Demand and supply are two key concepts necessary for understanding microeconomics. Demand can be defined as the amount of product or service that customers are ready to buy at a set price. In turn, the definition of supply is a stock or amount of something (good or service) that a producer has at their disposal, available for use. Economic agents – buyers and sellers – are brought together by the market where they negotiate and make choices that shape demand and supply. Their interactions may take a multitude of forms from haggling face-to-face on the market place to making online purchases from across the globe, without ever meeting in person.
The Ceteris Paribus Assumption
When analyzing the relationship between the demand and supply curve, only two variables are considered: quantity on the horizontal and price on the vertical axis. The basic laws of supply and demand hold true only under the so-called ceteris paribus assumption. The term comes from a Latin phrase meaning “other things being equal” or “else is unchanged.” This implies that the product’s or service’s price is the only economic factor that is changing, while all others are kept constant. The assumption helps one study the effects of one economic variable separately from all other potentially contributing factors.
Demand and Supply Relationship Variations
Basic Laws of Supply and Demand
The relationship between supply and demand determines the price of a good or a product. Below are the illustrations of the basic laws of supply and demand with real-life examples:
- If demand increases and supply remains constant, it results in higher equilibrium price and higher quantity. However, if demand decreases, one expects lower equilibrium price and lower quantity (see Image 1 for illustration). An example would be a drop in interest in Halloween costumes after the 31st of October. These products will likely to be sold in smaller volumes and at a lower price due to the decreased demand.
- If supply increases and demand remains constant, it results in a lower equilibrium price and higher quantity. However, in the event of a decrease in supply, one may expect a higher equilibrium price and lower quantity (see Image 1 for illustration). For example, at the start of the Covid-19 pandemic, customers rushed to buy more masks and disinfectants, but the producers did not boost the supply yet. As a result, these products were sold at a higher price than usual and were difficult to find at local drugstores.
Factors Affecting Demand
A shift in demand means a positive or negative change in the demanded quantity if the price stays the same. Income is one of the key factors that affect a person’s willingness to purchase a product or a service. With growing income, a person enjoys better purchasing power and can afford more goods that used to be out of reach at an earlier stage of life. If it is the country’s average income that is rising, industries may notice significant demand shifts to the right even if the prices stay constant (see Image 3). For example, a nation with a booming economy may have more people buying mid-range cars for the first time. In Image 1, the demand for such cars shifts from position D to D, the price (vertical axis) stays the same, and the quantity (horizontal axis) grows. Based on customers’ behavior regarding changes in income, Browning and Zupan (2020) identify two categories of goods: normal and inferior. A normal good is more on-demand in the event of rising income – it could be fine jewelry, expensive trips, and private property. Conversely, an inferior good drops in demand when a person upgrades financially. For instance, someone who can afford to buy a new car will no longer be interested in used car options.
Surely, income is not the only contributing factor that can shift demand. Browning and Zupan (2020) point out demographic trends that may lead to an increase or decrease in the number of willing customers. An example is Millennials buying much fewer diamond rings than Baby Boomers (Martin, 2017). The younger generation approaches money and marriage differently, which drives the sales down. They also marry less or later in life, which does not affect diamond ring sales numbers positively either. Another factor is the price of complements – goods or services purchased together so that the trends in their consumption affect each other. Brand (2019) reports that in 2018 alone, car sales volumes in Shanghai, one of the strongest Chinese economic hubs, dropped by almost 30%. When investigating the roots of this phenomenon, carmakers discovered that cars were complementary to houses. Since the Chinese housing market was doing terrible, customers were giving up on buying new vehicles as well.
Factors Affecting Supply
A shift in the supply means demonstrates the changes in quantity supply depending on the prices, assuming ceteris paribus. When analyzing the factors that affect supply, it is important to understand the main motivation of companies. First and foremost, they are interested in profit, or, in other words, increasing the margin between revenues and costs. Labor, materials, and machinery go into production, and each factor generates expenses. If a company finds a way to drive the costs down, for example, by outsourcing labor overseas, but the price remains unchanged, it will enjoy higher profits. For example, in the US, the average minimum wage is $7.25 per hour, though this figure varies depending on the state. A retailer like H&M can contract factories in Bangladesh and pay their workers $0.49 an hour, saving millions of dollars (Spellings, 2018).
The opposite is also true: if the costs of production rise for whatever reason, the company might have to increase prices to break even or profit (see Image 4 for illustration). An example would be a private medical clinic that imports raw materials from abroad and pays in foreign currency. As the national currency rate drops in relation to the foreign currency rate, the clinic faces higher production costs. To avoid a budget deficit, it decides to increase prices for medical services. This is something that is taking place in many developing countries such as Brazil, Mexico, and Russia during the Covid-19 pandemic as their currencies become volatile and devalue.
Brand, R. (2019). Why are the Chinese buying fewer cars? BBC News. Web.
Browning, E. K., & Zupan, M. A. (2020). Microeconomics: Theory and applications. John Wiley & Sons.
Martin, E. (2017). 3 reasons millennial couples are ditching diamonds. CNBC. Web.
Spellings, S. (2018). H&M still isn’t paying workers a living wage. The Cut. Web.