Economic Principles: Demand, Supply, and Market Dynamics
Understanding Demand in Economics
Demand is an economic principle that describes a consumer’s desire, willingness, and ability to pay for a specific good or service. An increase in demand means an increase in quantity demanded at every given price and an increase in consumer willingness to pay at each given quantity. A decrease in demand means a decrease in quantity demanded at every given price and a decrease in consumer willingness to pay at each given quantity.
Factors Affecting Demand
- Change in Price
- Change in Income
- Normal Necessities
- Luxuries
- Inferior Goods
- Competition
- Market Expectations
- Alternative Goods
- Complementary Goods
Demand Curves
Demand curves show the relationship between the price of an item and the quantity demanded over a period of time. There are two reasons why more is demanded when the price falls:
- Income Effect – Consumers can maintain the same consumption for less, and the resulting income can be used to buy more of the product.
- Substitution Effect – The product is cheaper than alternatives, and consumers switch their spending to this product due to it being cheaper.
Market Failure
Market failure occurs when freely functioning markets fail due to inefficient and ineffective allocation of resources. There is a loss of social and economic welfare when market failure occurs. Generally, the government will intervene to ensure that the market can become competitive again. Negative and positive externalities drive market failure and levels of government intervention.
Government Intervention in Markets
How does the government intervene?
- Taxation – To redistribute and provide incentive or disincentive effects.
- Subsidies – To encourage production or consumption (known as negative taxes).
- Regulation – Codes of market practice, legislation, and industry bodies.
- Identifying Property Rights – Intellectual property, granting copyrights/patents.
- Direct provision of goods – Merit goods provided directly by the government.
Government Regulation
Markets are regulated and deregulated by the Office for Fair Trading, which refers specific cases to the Competition Commission or the Advertising Standards Agency, depending on the issue.
Demand Elasticity
Demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables, such as prices and consumer income. Demand elasticity is calculated by taking the percent change in the quantity of a good demanded and dividing it by a percent change in another economic variable. A higher demand elasticity for a particular economic variable means that consumers are more responsive to changes in this variable, such as price or income.
Demand elasticity measures a change in demand for a good when another economic factor changes. Demand elasticity helps firms model the potential change in demand due to changes in the price of the good, the effect of changes in prices of other goods, and many other important market factors. A grasp of demand elasticity guides firms toward more optimal competitive behavior and allows them to make more precise forecasts of their production needs. If the demand for a particular good is more elastic in response to changes in other factors, companies must be more cautious with raising prices for their goods.
Types of Elasticity of Demand
One common type of demand elasticity is the price elasticity of demand, which is calculated by dividing the percent change in quantity demanded of a good by the percent change in its price. Firms collect data on price changes and how consumers respond to such changes and later calibrate their prices accordingly to maximize their profits. Another type of demand elasticity is cross-elasticity of demand, which is calculated by taking the percent change in quantity demanded for a good and dividing it by the percent change of the price for another good. This type of elasticity indicates how demand for a good reacts to price changes of other goods.
Price Elasticity of Demand
Price elasticity of demand is a measure of the relationship between a change in the quantity demanded of a particular good and a change in its price. Price elasticity of demand is a term in economics often used when discussing price sensitivity. The formula for calculating price elasticity of demand is:
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
Supply in Economics
Supply is a fundamental economic concept that describes the total amount of a specific good or service that is available to consumers. Supply can relate to the amount available at a specific price or the amount available across a range of prices if displayed on a graph.
The Law of Supply
The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a good or service increases, the quantity of goods or services that suppliers offer will increase, and vice versa. The law of supply says that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the quantity offered for sale.