Demand and Supply

Why does a good cost what it costs? The answer lies in two forces present in every market: demand (how much buyers want) and supply (how much sellers offer). Where these two meet, the price is set. Demand and supply are the heart of economics. Once you understand them, you can explain almost any price in the marketplace.

Demand is the quantity of a good that buyers are willing and able to buy at a given price. The law of demand states that, other things being equal:

the lower the price, the more people buy; the higher the price, the less they buy.

This gives a downward-sloping demand curve. It makes intuitive sense: when something gets cheaper, we buy more of it. We also switch to alternatives when it gets dearer. Demand also shifts with income, tastes and the prices of related goods.

Price moves a buyer along the demand curve. Other factors shift the whole curve. The direction of each shift is precise and testable:

• Substitutes: goods that replace each other, like tea and coffee. When the price of a substitute rises, demand for the good increases, because buyers switch over to it.
• Complements: goods used together, like cars and petrol. When the price of a complement rises, demand for the good decreases, because the pair becomes costlier to use as a whole.
• Normal goods: demand rises when consumer income rises. Most goods behave this way.
• Inferior goods: demand falls when consumer income rises. Buyers move up to better options, so coarse grain gives way to fine rice, for example.
• Tastes and expectations: a fashion for a good, or the expectation that its price will rise soon, raises current demand.

So a rise in income increases market demand only for normal goods, not inferior ones. And a price rise in a complement cuts demand, while a price rise in a substitute raises it. Keep the two pairs distinct.

Behind every demand curve sits a consumer making choices. A consumer is in consumer equilibrium when they maximise the satisfaction (utility) of their wants within their given income. Income acts as a budget constraint: the consumer spreads spending across goods until no reshuffle of the same money could yield more satisfaction. This is distinct from market equilibrium, which concerns the whole market, not one buyer.

Supply is the quantity of a good that sellers are willing to offer at a given price. The law of supply states that, other things being equal:

the higher the price, the more sellers offer; the lower the price, the less they offer.

This gives an upward-sloping supply curve. Higher prices make production more profitable, so firms produce and sell more.

Demand pulls one way and supply the other. The market settles at the equilibrium price, the price at which the quantity demanded exactly equals the quantity supplied. There is no shortage and no surplus.

If the price is too high, supply exceeds demand. This creates a surplus and pushes the price down. If the price is too low, demand exceeds supply. This creates a shortage and pushes the price up. In this way the market, through the "invisible hand", automatically moves towards equilibrium.

How strongly does demand respond to a change in price? That is measured by elasticity.

• Demand is elastic if a small price change causes a large change in quantity (e.g. luxuries, goods with many substitutes).
• Demand is inelastic if quantity barely changes when price changes (e.g. necessities like salt or medicine).

Elasticity matters greatly in real life. It tells businesses how a price change will affect their sales. It also tells governments how a tax will affect demand.

Demand and supply set the price, but how freely they do so depends on how the market is organised. Not all markets work the same way. A vegetable market with hundreds of sellers behaves very differently from a town with a single electricity supplier. Market structures describe this organisation: how many sellers there are, how similar their products are, and how much power any one of them has over price. The structure shapes prices, choice and competition.

Perfect competition is the ideal of a fully competitive market. It has:

• Many buyers and many sellers: each is tiny compared with the whole market.
• An identical (homogeneous) product: every seller offers the same good.
• Easy entry and exit: firms can join or leave freely, and everyone is well informed.

Because each seller is tiny compared with the whole market, no single seller can influence the price. They are all price-takers who must accept the market price. A village vegetable market comes close to this ideal.

At the opposite extreme is monopoly, where there is a single seller of a product with no close substitutes.

A monopolist has great market power. Facing no direct competition, the firm can set the price, making it a price-maker. It usually charges more and produces less than a competitive market would. Monopolies may arise from control of a resource, a patent, or a government grant. They can exploit consumers, so they are often regulated.

Most real markets lie between these extremes:

• Monopolistic competition: many sellers offer slightly different (differentiated) products, such as restaurants, toothpaste brands or clothing. Each seller has a little price-setting power through branding, but still faces strong competition from rivals.
• Oligopoly: a few large firms dominate the market, such as telecom or car companies. Each firm's decisions affect the others, so they watch one another closely, sometimes competing fiercely and sometimes colluding.

Knowing which structure a market has helps explain its prices, advertising and degree of consumer choice.