Almost every holiday season, the most popular "must have" toy is in short supply. And there's usually a strong secondary market for the item – with parents paying well over the retail price just to make their children happy.
Then, in January, stores reduce the prices of their remaining holiday items – cards, decorations, and so on.
Why do parents – and stores – behave this way?
The answer is in the laws of supply and demand. Together, these laws give us strong clues about what to produce, how much to produce, and how much to charge.
Because supply and demand play such a central role in our economy, it's important to understand how they operate – and how you can use them to ...view middle of the document...
Since price is an obstacle, the higher the price of a product, the less it is demanded. When the price is reduced, demand increases.
So, there is an "inverse" relationship between price and quantity demanded. When you graph the relationship, you get a downward-sloping line, like the one shown in figure 1, below:
To create a market demand curve for gasoline, individual demand is totaled and combined.
The extent to which demand changes with price is known as "price elasticity of demand."
Inelastic products tend to be those that people must have, but they use only a fixed quantity of it. Electricity is an example: if power companies lower the price of electricity, consumers may be happy, but they probably won't use a lot more power in their homes, because they don't need much more than they already use. However, demand for luxury goods, such as restaurant meals, is extremely elastic – consumers quickly choose to stop going to restaurants if prices go up.
Price elasticity also affects supply. Products with an inelastic supply usually have a long lead time, with little control over the quantity produced. Farm crops are one example, because if there's a price change, farmers can't decide halfway through the growing season to produce more or less of a certain crop. On the other hand, products with a high elasticity of supply tend to come from industries that can change their production levels more quickly – for example, oil (although the oil industry may be operating close to full capacity, right now.).
The Law of Supply
While demand explains the consumer side of purchasing decisions, supply relates to the producer's desire to make a profit. A supply schedule shows the amount of product that suppliers are willing and able to produce and make available to the market, at specific price points, during a certain time period. In short, it shows us the quantities that suppliers are willing to offer at various prices.
This happens because suppliers tend to have different costs of production. At a low price, only the most efficient producers can make a profit, so only they produce. At a high price, even high cost producers can make a profit, so everyone produces.
Using our gasoline example, we find that oil companies are willing and able to supply certain amounts of gas at certain prices, as seen below. (Note: we've assumed a simple economy in which gas companies sell directly to consumers.)
Gas Supply per Consumer
Price per liter Quantity (liters)
supplied per week
At a low price of $1.20 per liter, suppliers are willing to provide only 50 liters per consumer per week. If consumers are willing to pay $2.15 per liter, suppliers will provide 120 liters per week. The question is this: what prices are needed to convince producers to offer various quantities of a product or service?
As price rises, the quantity supplied rises as well. As price falls, so does...