- It is the main model of price determination used in economic theory.
- The price of a commodity is determined by the interaction of supply and demand in a market.
- The resulting price is referred to as the equilibrium price and represents an agreement between producers and consumers of the good.
- In equilibrium the quantity of a good supplied by producers equals the quantity demanded by consumers.
Relationship of price to supply (S) and demand (D)
- The quantity of a commodity demanded depends on the price of that commodity and potentially on many other factors, such as the prices of other commodities, the incomes and preferences of consumers, and seasonal effects.
- In basic economic analysis, all factors except the price of the commodity are often held constant; the analysis then involves examining the relationship between various price levels and the maximum quantity that would potentially be purchased by consumers at each of those prices.
- The price-quantity combinations may be plotted on a curve, known as a demand curve, with price represented on the vertical axis and quantity represented on the horizontal axis.
- A demand curve is almost always downward-sloping, reflecting the willingness of consumers to purchase more of the commodity at lower price levels.
- Any change in non-price factors would cause a shift in the demand curve, whereas changes in the price of the commodity can be traced along a fixed demand curve.
Increase in equilibrium price (p) and equilibrium quantity (q)
- The quantity of a commodity that is supplied in the market depends not only on the price obtain for the commodity but also on potentially many other factors, such as the prices of substitute products, the production technology, and the availability and cost of labour and other factors of production.
- In basic economic analysis, analyzing supply involves looking at the relationship between various prices and the quantity potentially offered by producers at each price, again holding constant all other factors that could influence the price.
- Those price-quantity combinations may be plotted on a curve, known as a supply curve, with price represented on the vertical axis and quantity represented on the horizontal axis.
- A supply curve is usually upward-sloping, reflecting the willingness of producers to sell more of the commodity they produce in a market with higher prices.
- Any change in non-price factors would cause a shift in the supply curve, whereas changes in the price of the commodity can be traced along a fixed supply curve.
Increase in equilibrium price (p) and a decrease in equilibrium quantity
- It is the function of a market to equate demand and supply through the price mechanism.
- If buyers wish to purchase more of a good than is available at the prevailing price, they will tend to bid the price up. If they wish to purchase less than that is available at the prevailing price, suppliers will bid prices down.Thus, there is a tendency to move toward the equilibrium price. That tendency is known as the market mechanism, and the resulting balance between supply and demand is called “market equilibrium”.
- As the price rises, the quantity offered usually increases, and the willingness of consumers to buy a good normally declines, but those changes are not necessarily proportional.
- The measure of the responsiveness of supply and demand to changes in price is called the price elasticity of supply or demand, calculated as the ratio of the percentage change in quantity supplied or demanded to the percentage change in price.
- Thus, if the price of a commodity decreases by 10 percent and sales of the commodity consequently increase by 20 percent, then the price elasticity of demand for that commodity is said to be 2.
- The demand for products that have readily available substitutes is likely to be elastic, which means that it will be more responsive to changes in the price of the product. That is because consumers can easily replace the good with another if its price rises. The demand for a product may be inelastic if there are no close substitutes and if expenditures on the product constitute only a small part of the consumer’s income. Firms faced with relatively inelastic demands for their products may increase their total revenue by raising prices; those facing elastic demands cannot.
- Supply-and-demand analysis may be applied to markets for final goods and services or to markets for labour, capital, and other factors of production. It can be applied at the level of the firm or the industry or at the aggregate level for the entire economy.