Study tips: Understanding supply and demand curves (advanced level)

The concept of supply and demand explains interactions between suppliers and consumers in a market.  For example, why do sellers continually adjust their pricing to remain competitive? 

If you are unsure of the answer, then read the first article in this series on supply and demand before continuing.

In the previous article, I wrote about my experience of looking for a new mobile phone.  Price was a major consideration but it is a very competitive market with lots of sellers and buyers, a huge variety of products, with a range of features, and lots of information available about each.  These all have an impact on the level of competition in the market and, consequently supply and demand.  That said, price is probably the most influential factor. 

When I first looked, the price of the handset I wanted was high.  When prices go up then, then demand for them is likely to contract.  When I looked again, prices had fallen so the expectation was that demand would expand.

The law of demand

This is called the law of demand and can be seen on a demand curve, which always slopes downwards and bizarrely is usually shown as a straight line not a curve!

If prices fell from £400 to £200 then demand would expand along the demand curve from 3 million to 6 million.

However, if prices then increased to £300 demand would contract back along the curve to 4 million.

The law of supply

The law of demand works in conjunction with the law of supply, which states that, as prices increase, quantities will increase and vice versa.  New suppliers will come into the market if they can see potential profit, and existing suppliers will want to maximise their profits by producing more goods. They can do this most effectively when demand for goods and services is high and consumers are willing to pay high prices. 

In this example for a different handset, if prices are able to increase from £100 to £200 then supply will expand along the supply curve from 20 to 40 thousand.  If prices drop, because consumers won’t pay the higher price, the supply will contract, as companies stop selling the product, perhaps withdrawing from the market, because they cannot cover their costs. That will be seen as a move back along the curve.

The supply curve relates to suppliers deciding to increase their output or to enter into new markets with high levels of demand, as long as there aren’t excessive barriers to entry.

The result of this though, will eventually be that supply outstrips demand, resulting in surpluses.  Then suppliers are forced to drop their prices in order to generate sales, although if demand then overtakes supply, shortages can occur.  This is because buyers want prices to be as low as possible and sellers want them to be as high as possible. 

Equilibrium

So, the market has to find a balance or equilibrium, in other words, a price that both consumers and suppliers are happy with.  This is the point at which demand and supply curves intersect. 

The price mechanism

The increasing and decreasing of prices caused by the laws of supply and demand, is known as the price mechanism.  It reflects the shifts along the supply and demand curves to constantly try and maintain an equilibrium price; where supply equals demand.

The price mechanism is not the only factor that determines prices, they are affected by the type of goods being sold, whether they are a necessity or luxury, can be substituted for a similar product or compliment another, as well as market forces.

Recap

Whilst changes in the price mechanism cause shifts along the curves, any other changes caused by market forces, such as consumer preferences or the price of substitute products, actually cause the whole curve to shift.

Impact of market forces

Let’s say that the handset I wanted was favourably reviewed on a prime-time television show and as a result demand for it increased.

On the demand curve below, you can see that the price has remained at £300 but demand has increased from 2 to 5 million because the whole curve has moved to the right.

Equally, if demand falls, due to something other than a price change, the curve will move to the left.

Wholesale shifts of the supply curve happen in a similar way. Decreases in supply, maybe caused by a problem with microchips resulting in a shortage of handsets, will cause the whole curve to shift to the left.

In the example below, you can see that the price hasn’t changed from £100, because consumers won’t pay any more, but supply has decreased from 40 to 20 thousand because suppliers cannot meet demand.

If supplies increase again, for example because changes in technology make the production process more efficient and therefore increase capacity, then the supply curve will shift back to the right.

Summary

The concept of supply and demand is fundamental to the macro-economic environment and it is important to understand how prices are determined by the price mechanism (represented by shifts along the curves due to price changes) and market forces (which cause shifts of the curves) and the impact of the type of goods (normal either necessity or luxury, substitute and complementary).  I’m now waiting for my handset to arrive so need to research a new sim-only deal, which is a good example of a substitute good because texts, calls and data are the same regardless of the supplier!

Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.