Supply and demand
Microeconomics studies the interaction between buyers (i.e. consumers) and sellers (i.e. businesses) and the factors that influence their decisions. It can provide an insight into the ways in which setting different prices for products will affect the quantity of products demanded (i.e. purchased) by consumers, which in turn can help sellers to determine the optimal price they should charge for products and the quantity of products that they should produce at that price point to achieve maximum profitability.
Supply: the quantity of a product or service available for consumers to purchase at a specific price.
Demand: the quantity of a product or service that consumers are able and willing to purchase at a specific price.
With all this in mind, we’ll now look at some of the elements that can affect supply and demand.
Price
The price charged for a product will, at least to some extent, affect demand for that product. Naturally, as prices increase, demand will usually fall, as fewer consumers will be able or willing to purchase the goods in question. For instance, a supermarket may sell 1,000 apples in a day if they charge 30p per apple, but if the price of each apple was increased to £1, the number of sales would likely decrease significantly. However, the way in which price affects demand varies depending on the type of product being sold (this concept is sometimes referred to as “price elasticity of demand”).
Price elasticity of demand: this measures the extent to which price changes affect demand. Price-elastic products are products for which demand changes significantly in response to price changes. Examples include necessities (e.g. every-day household items) and other somewhat generic items that can easily be purchased from alternative suppliers (e.g. paper). Price-inelastic products are products for which demand changes less dramatically in response to price changes, usually because the products are fairly unique or rare. Examples include luxury goods such as designer items, which are less easily substituted by other products.
If demand for a product increases to a greater extent than the supply of that product, businesses may be able to charge a higher price for it. This is especially the case if there is an excess of consumers competing to purchase the product at a particular price. In such instances, whilst a price rise would inevitably deter some consumers from purchasing the product, the excess demand that had existed at the lower price indicates strong demand should still exist at a higher price.
However, if prices are increased too dramatically, demand may fall to a level that generates less profit overall than would have been generated at the lower price (in other words, a business may generate more profit overall if the price it charges results in significantly more sales, even if the business generates less profit per individual sale). Accordingly, for a company to generate optimal profit levels, a balancing act must be struck between generating as much profit as possible per individual sale and generating as many sales as possible.Output
Supply will of course be determined by a business’ level of output, meaning the quantity of goods it produces and makes available for sale. For goods that are identical to, or can be easily substituted by, goods supplied by other businesses (e.g. milk or petrol), supply will also be affected by the quantity of goods produced by other suppliers in the market. If supply outweighs demand, businesses may have to reduce prices to increase demand (in order to ensure a greater number of products are sold overall).
Availability of similar or identical goods
Demand at a particular price point may also be affected by the availability and price of identical or similar goods offered by other businesses (i.e. competitors). For example, if Supermarket A sells their own brand of baked beans for 50p and Supermarket B subsequently reduces the price of its own baked beans to 30p, demand will likely fall for Supermarket A’s baked beans and increase for Supermarket B’s.
Substitute and complementary goods
Demand may also be affected by the price and availability of substitute goods or complementary goods.
Substitute goods: products that a consumer could purchase to satisfy the same purpose, need or want as a different product sold by another company. For instance, a train ticket may be a substitute for a plane ticket (if the route is similar) and if the price of rail travel drops, consumers may consequently decide to take a train rather than fly where possible.
Complementary goods: products that can or must be purchased alongside another product. For instance, petrol and (increasingly) electricity are complementary products to cars. If the price of petrol or electricity dramatically increases, consumers may (in the long term) be less inclined to purchase cars.
A fall in the price of a substitute product may increase the demand for that product and consequently reduce the demand for goods to which the substitute product serves a similar purpose. In contrast, a fall in the price of a complementary product may increase demand for the products to which it is a complement, as the cost of the overall package will reduce.
Input costs and profit margins
The quantity of goods supplied may also depend on the input costs involved in producing the goods. If costs are low and the potential profits are high for a product, supply will likely increase as the potential upside will encourage businesses to produce more products (and incentivise other businesses to enter the market). However, as supply increases, businesses may need to start competing on price in order to generate additional sales, resulting in the price decreasing for consumers.