Demand, supply, and prices
Prices are among the most important signals in business. Understanding how demand and supply set them helps businesses make better decisions.
The law of demand
The law of demand states that, other things equal, as price rises, the quantity customers want to buy falls. Higher prices lead some customers to buy substitutes or simply buy less. Demand is shown as a downward-sloping curve relating price to quantity demanded.
What shifts demand
Demand shifts when factors other than the product's own price change: customer incomes, tastes and trends, prices of substitutes (Coke and Pepsi) and complements (printers and ink), expectations about future prices, and the number of buyers. A successful advertising campaign aims to shift demand outward.
The law of supply
The law of supply states that, other things equal, as price rises, producers are willing to supply more, because higher prices make production more profitable. Supply shifts with input costs, technology, the number of sellers, taxes, and expectations.
Market equilibrium
The equilibrium price is where quantity demanded equals quantity supplied. If price is above equilibrium, there is a surplus (unsold stock), pushing prices down; below it, there is a shortage, pushing prices up. Retailers see this when unsold items are marked down or popular items sell out.
Price elasticity of demand
Price elasticity measures how strongly quantity demanded responds to price. Demand is elastic when customers are very price-sensitive (many substitutes, luxury items) and inelastic when they are not (necessities, few substitutes, such as petrol or medicine in the short run). Elasticity tells a business whether raising prices will increase or reduce revenue.
Elasticity and pricing decisions
If demand is inelastic, a price increase raises total revenue, because customers keep buying. If demand is elastic, a price increase lowers total revenue, because many customers leave. Businesses use data and experiments to estimate how customers respond before changing prices.
Costs and break-even
Businesses have fixed costs, which do not vary with output (rent, insurance), and variable costs, which do (materials, hourly labour). The break-even point is the output at which total revenue equals total cost. Break-even quantity equals fixed costs divided by (price minus variable cost per unit).
Worked example
A food truck has fixed costs of 3,000 dollars per month. Each meal sells for 12 dollars and costs 7 dollars in ingredients and packaging. The contribution per meal is 5 dollars, so the break-even point is 3,000 / 5 = 600 meals per month. Every meal beyond 600 adds 5 dollars to profit.
Key takeaways
The law of demand: higher prices reduce quantity demanded; demand shifts with income, tastes, related goods, and expectations. The law of supply: higher prices increase quantity supplied. Equilibrium is where they meet; surpluses and shortages push prices toward it. Price elasticity shows customers' price sensitivity; raising prices increases revenue only if demand is inelastic. Break-even quantity equals fixed costs divided by contribution per unit.
Flashcard
Higher price, lower quantity demanded
Check your understanding
A business has fixed costs of 10,000 dollars, a price of 50 dollars, and a variable cost of 30 dollars per unit. What is its break-even quantity?