cinema, fashion and childrens” toys (witnessed by the resurgence of the yo-yo in 1998).