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General Awareness > Economics and Governance > Theory of Demand and Supply
Economics and Governance

Theory of Demand and Supply

The Theory of Demand and Supply is a central concept in the understanding of the Economic system and its function. The quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at a particular price. In the following section, we will see how the concept of supply and demand are related to each other and how they affect each other. Let us begin!

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Theory of Demand and Supply

We know that a market is an arrangement that enables buyers and sellers to get information and do business with each other. A competitive market is a market that has many buyers and many sellers so no single buyer or seller can influence the price. The money price of a good is the amount of money needed to buy it. The relative price of a good—the ratio of its money price to the money price of the next best alternative good—is its opportunity cost.

Theory of Demand and Supply

                                                                                                                                            Source: Youtube.com

The market is governed by the law of demand. First, let us define what we mean by demand in terms of the market:

Demand for commodity implies (i) the desire to acquire it, (ii) willingness to pay for it, (iii) ability to pay for it. The Law of demand states that:

The relationship between Price and quantity demanded is an economic law. The quantity of a good demanded per period relates inversely to its price, other things constant.

The law of demand results from (i) Substitution effect, (ii) Income effect.

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Substitution Effect

When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded of the good or service decreases.

Income Effect

When the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded of the good or service decreases.

Demand Curve and Demand Schedule

The term demand refers to the entire relationship between the price of the good and quantity demanded of the good.

A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.

An exception to Law of Demand: Giffen Goods

A Giffen good is one which people paradoxically consume more of as the price rises, violating the law of demand. For example, during the Irish Potato Famine of the 19th century, potatoes were considered a Giffen good. Potatoes were the largest staple in the Irish diet, so as the price rose it had a large impact on income.

People responded by cutting out on luxury goods such as meat and vegetables, and instead bought more potatoes. Therefore, as the price of potatoes increased, so did the demand.

Demand Schedule and Demand Curve

The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded.

The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

Types Of Demand

Individual Demand

The quantity of a commodity an individual is willing and able to purchase at a particular price, during a specific time period, given his/her money income, his/her taste, and prices of other commodities, such as substitutes and complements, is referred to as the individual demand for the commodity.

Market Demand

The total quantity which all the consumers of the commodity are willing and able to purchase at a given price per time unit, given their money incomes, their tastes, and prices of other commodities, is referred to as the market demand for the commodity.

Autonomous Demand

An autonomous demand or direct demand for a commodity is one that arises on its own out of a natural desire to consume or possess a commodity. This type of demand is independent of the demand for other commodities.

Durable Demand

Durable goods are those goods for which the total utility or usefulness is not exhaustible in the short-run use. Such goods can be used repeatedly over a period of time.

Non-Durable Demand

The demand for non-durable goods depends largely on their current prices, consumers’ income, and fashion. It is also subject to frequent changes.

Short-Term and Long-Term Demand

Short-term demand refers to the demand for goods over a short period.

The long-term demand refers to the demand which exists over a long period of time.

Factors Influencing Demand

Following are the main factors that influence the demand of an object:

  • Price of good or service (P)
  • Incomes of consumers (M)
  • Prices of related goods & services (PR)
  • Taste patterns of the consumer (T)
  • Expected future price of the product (Pe)
  • Number of consumers in a market (N)

Market Demand

Market demand is the sum of all individual demands at each possible price. Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

Supply

If a firm supplies a good or service, then the firm:

1. Has the resources and the technology to produce it,

2. Can profit from producing it, and

3. Has made a definite plan to produce and sell it.

Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce. The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price.

The Law of Supply

The law of supply states:

Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.

The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases. Producers are willing to supply a good only if they can at least cover their marginal cost of production.

Supply Curve and Supply Schedule

The term supply refers to the entire relationship between the quantity supplied and the price of a good. The supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same.

A supply curve is also a minimum-supply-price curve. As the quantity produced increases, marginal cost increases. The lowest price at which someone is willing to sell an additional unit rises.

A Change in Supply

The six main factors that change the supply of a good are:

a. The prices of factors of production
b. The prices of related goods produced
c. Expected future prices
d. The number of suppliers
e. Technology
f. State of nature

Market Equilibrium

Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers.

The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price.

  • The price regulates buying and selling plans.
  • Price adjusts when plans don’t match.

Practice Question

Q 1: If the number of customers in the market increases suddenly, the supply will:

A) Increase                          B) Decrease                 C) Not affected                         D) Depends on the number of customers.

Ans:  C) Not affected

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