Possessing basic knowledge of economic theory is handy, but no one would say it is the most important thing. Especially not when you compare it to learning how to drive or knowing how to balance a household budget. Nevertheless, economics – especially the forces that support it – influence our lives. At the most rudimentary level, economics tries to illustrate how and why people make the purchasing choices they do. Overall, there are four key economic concepts that help explain human decision-making. There is scarcity, costs and benefits, incentives, and supply and demand.
The meaning behind this law
The law of supply and demand is one of the most basic economic laws and is arguably the most recognizable. It is a theory that illustrates the interactions between a resource’s sellers and those who are buying that resource. It also defines the relationship between a product or good’s price and people’s willingness to either buy or sell it. Generally speaking, as the price grows, people are inclined to supply more and demand less. The reverse applies when the price drops.
The theory draws from two separate laws: the law of demand and the law of supply. The two interact in order to pinpoint the market price and volume of goods available on the market.
There is a contradicting relationship between the supply of goods and services and prices when demand remains the same. Take an increase in supply for services and goods while demand remains the same for example. In this case, prices often drop to a lower equilibrium price and a higher equilibrium quantity of goods and services. Now, imagine a decrease in the supply of goods and services while the demand does no change. Here, it is the reverse. The prices will rise to a much higher equilibrium price and a lower quantity of goods and services.
Elasticity of price
An increase in prices usually leads to lesser demand. An increase in demand typically results in an increase in supply. Be that as it may, the supply of various products has a different response to demand. The demand for some products is a lot less price-sensitive than others.
Economists label this brand of sensitivity as “price elasticity” of demand. These are products with prices that are sensitive to demand are seemingly price elastic. Inelastic pricing is indicative of an especially weak price influence on demand. The law of demand still applies here, but pricing is comparatively less forceful and thus, its impact on supply is weaker.
A product’s price inelasticity may be the result of more affordable alternatives being available in the market. Alternatively, it may insinuate that the product is deemed unnecessary by consumers. An increase in prices will decrease demand if consumers can successfully find substitutions. However, it will also have less of an impact on demand when there are no available alternatives. For example, health care services have very few substitutions, and demand continues to be strong even when prices rise.
Let’s approach supply and demand a little differently. Imagine you are someone who is an avid consumer of burgers. Now, what would happen if the prices for burgers went up by $4? You would likely not purchase them as often as before because they would suddenly be out of your price range. If there was an increase in the price of burgers, then the demand for burgers would decrease.
What can you take away from this hypothetical scenario? Well, it is important because it presents the contrasting relationship between price and quantity in demand.
Now, imagine you are on the other side. You are the manager of selling burgers. In this situation, what would you do if you were to boost the quantity? You hope to sell them at a much higher price. This mainly because you want to receive some of the money going into producing the excess. Similarly, if there is a drop in burger prices, the suppliers would end up selling less to preserve their supply.
The relevancy of this scenario lies in the way that it shows the direct relationship between price and supply quantity.
Factors that affect them
Supply is primarily a function of production costs, including:
- Labour and materials, which reflect their opportunity costs of alternate uses to supply consumers with other goods
- Physical technology that is available to blend inputs
- The total number of sellers and their productive capacity during the time frame
- Regulations, taxes, or other institutional production costs
When it comes to demand, the preferences of consumers among various goods are a crucial determinant. The prices – and very existence – of other consumer goods acting as replacements or complementary products can alter demand. Condition changes that impact consumer preferences also hold importance, like seasonal changes or advertising effects. In come modifications are vital in either boosting or shrinking the quantity demanded at a given price.
Impacting the monetary policy
The law of supply and demand affects plenty of abstract things as well, including a nation’s monetary policy. This occurs amid interest rate alterations. Interest rates are the cost of money and are the favourite tool of central banks. They use them as a way to either increase or reduce the money supply.
Lower interest rates mean that more people are borrowing money. This in turn increases the money supply. There is more money in circulation in the economy, which translates to more hiring and an increase in economic activity and spending. Moreover, there is a tailwind for the price of assets.
Raising interest rates results in people taking their money out of the economy and moving it to the bank. Put simply, they are taking advantage of a boost in the risk-free rate of return. Furthermore, it dissuades borrowing, as well as purchases or activities that require financing. This has a tendency to decrease economic activity and negatively impacts asset prices.
The law of supply and demand is also emulated in how differences in money supply can impact asset prices. Slashing interest rates effectively increases the money supply. However, the asset amount in the economy stays the same, yet the demand for these assets grows. This in turn drives prices up. More dollars chase a fixed amount of assets and decreasing the money supply works in a similar fashion. While assets remain fixed, the number of dollars in circulation drops. As a result, there is downward pressure put on prices because there are fewer dollars chasing these assets.
COVID-19 left an impact on markets in a way that is similar to how an outside force would affect them. And that is through supply and demand. In more competitive markets, supply and demand dictate the ways buyers and sellers determine how much of a good or service they should trade. Specifically, in reaction to changes in the price.
The pandemic also triggered external and instantaneous changes to consumer demand. This is both in magnitude and in composition as the preferences change in response to various factors. These include infection risk, lower positive areas in social consumption, and clear-cut government protocols.
R. Maria del Rio-Chanona, Penny Mealy, Anton Pichler, François Lafond, and J. Doyne Farmer wrote a report for the “Oxford Review of Economic Policy.” It focuses on supply and demand shocks during the pandemic. According to it:
“Following social-distancing measures, suppose industry is capable of producing only 70% of its pre-crisis output, e.g. because workers can produce only 70% of the output while working from home. If consumers reduce their demand by 90%, the industry will produce only what will be bought, that is, 10%. If instead consumers reduce their demand by 20%, the industry will not be able to satisfy demand but will produce everything it can, that is, 70%.”
Put simply, the knowledgeable first-order reduction in output from the instantaneous shock will be the larger of the supply and demand shock.