Demand, Supply and Market Price Determination

Consumer behaviour Utility is the economists term for the satisfaction a customer derives from the goods that they buy. Marginal utility is the increase in total utility arising from an increase in consumption by one more. For example, suppose I like eating bananas, and I have already eaten one banana; then the satisfaction I get from consuming a second banana is called by economists the marginal utility. Marginal utility is the utility gain from the consumption of one more item. Basically, economists are assuming that people derive satisfaction from the consumption of goods in general, and that people seek to consume as much as they can within their budget. However, the Law of diminishing marginal utility states that the rate at which total utility rises diminishes as consumption of a good increases and that eventually there will be negative marginal utility. To explain this, imagine eating bananas. The first banana is delicious. Already, by the time you reach the second banana your hunger has been partially satisfied, and although the second banana is also delicious, it does not give as much satisfaction as the first. Nonetheless, the satisfaction is still positive, so total utility is still rising. However, by the time you get to your tenth banana you may be feeling sick of bananas, and sooner or later, as you consume more and more of a good, you will less and less satisfaction from it.

Price as a measure of utility The price that we are prepared to pay for a good is related to the satisfaction we gain from it. Say one has a choice between two goods, both of which yield the same utility on consumption. Then it makes no sense to pay more for one of the goods than for the other. Thus, price is thought to be proportional to utility for each individual person. The Optimum position for a consumer is when he or she maximizes his satisfaction (his utility) for a given fixed income. Consumers distribute their expenditures among all available commodities until the last penny spent on each commodity yields the same marginal utility. The theory of consumer behaviour assumes that (a) consumers want to maximize their satisfaction, as measured by utility; (b) know what satisfaction they derive from each good and can compare them; (c) are rational in their decision making.

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What all of this means is that we can assume that the decisions people make about how much to pay for a good are closely related to how much satisfaction they derive from it.

Market A market is any mechanism, formal or informal, institutional or not, whereby buyers and sellers can communicate with each other to buy and sell a commodity. A market could be literally an open space of ground where sellers set up stalls and purchases walk around to view and buy the goods. However, many goods are now bought and sold via the Internet, so this provides another market.

Effective demand Effective demand is the demand for a good that customers are able and willing to back with money. What this means is that merely wishing to have a good is not effective demand. For the wish to turn into demand in the economists sense, the person with the wish must be prepared to part with his cash in order to fulfil it at least at some price or other. Effective demand is also demand per unit of time. What this means is, for example, is the number of bananas consumed per week. This might be doubled if the time period was doubled to two weeks. But it is usual to refer to the quantity demanded per unit of time as simply quantity. It is also usual to refer to effective demand as simply demand.

Demand curve A demand curve is a graphical representation of the relationship between effective demand (or just demand) and price. The idea of a demand curve is intuitively clear, but strictly speaking it is the result of adding up the individual demand schedules for each persons consumption of a good. A demand schedule specifies how much a good a person will purchase at a given price. For example, one might buy six bananas a week at 20p per banana but only three at twice that price. Then, to achieve the total demand curve for bananas, one needs to add up the demand for bananas of every individual to obtain the demand for bananas for the market as a whole.

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Price

Demand Quantity demanded per unit of time

The downward slope of the demand curve reflects the law of diminishing marginal utility. Economists generally assume that individuals get less and less satisfaction from consuming more and more of a given good. Hence, they conclude that an individuals demand for a good will fall with price. Thus, it is expected that the demand for a good will be downward (or negatively) sloping. We tend to represent the demand for a good by a straight line in our graphs. But there is no necessary reason why the relationship should follow a straight-line graph (we say should be linear). The demand could take any number of shapes for instance
Price

D
Quantity

Note also that here we have abbreviated demand per unit of time to just demand, and used the symbol D to represent the demand curve.

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Normal goods In fact, not all goods do have negatively sloped demand curves, so those that do are called normal goods.

Properties of the demand curve A change in price does not affect the position of the demand curve. The demand curve describes the relationship between price and demand. On the other hand, any other changes that can affect the demand for a good will affect the position and/or slope of the demand curve. In graphical terms this could mean that the demand curve will shift to the right or shift to the left. Since a shift to the right means that more of the good is demanded at every price, this is called an improvement in the conditions of demand.

Price

D* D
Quantity
An improvement in the conditions of demand leads to a shift to the right of the demand curve from D to D*.

Supply Supply works in a similar way to demand. It is assumed that suppliers seek to maximise profits. The higher the price of a good, the easier it is to make a profit. Consequently, suppliers will offer more and more of a good to the market as the price goes up. Thus, under normal conditions, the supply of a good will increase as the price increases. Supply is also strictly speaking supply per unit of time; although it is customary to omit this when referring to supply.

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Price

Supply

Quantity

Interaction of supply and demand When the market is working perfectly, so that everyone knows exactly how much is going to be supplied at a given price, and how much is going to be demanded at a given price, the rational and logical conclusion is that the quantity supplied to the market will be exactly the same as the quantity demanded, and that the price the goods are supplied at will be the same as the price that they sell at. Suppliers will ask exactly what customers are prepared to pay at the equilibrium level of quantity. This leads to a simple graphical representation of the market.
Price

Equilibrium Price

D
Equilibrium Quantity

Quantity

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This assumes that the market operates perfectly. However, in practice markets may not be perfect, and some mismatch between supply and demand can take place. At a given time there may be more goods brought to the market and offered at such a price that not all of them are taken up by customers. This leads to what are called dynamic considerations of the interaction of supply and demand. The term dynamic is used to describe how anything is affected by the passage of time. We would consider the question of how long it takes for a market to reach equilibrium. A market could be sluggish or volatile. A market could be such that it never reaches equilibrium. This also leads to an advanced topic known as cobweb analysis, which describes how fluctuations in the market price and quantity demanded arise from delays between how supply is fixed at a given time. However, consideration of this topic only complicates matters, and for the present we will ignore it, and assume that the market is perfect a hence that any changes in demand nd or supply lead immediately to changes in the equilibrium price.

Changes in the conditions of demand or supply Changes in the conditions of demand or supply lead to changes in the equilibrium price and quantity demand. The graphs make this quite clear.

Price

S P' P D* D Q Q'
Quantity

An improvement in the conditions of demand leads to an outward shift of the demand curve. This causes the price of the good to increase from P to P and the quantity demanded to increase from Q to Q .

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