Analysis of Demand and Supply

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Supply and demand curves are at the foundation of the decisions made by business managers and consumers. However, numerous factors can affect the shifts and movements along these curves. Let's look at different ways to analyze supply and demand curves.

What Is Demand?

Demand is the amount of goods or services that consumers are willing to pay at each price point. It is based on wants and needs and the ability to pay. If consumers are unable to pay for goods and services, demand does not exist. When the price of a good or service rises, demand decreases. Conversely, if the price of a good or service falls, demand goes up. This law of demand represents an inverse relationship between price and quantity demanded.

Take the price of gasoline, for example. When the price of a gallon of gasoline increases, consumers start finding ways to reduce consumption by combining errand trips, taking vacations closer to home, forming carpools or commuting by mass transit.

However, the demand for a product is not infinite; people usually want only a certain amount of a good. Purchasing additional quantities of a product yields less and less satisfaction.

How to Graph a Demand Curve

A demand curve can be illustrated by constructing a graph with price plotted on the vertical axis and quantity demanded on the horizontal. The demand curve will slope downward from left to right as price declines and demand increases. Demand curves can be flat or steep, or they can be straight or curved. The relationship between price and demand will be unique for each good or service being analyzed.

What Is Supply?

Supply is the amount of goods or services available or produced, based on a number of factors such as input resources, labor, technology and regulations. Let's consider again the price of gasoline.

If a new gas reserve is discovered unexpectedly, the supply suddenly increases. Because gas becomes less scarce, prices become more competitive to beat out other suppliers for sales volumes. Prices will decrease to the level where the demand matches, because demand will naturally increase: Cheaper gas is more attractive than its more expensive counterpart.

How to Graph a Supply Curve

Graphically, a supply line is represented by an upward sloping curve from left to right with price on the vertical axis and quantity plotted on the horizontal axis. In the case of both supply and demand relationships, all other variables are assumed to remain constant when constructing these graphs.

What Is Supply and Demand Equilibrium?

Since the data for the supply and demand curves can both be plotted on the same graph, they will intersect at an equilibrium point. This is the price/quantity point where consumers and producers are satisfied with their decisions, and the market is in balance. The quantity supplied equals the quantity demanded.

The laws of supply and demand ensure that the market always recalibrates to equilibrium. When the market price is higher than the equilibrium price, the supply quantity will be greater than the quantity demanded, resulting in excess supply. Producers will then have the incentive to cut prices down to the equilibrium level to sell this excess supply.

If the market price is lower than equilibrium, competition between buyers creates excess demand. Producers then have the opportunity to raise prices up to the equilibrium level.

What Factors Affect Demand?

The factors that affect demand cause a shift of the entire demand curve to either the left or the right. This is different from a movement along the demand curve, which would be a result of a price change.

The factors that affect the demand curve are changes in:

Tastes and preferences. Consumer tastes are constantly changing, and demand for products rises and falls as a result. Kale is an example of changing tastes. For years, kale was used as a decoration for commercial buffets, then its health benefits become more publicized. As a result, demand for kale rose and prices increased.

Income level. When consumer incomes increase, they are able to demand and buy more normal goods, which are products whose demand goes up as income rises. For example, suppose a car costs $25,000 and 19 million buyers are willing to pay this price. Now, suppose consumer incomes increased; with more money available to spend, 21 million people can afford to pay $25,000 for the car.

In this case, demand for cars increased with a rise in income, and the demand curve shifted to the right.

Prices of substitutes. An increase in the price of one product can increase the demand for its substitute. Coca-Cola and Pepsi are excellent examples of this effect. If Pepsi increases its price, consumers will quickly switch to buying more Coke.

Complements. Complementary goods are products typically bought together, like yoga classes and mats or bread and butter. If the price for yoga classes falls, more people will sign up, increasing the demand for mats. A drop in the price of bread will increase the demand for butter to put on the bread.

Expectation of future prices. If consumers expect prices to drop in the near future or go on sale, they will delay their purchases, shifting the demand curve to the left. English muffins, for example, are frequently offered at buy one, get one free. Consumers know this, so rather than pay full price for a single package, they wait for the special offer.

The opposite is true for anticipated price increases, shifting the demand curve to the right in advance of price rises.

Changes in buyer demographics. Changing demographics affect the demand for different products. For instance, the increasing percentage of elderly people in the population increases the demand for nursing homes, hearing aids and in-home health care.

What Factors Affect Supply?

The factors that affect the shifts in a supply curve are changes in:

Cost of production. Changes in the costs to manufacture a product will cause the producer to modify production volume. Suppose a car manufacturer receives an increase in the price of steel and raises the price of cars to cover the increase. Consumers will demand a lower quantity of cars at the higher price, causing the manufacturer to reduce output and shift the supply curve to the left.

Technology. Improvement in technology that reduces the cost of production will enable producers to lower selling prices and sell more cars. This shifts the supply curve to the right.

Number of suppliers. The addition of new suppliers increases the quantities available at the same prices and shifts the supply curve to the right.

Government regulations. Some government regulations can increase the cost of production. As a result, a manufacturer might reduce the quantity supplied because the profit is reduced, shifting the curve to the left.

What Is the Importance of Supply and Demand Analysis?

All business managers and consumers use supply and demand analysis to make decisions. Business owners analyze the factors that affect supply and demand curves to determine what volume to produce and how to price their products. Consumers make buying decisions, either consciously or instinctively, based on their wants and needs and perceived value received at particular price points.

The basics laws of supply and demand form the foundation of a competitive, capitalistic environment.

References

About the Author

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.