Supply And Demand Compared

Definition

Supply and demand compared is a fundamental economic principle that refers to the relationship between the availability of a product or service and the desire for it, first described by Adam Smith in 1776.

How It Works

The law of supply and demand dictates that as the price of a product increases, the quantity supplied also increases, while the quantity demanded decreases. This is because higher prices make production more profitable for suppliers, encouraging them to produce more, while consumers are less willing to buy at higher prices. Ricardo's comparative advantage model, 1817, further explains how countries can benefit from trade by specializing in the production of goods for which they have a lower opportunity cost. For instance, Boeing produces ~800 aircraft annually (Boeing annual report), and the company's production levels are influenced by the demand for air travel, which is affected by factors such as global economic conditions and fuel prices.

The supply and demand relationship is also influenced by external factors, such as government policies and technological advancements. For example, the implementation of tariffs on imported goods can increase the price of those goods and reduce demand, while also encouraging domestic production and increasing supply. The law of diminishing marginal utility also affects the demand curve, as consumers tend to derive less satisfaction from each additional unit of a product they consume. According to Alfred Marshall's supply and demand model, 1890, the equilibrium price and quantity of a product are determined by the intersection of the supply and demand curves.

The supply and demand compared principle is also applicable to labor markets, where the supply of labor is influenced by factors such as wage rates, working conditions, and education levels. The labor market equilibrium is reached when the supply of labor equals the demand for labor, and any deviation from this equilibrium can lead to unemployment or labor shortages. For example, the introduction of minimum wage laws can increase the supply of labor, as higher wages attract more workers, but can also reduce the demand for labor, as employers may be less willing to hire workers at higher wages.

Key Components

• Price elasticity of demand: measures how responsive the quantity demanded is to changes in price, with a higher elasticity indicating a greater response. An increase in price elasticity of demand can lead to a decrease in revenue for suppliers.
• Supply chain: refers to the network of organizations and activities involved in the production and distribution of a product, with disruptions to the supply chain potentially leading to changes in supply and demand.
• Substitutes: are products that can satisfy the same needs as a particular product, and an increase in the price of a product can lead to an increase in demand for its substitutes.
• Complementary goods: are products that are used together, and a decrease in the price of one product can lead to an increase in demand for its complementary goods.
• Government policies: such as taxes, subsidies, and regulations, can influence the supply and demand relationship by affecting the cost of production, the price of goods, and the availability of information.
• Market structure: refers to the characteristics of a market, such as the number of buyers and sellers, and the level of competition, which can influence the supply and demand relationship.

Common Misconceptions

Myth: The law of supply and demand is only applicable to free market economies — Fact: The principle of supply and demand is a fundamental economic concept that applies to all economies, regardless of the level of government intervention or market structure. The Soviet Union, for example, experienced shortages and surpluses due to the misallocation of resources, despite its planned economy.

Myth: The supply and demand curve is always linear — Fact: The supply and demand curve can be non-linear, with the shape of the curve influenced by factors such as the price elasticity of demand and the income effect. For instance, the demand curve for a luxury good may be more elastic than the demand curve for a necessity.

Myth: The equilibrium price and quantity are always stable — Fact: The equilibrium price and quantity can be unstable, with changes in external factors such as technology, consumer preferences, or government policies leading to shifts in the supply and demand curves. The cobweb model, for example, describes how supply and demand can oscillate over time due to delays in adjusting production levels.

In Practice

The supply and demand compared principle can be observed in the global market for oil, where the price of oil is influenced by the supply of oil from producers such as Saudi Arabia and the demand for oil from consumers such as the United States. According to the US Energy Information Administration, the global demand for oil was approximately 100 million barrels per day in 2020, while the global supply of oil was around 99 million barrels per day. The difference between supply and demand can lead to fluctuations in the price of oil, with a surplus of oil leading to lower prices and a shortage of oil leading to higher prices. In 2020, the COVID-19 pandemic led to a decrease in demand for oil, resulting in a surplus of oil and a decrease in the price of oil to around $40 per barrel (US Energy Information Administration).