The interaction of the market forces of demand and supply help in price determination, thereby arriving at an equilibrium price.
Have you ever wondered why you pay a certain amount for a pair of jeans or a carton of milk? Who or what determines that a particular product should have a particular price? Can any individual decide the price? Or is it determined by the manufacturer of the product? Or is it somehow determined by both? If you studied economics in school, you must be familiar with the terms “demand” and “supply”. Demand and supply to economics are what addition and subtraction are to math—they’re the basics!
Price is a result of the interaction between demand and supply. In simple terms, demand refers to what and how much a consumer wants. Supply refers to how much (quantity) a manufacturer can produce to meet the demands of the consumer. That means neither of the forces of the market (demand or supply) is superior, but their interaction results in the determination of the price of a commodity.
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Are there laws in economics?
Just as physics is governed by a set of laws, so too is economics. When would you be more interested in buying a pair of jeans—when the price is high or when the price is reduced? Obviously, when the price is lower, right? Who wants to pay more when you could get the same commodity at a lower price? This is what the law of demand states: keeping other factors constant, the higher the price of a commodity, the less will be its demand. Price and demand are inversely related to one another.
Now imagine that you’re not the consumer, but rather the manufacturer of a commodity. You’ve gone through the effort of setting up a factory, employing laborers, and paying for the raw materials required to make the product. Now, what do you want in return? Profit! The main aim of suppliers is always the maximization of profit. That means if the price of a product is greater, the supplier would be interested in providing a larger quantity in order to make more profit. This is the law of supply: keeping other factors constant, the higher the price of the commodity, the greater will be the quantity supplied. Here, price and supply are directly proportional.
Price Equilibrium: How do demand and supply interact to settle on one price?
As we all know, there is no single consumer profile and no single type of supplier, which means that we’re dealing with a market. The consumers collectively demand a particular quantity of a commodity and the suppliers then try supplying that given quantity. The price that the consumer is ready to pay and that the supplier is ready to supply is known as the equilibrium price. This is how price is determined. Equilibrium is achieved in the market when quantity demanded equals quantity supplied.
However, theory doesn’t always equate to practicality, does it? It’s not possible to always arrive at a permanent price point right off the bat. The price cannot always remain constant. Haven’t you ever seen a shortage of products or an excessive overstock of products? This is entirely normal.
Change in equilibrium price
When there is a surplus in the market, that means the supply is greater than the demand. The suppliers then lower their price so the consumers are willing to buy a larger quantity. As we have learned with the law of demand, a decrease in price will result in an increase in demand. Similarly, when there is a shortage of a commodity, suppliers can increase their price because they now have an upper hand. This interaction of increase and decrease in the price determines the price of a product once it’s settled. If we talk in terms of graphs, the intersection of the demand and supply curves is the price equilibrium.
Price elasticity of demand and supply
Have you ever played with an elastic band? Some bands are more stretchable than others. The more the band stretches, the more elastic it is. In the same way, the demand for certain commodities is more elastic than others. In other words, the demand can fluctuate more than it can for other items. Substitute goods have more elasticity than goods that have no close substitutes.
For example, glass and steel bottles can be substitute goods, meaning that they can be substituted if the price of one rises. Thus, the demand for these goods is elastic. If the price of glass bottles increases, its demand will fall, as consumers will shift to steel bottles, as these are relatively cheaper.
In the same way, goods that have no close substitutes, like salt, have an inelastic demand. Even if suppliers increase the price, consumers cannot shift to any other product to replace it.
Isn’t it interesting how demand and supply work to arrive at an agreed-upon price point? Although demand and supply are the main determinants of price, there are other factors to consider as well. The price of commodities can also be influenced by government regulations, the level of competition amongst suppliers, natural calamities, and military conflicts. That’s why—when we talk about laws of demand and supply—we say that the ‘other’ factors are assumed to be constant.