4min read
Published on: Jun 3, 2024
#Financial Markets
High demand and low supply boost prices, and excess supply and low demand push prices into decline. The age-old law of supply and demand is distorted by several real-world factors.
If you’ve ever planned your monthly budget, you have already practised microeconomics, including the law of supply and demand. Though the concept can be tricky, understanding it is essential for all who seek to deal successfully with the market, whether buying or selling.
To introduce the principle in a few words, high demand and supply shortages boost prices, and excess supply, combined with low demand, pushes prices into decline. At market equilibrium, which is the point at which the two forces meet, the two forces stabilise the price.
This fundamental economic concept dates back to 1796 and was put forward in Sir James Steuart’s monumental book, ‘An Inquiry Into the Principles of Political Economy’. Below, we will explain the law of supply and demand in today’s economy and give real-world examples of how the principle works.
The law of demand says that as prices go up, demand usually falls. This negative relationship is because buyers are limited by their resources; when the price is high, buyers also can buy less, so the demand would lower.
On the other hand, affordable prices spur demand. Therefore, demand curves mostly slope downward from left to right. This is also influenced by the income effect, which causes demand to change based on how the prices of products relate to the income of consumers.
There are exceptions: daily goods, for example. These are usually cheap commodities that, ironically, are in demand as their prices go up, and this is because they become a substitute for pricier choices. This fact emphasises the complicated interplay between price and perception, an idea most clearly demonstrated by Thorstein Veblen's concept of “conspicuous consumption.”
On the flip side, the law of supply suggests a direct correlation between price and the quantity of goods suppliers are willing to offer—demand shifts to the right at higher prices while it shifts to the left at lower prices.
On the other hand, decreasing prices diminish profits, causing supply contraction. Thus, supply curves rise from left to right. The price elasticity of supply is limited by several factors, with sudden supply shocks leading to critical goods being disproportionately overpriced.
Essentially, a transaction happens when a price matches supply with demand, a concept observed in markets for thousands of years.
Image: Supply and demand, by EconomicsOnline
Ancient scholars disagreed with the idea of a “just” price that covers the costs and gives a fair return through the actual market price. The concept of price as the signal that equilibrates supply and demand resulted from the understanding of the economists of the “Age of Enlightenment.”
It is also important to recognise that supply and demand respond differently to price changes. Price elasticity means that products with high elasticity experience massive demand changes with changes in prices. On the other hand, basics tend to have low elasticity; their demand is more constant even while prices change.
The price discovery concept involves supply and demand curves being drawn for a theoretically free market, where the buyers and sellers act independently, with only the price influencing them. These curves or their elasticities are modified by external influences such as taxes, government regulations, market potential, availability of alternatives, and economic trends. However, as long as market players are free to choose, these basic market forces continue.
The clean equations of supply and demand rarely correspond to the messy realities of actual economic life. Determining the exact equilibrium price (Pe) and quantity (Qe) is a theoretical calculation that does not consider the individual differences in what buyers are willing to pay and sellers are willing to accept.
Plus, the pure supply and demand model is distorted by several real-world factors that complicate economic interactions.
In contrast to the perfect competition ideals adopted in elementary supply and demand models, fundamental markets are often characterised by the dominant producers that control prices massively.
This is especially true in products with inelastic demand, which means they are necessary irrespective of the cost, such as oil, medication, or even cigarettes.
In such markets, a monopoly can significantly increase prices, realising that people cannot do without such goods even if they cost more. Though this situation increases profits for monopolists, its nature is exploitative and illegal.
Governments sometimes set price floors to keep market prices from falling to a level that will make the producers suffer financially. Minimum prices, such as those established for agro products such as tomatoes, guarantee the farmers their revenue. If no such interventions are made, the equilibrium price will go so low that it will cause economic ruin for those in the farming sector.
Similar to price floors, subsidies are a kind of financial help to producers. Referring to the tomato market again, subsidies may help to eliminate a particular share of production costs, relieving the economic burden on the farmers. This assistance is designed so that the farmers are financially sustainable even if the market price of their product falls much lower.
Taxes are another government instrument often used to affect market outcomes, commonly to raise public funds to finance infrastructure or other government projects. Such taxes cause the market price to exceed the price set by free market forces, transferring the extra cost burden to consumers but not sellers, as additional revenue would go to government funds.
These examples show that although supply and demand provide an essential structure for comprehending economic principles, the actual situation is affected by the interventions that try to balance market outcomes with social and economic policy goals.
Economic data, interest rates, and corporate results greatly influence the relationship between supply and demand in stock prices.
Image: Supply and demand impact on the stock market
The stock demand increases when the economy acts positively because the investors expect better earnings. On the contrary, higher interest rates decline stock demand as safer investments offer better returns. However, economic development can counter this impact, which raises the demand for stocks.
Corporate earnings are another key influencer, as variations in profit, sales, margins, and future projections can lead to stock volatility, especially when companies report their quarterly or annual results. While stock demand changes may occur swiftly due to these forces, stock supply is relatively inert, only changed by stock buybacks or delisting events. Buybacks shrink the library of shares available, with stock prices probably increasing if demand holds, whereas delisting occurs mainly when the companies go bankrupt or private.
Essentially, stock supply adjusts slowly, while demand can spike suddenly due to economic announcements, central bank actions, and company earnings. Key spikes also include the timing of earnings reports and forecasts.
In short, supply and demand are essential to know in our day-to-day life.
Both dynamics have a subtle yet definitive influence on a daily basis. These laws operate either to catch the trends in consumer products, with the shift of prices or inflation.
Explore the current supply and demand dynamics before spending too much on a new car or the latest gadget – you will thank us later.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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