Supply and Demand

The market forces of supply and demand determine price and quantity available across all markets - be it in the housing market, the local Greengrocer's and definitely on the Stock Exchange.

The theory of Demand 

Demand basically refers to how much of a product or service people are willing to buy across the market. It is normally referred to as Effective Demand because of course we would all love a Mercedes SL but won't be able to pay for it. Effective Demand therefore takes into account the 'real' demand for a good - meaning the number of people who can actually pay for the product and of course want to buy it.

For instance, take this basic demand curve below. Although it appears to be straight it is in fact technically called a curve (so don't be pedantic).

This basic curve shows the effect of increasing price from P1 to P2. We can see that as price increases quantity demanded decreases from Q1 to Q2. We could also refer to this as a contraction of demand. This makes sense, given that as price increases we would expect less consumers to buy our product; assuming the product is price elastic.

What causes demand to fluctuate? 

Well obviously income is major factor in the demand for a product; in that generally if income increases people have more cash to spend and so their buying power increases. They can then purchase more goods and services which stimulates the economy. Of course this is only after inflation has been accounted for. If inflation rate is above the rate of increase in your income then your 'real income' actually decreases as the increasing prices of goods counters your rising wages and so buying power decreases :(

However some essentials will be purchased whatever happens - Be it economic hardship or financial stability the demand for oil and bread will never really fluctuate with increased income as they are fairly price inelastic. Oil and bread are two such items that will not show a correlation between income and demand. This is because they're necessities in life and so it is the luxuries such as a new MP3 Player that are compromised over these essential items in times of hardship.

Also fashion trends may increase the demand. When Apple launched the Ipod everyone fell victim to the Ipod Epidemic! regardless of Apple's premium prices demand was high. They were in trend and so people who wanted to make a statement had no choice but to demand the Ipod.

Finally the prices of other goods determine demand for product x:

Complements are goods that are often bought alongside another product. For example buying tomato ketchup to go with chips or buying petrol for your car. Therefore if the price of chips increases the demand for sauce may in theory decrease as people decide to switch from chips to a cheaper alternative.

Substitutes are goods similar to each other. If the price of the Ferrari 430 rises I will have to buy the Lamborghini Gallardo instead (what a shame...) and so therefore demand alters according to the prices of competitors' goods/services.

Of course with commodities where there are no substitutes buyers have no choice so demand isn't affected as much.

If you take one thing away from this article it will probably be this: Increasing Demand for a product generally increases the price. This makes sense. If we all demand gold so much why would the seller sell it off cheap when they know that by increasing price there will still be somebody who will buy it? We must also look at supply for this too. Of course it is a scarce resource and so not everyone can have as much as they want. Hence supply is regulated by increasing price in order to manipulate demand to an extent. Gold is too expensive, I will buy silver instead...

What causes a shift in the demand curve?

Any factor that will increase or decrease the demand besides price will cause a shift to the left (inward shift) or a shift to the right (outward shift). These factors are therefore non-price determinants of demand. The following graph represents an outward shift in the demand curve:

The graph shows that due to an outward shift in the demand curve quantity demanded is greater at any given price. Take for instance a given price, P1. On the original curve (D) the quantity demanded is Q1. However after the outward shift quantity demanded increases to Q2 even though the price is still the same!

To explain this we need to know some factors that cause a shift. They include income, taxation and price of substitutes. So, if income increases it causes an outward shift in the demand curve as we assume that not everyone's wages are the same. This means that providing tax hasn't increased in line with increased wages, real income increases.

 People have more disposable income each month to spend on anything they desire and so this bulks up demand at any price. If low income earners couldn't afford a £200 dress one month and then their income increases the next month, they may suddenly be able to afford that same £200 dress. Even though the price hasn't gone up, more people who had lower wages suddenly create extra demand at the same price. Magic...

Page 2 - Supply  , Page 3 - Equilibrium