The Law of Supply and Demand

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A market is an environment where buyers and sellers interact to exchange goods, the price for which are determined by both the supply and demand for them. ‘A market uses prices to reconcile decisions about consumption and production’.¹ The supply/demand model helps to explain how the market works and gives a greater understanding of actual market behaviour. Therefore, analysis of this concept can be used to develop economic and business decisions and policies. The purpose of this assignment is to outline the basic elements of the model and discuss its usefulness in understanding actual behaviour in the market place.

The supply of goods and resources are limited in comparison to peoples requirements, and individuals must make decisions based on what goods to buy or produce and what goods to forgo. Because of this scarcity of resources, individuals, businesses and governments must make decisions on how to allocate them most efficiently. The market mechanism resolves the problem of allocation by adjusting prices to coincide with demand and scarcity. Market prices continuously adjust to equate quantity demanded with quantity supplied. This forms the basis of the supply/demand model which also analyses the reaction of suppliers and customers and makes predictions about how they will react to changes in the market. The predictions are then applied to the actual market. The model is beneficial as an aid to making economic decisions because the concept assumes the effects of various changes in theory, which can be applied in practice to the actual business world. Elements of the theory are used annually in our budget, for example, in the pricing of inelastic products such as cigarettes, diesel, petrol etc. These are necessities and, as per the theory, a price rise has little or no effect on demand for these inelastic products.

The law of supply demonstrates the quantities that will be sold at a certain price. It makes assumptions about how suppliers will respond to changes in price and other influences in a competitive market and can be depicted in diagramatic form for further clarification. The relationship between price and quantity supplied is shown by an upward slope. This means that the higher the price obtained in the market the higher the quantity producers will supply and the higher their profits will be. This part of the model could be seen over the past number of years in the housing market, where the ability to get higher prices for houses encouraged builders to increase supply.

The model also states that apart from price, there are other determinants of quantity supplied and when these change, the supply curve itself will shift to the right or left meaning that at each price a different quantity will be supplied. Advancement in technology has resulted in an increase in production due to more efficient methods of production, and the supplier can get a greater output from the same or a similar input. In addition, lower input prices encourage firms to supply more. One can see how this concept can be related to actual market behaviour in the aviation industry, which is a prime example of a shifting supply curve. In times of increasing demand, during the booming economy, the supply curve for flights shifted to the right showing increased supply. Currently however, with increasing input costs such as oil prices and decreasing demand, the supply curve has now shifted in the opposite direction. Application of the theory together with examining past facts can aid businesses and indeed governments in economic decision making.

‘The elasticity of supply measures the responsiveness of quantity supplied to the price the suppliers receive’.² Two major factors in the elasticity of supply are: (a) time element and (b) elasticities of supply of the inputs. Suppliers cannot always react quickly to a change in price in the short run. Also, if inputs in the production of the commodity are elastic...
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