Supply and Demand Analysis- How much does it really explain

Introduction

Supply and demand are fundamental concepts in economics that describe the relationship between the availability of a product (supply) and the desire for that product (demand) with the implication that relationship plays a crucial role in determining the price of goods and services in a market economy.

The Laws of Demand and Supply

The law of demand states that, all else being equal, as the price of a good or service decreases, the quantity demanded increases, and vice versa. This inverse relationship is driven by the substitution effect (consumers switch to cheaper alternatives) and the income effect (consumers feel richer and buy more when prices drop). Correspondingly

The law of supply states that, all else being equal, as the price of a good or service increases, the quantity supplied increases, and vice versa. This direct relationship occurs because higher prices provide an incentive for producers to supply more of a good or service

Factors Affecting Demand and their relative importance (in parentheses)

Recent empirical work into the determinants of  demand patterns suggests

• Price of the Good: Higher prices typically reduce demand, while lower prices increase it. (Estimated at 35% impotence)
• Income Levels: Higher income generally increases demand for goods and services.(25%)
• Preferences and Tastes: Changes in consumer preferences can shift demand.(20%)
• Prices of Related Goods: The demand for a good can be affected by the price of substitutes and complements.(15%)
• Expectations: Future expectations of prices and income can influence current demand.(5%)

In other words, only 35% of purchases are based exclusively on price and 60% on price relative to income

Factors Affecting Supply:

• Production Costs: Higher costs reduce supply, while lower costs increase it.(40%)
• Technology: Advances in technology can increase supply by making production more efficient. (25%)
• Number of Sellers: More sellers in the market increase the total supply.(15%zero
• Prices of Related Goods: The supply of a good can be influenced by the prices of other goods that producers could make instead. (10%)
• Expectations: Future expectations of prices can affect current supply.(10%)

Market Equilibrium

Somehow within this complexity of various factors impacting on demand and supply a unification is to occur and market equilibrium is achieved where the quantity demanded equals the quantity supplied. At this point, the market price stabilizes, and there is no tendency for it to change unless there is a shift in supply or demand.

The process behind this referred to as the invisible hand which implies that, in the absence of Government interference and imperfect competition, the market under the combined pressures of supply and demand will move towards stability and determine the market clearing price. All of this driven by the price/quantity calculus. Any deviations from this will cause market disequilibrium

Standard Market Diagram

Complexity within simplicity

To assume that the intersection of two lines  can fully represent the complexity behind the determination of market price and quantity sold  is clearly simplistic, so why does this type of two-dimensional representation continue as a basic pillar of contemporary economics?

Principally this is because  there is no one market diagram, rather a large number specific to differences in product, price, the income of the buyers and the market structure. The familiar two- dimensional diagram is simply a generalisation of many possible markets, that, within their differing parameters  show how price operates in that market for example

• The slopes of the demand and supply schedules is used to represent differing market conditions. The slopes represent price elasticity of both supply and demand
• A steep demand curve represents a price inelastic good (for example an essentials) and in which price is not so important and other things such as taste, preferences, and income take on greater importance.
• In addition, the shape of the demand curve represents market structure, with imperfect markets represented by a steeper demand curve and a competitive market by a flatter average revenue or demand curve.
• Cobweb demand and supply curves allow for delayed response to price shifts by in either demand and supply, such as the case where agricultural products take time to produce and do not respond immediately to demand shift

Cobweb model allows for delayed response

Using statistics to formalise the complexity

To represent this complexity economists often use estimating or regression equations where many potential explanatory variables. in addition to price, can be used and their relative importance estimated. For example,

Q_d = a + B₁P + B₂I + B₃ T + e

Were.

• ( Q_d ) is the quantity demanded.
• ( P ) is the price of the good.
• ( I ) is the income of the consumer.
• (a) is the intercept term.
• (Bs) are the coefficients that measure the sensitivity of the quantity demanded to change in the price and income, respectively.
• (e) is the error term, capturing other factors affecting demand.

Estimating this equation allows the relative importance of each factor impacting on demand to be determined . Economists can also add considerably more complexity by using lagged variables for example, Q_d- represents demand lagged one period.

Generalised application

Virtually all economic market conditions may be analysed within the two-dimensional diagram. For example, a monopoly structure is implied by a steep demand and AR curve, excess demand is shown by the gap between market demand and supply at below market price, snob and Veblen goods have a price inelastic demand curve. But it is important to distinguish between the generalised diagram and one drawn to  fit the appropriate environment. The demand/supply diagram, sometimes known as the “Marshallian scissors” is just a generalised adjustment mechanism to view the impact of price changes. The way in which each diagram is drawn, principally the slope of the lines, determines the specifics of the economic problem and suggests potential solutions. It is applicable across all aspects of economics. For example, the interest rate results from the intersection of the supply and demand for money, the real wage rate is determined at the intersection of the demand and supply of labour (by type) and the exchange rate is determined by the intersection of the demand and supply for foreign currency.

So, students, remember that the supply and demand market diagram is just a generalised form to examine potential interaction between supply and demand  to price changes. To turn this into a predictive model, appropriate  specific circumstances you need to draw a situation- specific diagram with correctly sloped demand and supply curves.

Supporting video

https://bizfluent.com/how-8726231-calculate-function-using-regression-analysis.htm