Theory of Demand and Supply
theory of demand and supply is a fundamental concept in economics that explains how markets function. It describes how the quantity of goods demanded by consumers and the quantity supplied by producers determine the equilibrium price and quantity in a market. Here’s a detailed breakdown of both theories:
Theory of Demand
**1. Definition of Demand
- Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices over a specific period. It reflects consumers’ purchasing behavior and their willingness to pay for a product.
**2. Law of Demand
- Law of Demand: Other things being equal, as the price of a good falls, the quantity demanded increases, and as the price rises, the quantity demanded decreases. This inverse relationship is due to:
- Substitution Effect: As the price of a good decreases, it becomes cheaper relative to other goods, leading consumers to substitute it for other more expensive goods.
- Income Effect: As the price of a good decreases, consumers effectively have more purchasing power (real income increases), leading to an increase in quantity demanded.
**3. Demand Curve
- Demand Curve: Graphically represents the relationship between the price of a good and the quantity demanded. It typically slopes downward from left to right, reflecting the law of demand.
**4. Factors Affecting Demand
- Price of the Good: Directly affects the quantity demanded.
- Income of Consumers: An increase in income generally leads to an increase in demand for normal goods and a decrease for inferior goods.
- Prices of Related Goods:
- Substitutes: An increase in the price of a substitute good can increase the demand for the original good.
- Complements: An increase in the price of a complement good can decrease the demand for the original good.
- Consumer Preferences: Changes in tastes and preferences can shift the demand curve.
- Expectations: Anticipated changes in future prices or income can affect current demand.
Theory of Supply
**1. Definition of Supply
- Supply refers to the quantity of a good or service that producers are willing and able to sell at various prices over a specific period. It reflects producers’ willingness to produce and sell goods.
**2. Law of Supply
- Law of Supply: Other things being equal, as the price of a good increases, the quantity supplied increases, and as the price decreases, the quantity supplied decreases. This direct relationship occurs because higher prices can incentivize producers to produce more of the good to increase profits.
**3. Supply Curve
- Supply Curve: Graphically represents the relationship between the price of a good and the quantity supplied. It typically slopes upward from left to right, reflecting the law of supply.
**4. Factors Affecting Supply
- Price of the Good: Directly affects the quantity supplied.
- Production Costs: An increase in production costs (e.g., wages, raw materials) can decrease supply.
- Technology: Advances in technology can increase supply by making production more efficient.
- Number of Suppliers: An increase in the number of suppliers can increase overall market supply.
- Expectations: If producers expect prices to rise in the future, they may decrease current supply to sell more at higher future prices.
Equilibrium
**1. Definition of Equilibrium
- Equilibrium occurs when the quantity demanded equals the quantity supplied at a particular price. At this point, the market is in balance, and there is no tendency for the price to change.
**2. Equilibrium Price and Quantity
- Equilibrium Price: The price at which the quantity demanded equals the quantity supplied.
- Equilibrium Quantity: The quantity of goods bought and sold at the equilibrium price.
**3. Shifts in Curves
- Demand Shift: A change in factors other than price (e.g., income, preferences) can shift the demand curve, leading to a new equilibrium price and quantity.
- Supply Shift: A change in factors other than price (e.g., production costs, technology) can shift the supply curve, leading to a new equilibrium price and quantity.
**4. Market Disequilibrium
- Excess Demand (Shortage): Occurs when the price is below the equilibrium price, leading to a situation where quantity demanded exceeds quantity supplied.
- Excess Supply (Surplus): Occurs when the price is above the equilibrium price, leading to a situation where quantity supplied exceeds quantity demanded.
Importance of Economics in the Civil Services Exam