Introduction

In the next 3 articles, we discuss how prices are set for a good or service in a free market by exploring the concepts of demand, supply and the relationship between them. I recommend that you read these three articles together; a conclusion is included after the last.

Whilst exploring these concepts, we will assume that:

1. There is a free market for the goods or services in question;
2. The market will operate under the conditions of perfect competition i.e. there are numerous consumers and producers (all with perfect information) who have to act as price takers, meaning they can't set the buying or selling price and must buy or sell at the determined market price; and
3. Other than price and quantity, all other factors remain equal unless stated (the ceteris paribus assumption).

Although no economy operates a fully free market, nor is there perfect competition in those markets, exploring supply and demand under these conditions can be a useful approximation to the real world.

Further, resources are allocated efficiently under these assumptions, and we can compare the results of our models to the real world to determine how we can make improvements.

A couple of points to note before we start. Firstly, when we discuss a good, we also mean a service.

Secondly, in these articles we talk about the overall market demand and supply for a particular good or service. The market demand and supply curves are made up of the individual demand and supply curves for each firm that produces / sells that good or service. In a perfect market, the demand and supply curves for individual firms in relation to a particular good or service will have the same characteristics. However, in reality, the demand and supply curves for each firm may differ from each other and the market. This is important when we discuss price elasticities, and how firms can adapt their individual strategies.

Relationship of price and demand

The demand curve, illustrated below, shows the demand for a good by consumers at given price levels over a period of time.

The relationship between price and demand is inverse; as prices go up, quantity demanded goes down. This is shown by the downward sloping nature of the demand curve (D1) on the diagram below.

There are two reasons the demand curve slopes downwards; the income effect and the substitution effect:

1. ‍Income effect - when the price of a good rises, people feel poorer and cannot buy as much of the good with their money; and‍
2. Substitution effect - when the price of a good rises, alternative goods will seem cheaper in comparison and people will switch to these.

Determinants of demand

The quantity of a good demanded at given prices is determined by a number of factors listed below:

1. ‍Taste - a good may be demanded more or less, dependent upon taste. Taste can be influenced by brand, advertising, trends etc;‍
2. Substitute goods - the price and availability of substitute goods can affect how much a good is demanded. If the price of a substitute good is lower, or the desirability greater, people may switch to the substitute good;‍
3. Complementary goods - complementary goods are those which are consumed together e.g. mobile phones and data packages, fish and chips. If the price of a complementary good goes up, less will be bought and the demand for the good in question will go down;‍
4. Income - as income rises, demand for goods will also rise. Exceptions to this rule are where the good is an inferior good (e.g. unbranded cereal), and the demand here may go down as income rises;‍
5. Expectations of future price - if people think prices will go up in the future they will buy now.

As noted above, when we look at a demand curve we assume that all the determinants of demand, apart from price, are constant. This is the ceteris paribus assumption. However, if these change, this would cause the demand curve to shift on the axes.

If the change results in demand increasing, the demand curve will shift outwards and consumers will demand more at a given price; movement from D1 to D2 below. For example, there may be a new market trend, or increased income levels within an economy during a time of prosperity etc.

If the change results in demand decreasing, the demand curve will shift inwards, and consumers will demand less at a given price; movement from D1 to D3 below. For example, there may be an increase in the amount of substitute goods available (e.g. the demand for a certain brand of smart phone may decrease if the availability of substitutes increases), or overall income levels within an economy decrease during a recession.