What is supply? Supply refers to how much of a good or a service is available for purchase at any given time. Supply is dependent on the resources that are required to produce the good or offer the service, such as land, labor, and capital (buildings and machinery), and the quantity of similar products that can easily be substituted for the product and that are competing for a customer’s attention. However, if all these factors are ignored or held constant, then supply is directly affected by price.

Supply is derived from a producer’s desire to maximize profits. The more money a business can get for its good or service, the more of its product it is willing to supply. In economic terms, the amount supplied will increase as the price increases; also, if the price is lower, less of the product will be supplied. This is known as the law of supply.

Let’s look at an example. Eddie opens a coffee kiosk in the middle of his college campus. He will want to supply more cups of coffee at $2.00 per cup than at $0.50 per cup. The reason for this is obvious: Eddie has a greater incentive to supply more cups of coffee if he can sell them at $2.00 each rather than at $0.50 each because he’ll generate more profit at the higher price. Notice in Table 2.2 that Eddie wants to supply only 10 cups of coffee at $0.50 per cup. However, if Eddie can charge $1.25, Eddie will supply 70 cups of coffee because he has a greater incentive to supply more cups at the higher price. Finally, at the price of $2.00, Eddie’s incentive to supply coffee is at its greatest. At that highest price, Eddie wants to supply 115 cups. We can illustrate this relationship between supply and price in a graph that economists call a supply curve, like the one shown in Figure 2.2. You can see that Eddie’s desire to supply, or sell, more cups of coffee is affected by price. The more he can charge, the more he wants to supply. However, as you can imagine, the demand for coffee has a different reaction to price.

Figure 2.2

The Supply Curve

Table 2.2

The Relationship between Price and Supply

What is demand? Demand refers to how much of a good or a service people want to buy at any given time. People are willing to buy as much as they need, but they have limited resources (money). Therefore, people will buy more of an item at a lower price than at a higher price. In our coffee example, as shown in Table 2.3, students are willing to buy only 12 cups of coffee at $2.00 a cup. When he reduces the price to $1.25, there is more demand with 55 cups being purchased. But the most demand is generated when the price is lowered to $0.50 a cup, and 120 cups are sold. In other words, as price decreases, demand increases. Again, economists illustrate the relationship between demand and price with a graph that they call a demand curve, as shown in Figure 2.3.

Figure 2.3

The Demand Curve

Table 2.3

The Relationship between Price and Demand

What factors determine price? As you’ve seen with Eddie’s coffee kiosk, there is an obvious conflict when setting a market price. Notice that Eddie wanted to supply coffee at a higher price but that he didn’t attract many customers by doing so. Customers were more willing to pay for coffee as the price dropped. As the price of a product increases, more of it is likely to be supplied. As the price of the product decreases, more of it is likely to be demanded by customers. Because these two concepts of pricing are at odds with each other, what determines the final price? Holding all other factors constant, prices are set at a point where supply equals demand.

The supply-and-demand relationship is one of the fundamental concepts of economics. At Eddie’s coffee kiosk, for example, at some point, supply and demand balance each other out. Although Eddie would love to sell coffee at $2.00 a cup (or even more), he realizes that not too many students are willing to buy coffee at that price. At $2.00 a cup, Eddie would end up with unsold product left over, creating a surplus. As Eddie begins to lower his price, he finds that more students are willing to buy his coffee. However, if Eddie lowers his price too much, to $0.50 a cup, for example, then the demand would be so great that Eddie would run out before he was able to satisfy all the students who wanted coffee, creating a shortage.

Ideally, Eddie would strive to determine a price at which he is willing to supply the coffee and at which students are willing to buy (demand) the coffee without anyone wanting more or without any coffee being left over. A surplus usually means that suppliers will lower prices to clear out inventory, whereas a shortage means suppliers will raise prices to take advantage of the higher demand. In both cases, the price will converge toward the market price, which, as noted previously, is the price at which supply equals demand. The market price (or equilibrium price) is illustrated in a supply-and-demand chart as shown in Figure 2.4. In this case, 60 cups of coffee is equally demanded and supplied at a price of $1.15.

Figure 2.4

The Market Price

In a perfect world, this is how pricing for products would be set. But we don’t live in a perfect world. Other factors that make us want more or less of a product outside of price can affect demand. There are also factors that affect our willingness or ability to provide a product, which can affect supply. We’ll look at those factors next.

What other factors besides price affect demand? Not too long after Eddie figured out the “perfect price” for a cup of coffee, he receives news that the college’s bookstore will begin to offer coffee, too. In addition, the college announces a tuition increase. How do these events affect the student’s willingness to buy coffee from Eddie? Will the new competition and higher student costs decrease demand for Eddie’s coffee?

There are many factors that affect the demand for a product besides its price. These factors, known as the determinants of demand, are as follows:

• Changes in income levels

• Population changes

• Consumer preferences

• Complementary goods

• Substitute goods

A positive change in any of these determinants of demand shifts the demand curve to the right, and negative changes shift the demand curve to the left. Table 2.4 summarizes the key determinants of demand. Let’s look at each in more detail.

Table 2.4

Key Determinants of Demand

Changes in Income Levels

When income levels increase, people are able to buy more products. Conversely, when income levels decrease, most people cut back on spending and buy fewer products. Therefore, as we’ll discuss later in this chapter, when the economy enters a recession and people begin to lose their jobs, the demand for some goods and services decreases. An improving economy will bring an increase in spending as more people find jobs and create an increase in demand for some goods and services. A change in income levels is one factor that affects the housing market, for example. With an increase in income, people can afford to buy a home for the first time or can afford to upgrade to a bigger, more expensive home if they already own a home. On the other hand, if people begin to lose their jobs, they may need to downsize into a smaller home and sell their more expensive home.

Population Changes

Businesses in resort communities experience an increase in demand during the “in” or “high” season. Increases in population create a greater demand for utilities (such as telephone, electric, sewer, and water services) and public and consumer services (such as restaurants, banks, drugstores, and grocery stores). Demographic changes, such as the aging baby boomers, also affect the demand for certain goods and services.

Consumer Preferences

The demand for a product can change based on what is popular at any given moment. Tickle Me Elmo dolls, Xbox One game systems, and the Apple iPad are all products that had high initial demand. As demand for these items increases, the demand curve shifts to the right. As demand begins to wane, the demand curve shifts to the left.

Complementary Goods

Products or services that go with each other and are consumed together, such as the iPhone and the apps associated with it, are considered complementary goods. The demand for apps is great as long as consumers are buying and using iPhones. When the Android-based phones emerged on the market, the demand for iPhones and apps in the Apple store decreased, shifting the demand curve for iPhone apps to the left. When the new iPad came out, the demand to download content from iTunes and the Apple store increased, shifting the demand curve for the online site to the right.

Substitute Goods

Goods that can be used in place of other goods, such as Coke for Pepsi or McDonald’s Quarter Pounder for Burger King’s Whopper, are substitute goods. Suppose, for example, someone reported getting violently ill after eating a McDonald’s Quarter Pounder. The demand for the McDonald’s Quarter Pounder will decrease, shifting that demand curve to the left, whereas the demand for the Burger King Whopper might increase, shifting the Whopper’s demand curve to the right.

In our example, a tuition increase may mean that students have less money to spend on items such as coffee, so Eddie may see his demand decrease. Additionally, competition from the bookstore offering coffee might also decrease Eddie’s demand, as Figure 2.5 shows. Eddie should also expect a temporary decrease in demand during the summer and holidays when fewer students are on campus. However, if Eddie begins to offer complementary items, such as breakfast and lunch foods, he may see an increase in demand.

Figure 2.5

Demand and Competition

Figure 2.5 Full Alternative Text

What makes supply change? Eddie started his business with a used industrial-sized coffeemaker. It makes good coffee, but Eddie is now thinking that he might need to buy a newer coffeemaker that would make coffee faster. In addition, he has heard that the price of the type of coffee beans he uses is going up. He could switch to a lower-quality bean, but he doesn’t want to reduce his standards. How could these new costs affect Eddie’s business and his willingness and ability to supply coffee? There are many factors that can create a change in supply. These factors, known as the determinants of supply, are as follows:

• Technology changes

• Changes in resource prices

• Price expectations

• The number of suppliers

• The price of substitute goods

Changes in any of these factors that help to create a good or a service can affect its supply and shift the supply curve to the left (have a negative impact on supply) or to the right (have a positive impact on supply). Table 2.5 summarizes the key determinants of supply and how they might affect business. Let’s look at each in more detail.

Table 2.5

Key Determinants of Supply