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Introduction to supply and demand theories

In an economy the relationship between demand and supply determines the price of a good. Theories relating to understand these relationships are law of demand and law of supply. According to these laws how the variation of oil prices happen in the market can be discussed. Now let us briefly discuss about theory of demand and supply.

Demand
The willingness and ability of buyers to purchase different quantities of a good at different prices during specific time period is known as demand.

The Law of Demand


The law of demand express that, if all other factors remain unchanged, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The quantity of a good that buyers (consumers) purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The graph below shows that the demand curve is a downward slope.

Price A B

P1 P2

Q1

Q2

Quantity Demanded

Points A and B are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve shows the negative relationship between price and quantity demanded. The higher the price (P1) of a good the lower

the quantity demanded (Q2), and the lower the price (P2), the more the good will be in demand (Q2).

Movements along the demand curve The only factor causes to movement along the demand curve is change in price of the product (assuming all other factors remain unchanged). When price of the product change from P 1 to P2 and P3, quantity demanded change from Q1 to Q2 and Q3 along the demand curve.

Price

P1 P2 P3

Shift in the demand curve

Q1

Q2

Q3

Quantity Demanded

Shift in the demand curve happens in two ways. Shift to right and shift to left. Right shift of a demand curve causes due to following reasons. Price of a substitute rises Price of a complement falls Expected future price rises Income rises Preference move towards good Population rises
Price

D2 D1 Q1 Q2 Quantity Demanded

The curve bellow shows leftward shift in the demand curve. Reasons for the shift are opposite of above mentioned factors.
Price

D1 Q1 Q2

D2 Quantity Demanded

Supply
The willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific time period is known as supply.

The Law of Supply


Comparable to the law of demand, the law of supply shows the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied by the suppliers. Producers supply more at a higher price because selling a higher quantity at a higher price increases there turnover.
Price

P2 B P1 A

Q1

Q2

Quantity Supply

A and B are points on the supply curve. Each point on the curve shows a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. Movements along the supply curve Change in price of the product causes the movements along the supply curve (assuming all other factors remain unchanged).
Price

P3 P2 P3

Shift in the supply curve

Q1

Q2

Q3

Quantity Supply

When talking about the shifts in the supply curve, there are rightward shift and leftward shift. Following curve a rightward shift. Factors affecting the shift are mentioned bellow. Price of input falls Availability of more efficient technology Expected future price falls Firms grow in size No. of firms in the industry grows
Price S1 S2

Q1

Q2

Quantity Supply

The following graph shows the leftward shift. Reasons behind this shift are opposite of above mentioned factors.
Price S1 S2

Q1

Q2

Quantity Supply

Market Equilibrium
Price Equilibrium Supply

Demand D Quantity

When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding. As mentioned above, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P and the quantity of the goods will be Q. These figures are referred to as equilibrium price and quantity. In the real market place equilibrium can only ever be reached in theory, so the prices of

goods and services are constantly changing in relation to fluctuations in demand and supply.

Excess Supply If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.
Price Supply P

Demand Q1 Q2 Quantity

At price P the quantity of goods that the producers wish to supply is indicated by Q2. At price P, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high. Excess Demand Excess demand is created when price is set below the equilibrium price as shown in the curve bellow. Because the price is so low, too many consumers want the good while producers are not making enough of it.
Price Supply

P Demand Q1 Q2 Quantity

In this position, at price P, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.