What two conditions must the buyers meet in order for there to be demand for a good or service?

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Price is dependent on the interaction between demand and supply components of a market. Demand and supply represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product takes place when buyers and sellers can agree upon a price.

This section of the Agriculture Marketing Manual explains price in a competitive market. When imperfect competition exists, such as with a monopoly or single selling firm, price outcomes may not follow the same general rules.

Equilibrium price

When a product exchange occurs, the agreed upon price is called an equilibrium price, or a market clearing price. Graphically, this price occurs at the intersection of demand and supply as presented in Image 1.

In Image 1, both buyers and sellers are willing to exchange the quantity Q at the price P. At this point, supply and demand are in balance. Price determination depends equally on demand and supply.

Image 1. Figure 1, Graph showing price equilibrium curves

It is truly a balance of the market components. To understand why the balance must occur, examine what happens when there is no balance, such as when market price is below that shown as P in Image 1.

At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would clamour for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market.

The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily, the market would be in surplus with too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases. Only when the price falls would balance be restored.

A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically, some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business.

Change in equilibrium price

When either demand or supply shifts, the equilibrium price will change. The section on understanding supply factors explains why a market component may move. The examples below show what happens to price when supply or demand shifts occur.

Example 1: Unusually good weather increases output

When a bumper crop develops, supply shifts outward and downward, shown as S2 in Image 2, more product is available over the full range of prices. With no immediate change in consumers' willingness to buy crops, there is a movement along the demand curve to a new equilibrium. Consumers will buy more but only at a lower price. How much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand.

Image 2. Figure 2, Graph showing movement along demand curve

In Image 2, price falls from P1 to P2 if a bumper crop is produced. If the demand curve in this example was more vertical (more inelastic), the price-quantity adjustments needed to bring about a new equilibrium between demand and the new supply would be different.

To understand how elasticity of demand affects the size of adjustment in prices and quantities when supply shifts, try drawing the demand curve (or line) with a slope more vertical than that depicted in Image 2. Then compare the size of price-quantity changes in this with the first situation. With the same shift in supply, equilibrium change in price is larger when demand is inelastic than when demand is more elastic.

The opposite is true for quantity. A larger change in quantity will occur when demand is elastic compared with the quantity change required when demand is inelastic.

Example 2: Consumers lower their preference for beef

A decline in the preference for beef is one of the factors that could shift the demand curve inward or to the left, as seen in Image 3.

Image 3. Figure 3. Graph showing movement along supply curve

With no immediate change in supply, the effect on price comes from a movement along the supply curve. An inward shift of demand causes price to fall and also the quantity exchanged to fall. The amount of change in price and quantity, from one equilibrium to another, is dependent upon the elasticity of supply.

Imagine that supply is almost fixed over the time period being considered. That is, draw a more vertical supply curve for this shift in demand. When demand shifts from D1 to D2 on a more vertical supply curve (inelastic supply) almost all the adjustment to a new equilibrium takes place in the change in price.

Price stability

Two forces contribute to the size of a price change: the amount of the shift and the elasticity of demand or supply. For example, a large shift of the supply curve can have a relatively small effect on price if the corresponding demand curve is elastic. That would show up in Example 1 above, if the demand curve is drawn flatter (more elastic).

In fact, the elasticity of demand and supply for many agricultural products are relatively small when compared with those of many industrial products. This inelasticity of demand has led to problems of price instability in agriculture when either supply or demand shifts in the short-term.

Price level

The two examples above focus on factors that shift supply or demand in the short-term. However, longer-term forces are also at work, which shift demand and supply over time. One particular supply shifter is technology. A major effect of technology in agriculture has been to shift the supply curve rapidly outward by reducing the costs of production per unit of output.

Technology has had a depressing effect on agricultural prices in the long-term since producers are able to produce more at a lower cost. At the same time, both population and income have been advancing, which both tend to shift demand to the right. The net effect is complex, but overall the rapidly shifting supply curve coupled with a slow moving demand has contributed to low prices in agriculture compared to prices for industrial products.

At various levels of a market, from farm gate to retail, unique supply and demand relationships are likely to exist. However, prices at different market levels will bear some relationship to each other. For example, if hog prices decline, it can be expected that retail pork prices will decline as well. This price adjustment is more likely to happen in the long-term once all participants have had time to adjust their behaviour.

In the short-term, price adjustments may not occur for a variety of reasons. For example, wholesalers may have long-term contracts that specify the old hog price, or retailers may have advertised or planned a feature to attract customers.

Summary

Market prices are dependent upon the interaction of demand and supply.

An equilibrium price is a balance of demand and supply factors.

There is a tendency for prices to return to this equilibrium unless some characteristics of demand or supply change.

Changes in the equilibrium price occur when either demand or supply, or both, shift or move.

In this episode of the Economic Lowdown Video Series, economic education specialist Scott Wolla explains the concept of demand. Viewers will learn how a change in the price of a good affects the quantity of the good consumers will buy and how changes in market conditions affect the demand for a good.

•  Listen to the audio version of this episode.

More episodes:

• The Economic Lowdown Podcast Series
• The Economic Lowdown Video Series

Transcript

Hi, I'm Scott Wolla, and today I’m talking about the economic concept of demand.

Economists define demand as the quantity of a good or service that buyers are willing and able to buy at all possible prices during a certain time period.

Notice that there are two components to demand: willingness to purchase and ability to pay.

I might be willing to buy a new Corvette, but if I don’t have the ability to pay for it, I am not part of the market demand for Corvettes.

Likewise, if I had the ability to pay for a can of sauerkraut, but not the willingness to buy it, it can’t be called demand. I’m simply not in the market for sauerkraut.

Understanding demand provides some insight into the behavior of buyers.

For example, if the price of chocolate bars were 50 cents each, I would buy two chocolate bars.

If the price of chocolate bars were 25 cents each, I would likely buy more than two—perhaps three bars.

If the price of chocolate bars were $1 per bar, I would likely buy fewer bars—perhaps only one.

The behavior I just described is called the law of demand by economists.

Simply stated, the law of demand says that as the price of a good increases, the quantity of that good demanded decreases.

Likewise, as the price of a good or service decreases, the quantity of that good or service demanded increases.

Notice that we include only two variables: price and quantity. That’s all that the law of demand does, it states how a change in the price of a good or service affects the quantity demanded.

Picture this…

If we put the quantity of chocolate bars on the X, or horizontal axis of a graph, and the price of chocolate bars on the Y, or vertical axis, as we plot the information we just discussed, we would start to see a picture of demand, or a visual relationship between the two variables.

The line that is created when we connect the points on the graph slopes downward.

This downward slope means that there is an inverse—or opposite—relationship between price and quantity demanded.

When price increases, quantity demanded decreases, and when price decreases, quantity demanded increases.

In fact, we could recreate this same scenario with almost any good or service and get the same result—a downward-sloping line.

This downward-sloping line is called a demand curve.

The demand curve is not static or unchanging. It shifts back and forth as conditions in the market change.

For example, if you heard of an impending chocolate shortage, you might expect chocolate prices to rise in the future.

As a result, you might run to your favorite candy store and buy extra chocolate bars before chocolate prices increase.

In this case, the original demand curve no longer tells the whole story; it must shift to the right to accurately reflect the change in chocolate bar demand.

Or put another way, your chocolate-bar demand curve shifted to the right because the quantity of chocolate bars demanded by you—and your fellow chocolate lovers—would be greater at each of the given prices.

What Things Change the Curve?

There are several reasons a demand curve might shift to the left or the right. In each of the following examples, imagine that the price of chocolate bars remains constant but something else in the market changes.

1. A change in consumer expectations. Your fear of a chocolate-bar shortage and rising prices is a good example of a change in consumer expectations. If many other chocolate lovers had similar fears, the demand curve for chocolate bars would shift to the right as more people bought chocolate bars.
2. A change in consumer tastes or preferences. Imagine that scientists discovered some new health benefits from eating chocolate. You can bet that more people would buy chocolate bars, causing the demand curve to shift to the right.
3. A change in the number of consumers in the market. A huge convention of candy lovers has come to town—and they want chocolate bars now! The demand curve shifts to the right.
4. A change in income. During recessions, the demand curve for chocolate bars usually shifts to the left because many chocolate lovers have smaller incomes due to the bad economy and can’t buy as much chocolate. This means, that the demand curve for chocolate bars—and nearly everything else—would shift to the left as people buy less chocolate.
5. A change in the price of a substitute good. Imagine that the price of licorice has fallen by half, while chocolate-bar prices have remained the same. You can bet that more than a few chocolate lovers would start eating licorice. As a result, the chocolate bar demand curve would shift to the left as people substitute licorice for chocolate, because licorice is cheaper. So a change in the price of a substitute—licorice—changes the demand for chocolate bars.
6. A change in the price of a complementary good. In this case, when I say complementary I do not mean free; I mean a good that is used with another good. Imagine that the prices of peanut butter and ice cream—your two favorite chocolate-bar complements—have doubled. You, and lots of others, would buy fewer jars of peanut butter and fewer containers of ice cream; and even though the price of chocolate bars hasn’t changed, you and other chocolate-bar lovers would likely cut back on your chocolate-bar purchases, shifting the chocolate-bar demand curve to the left.

Notice that I described two types of changes:

The first is called a change in the quantity demanded, which is the result of a change in price. A change in quantity demanded is illustrated by moving from point to point on a given demand curve, and is the result of a change in the current price of chocolate bars.

The second type is called a change in demand. The demand for a good or service changes—not when the price of the good changes—but when something else in the market changes; or example, an expectation that the price of chocolate bars may increase in the future.

Well, that sums up demand and that’s all the time we have for today. Thanks for watching.

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