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Importance of Demand and Supply Analysis

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Business economics is defined as the study of how businesses manage scarce resources. Microeconomics is the study of the decisions of individuals, households, and businesses in specific markets, whereas macroeconomics is the study of the overall functioning of an economy such as basic economic growth, unemployment, or inflation. Scarcity in microeconomics is not the same as poverty. It arises from the assumption of very large (or infinite) wants or desires, and the fact that resources to obtain goods and services are limited.

Decisions made by managers are crucial to the success or failure of a business. Roles played by business managers are becoming increasingly more challenging as complexity in the business world grows. Business decisions are increasingly dependent on constraints imposed from outside the economy in which a particular business is based-both in terms of production of goods as well as the markets for the goods produced. The continuous changes in the economic and business environment make it ever more difficult to accurately evaluate the outcome of a business decision. In such a changing environment, sound economic analysis becomes all the more important as a basis of decision making.

There are a number of issues relevant to businesses that are based on economic thinking or analysis. Examples of questions that managerial economics attempts to answer are:

  • What determines whether an aspiring business firm should enter a particular industry or simply start producing a new product or service?
  • Should a firm continue to be in business in an industry in which it is currently engaged or cut its losses and exit the industry?
  • Why do some professions pay handsome salaries, whereas some others pay barely enough to survive?
  • How can the business best motivate the employees of a firm?

The issues relevant to managerial economics can be further focused by expanding on the first two of the preceding questions.

Importance of understanding understand the mechanics of supply and demand both in the short-run and in the long-run for mangers:

In order to answer pertinent questions, managerial economics applies economic theories, tools, and techniques to administrative and business decision-making. The first step in the decision-making process is to collect relevant economic data carefully and to organize the economic information contained in data collected in such a way as to establish a clear basis for managerial decisions. The term "best" in the decision-making context primarily refers to achieving the goals in the most efficient manner

It is very important for managers to understand the mechanics of supply and demand both in short-run and long-run. Cause while taking decisions in an organization managers need to know about the price controls in the market, supply and demand for the product in market, interdependence and the grains from trade, the relationship between price and quantity demand consumer surplus, product surplus, Market efficiency and last but not the least is analyzing changes in equilibrium both in micro and macroeconomics.


Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, price will function to equalize the quantity demanded by consumers, and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity.

The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

Supply analysis:

Law of Supply

The law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at higher pri ce increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.

Relation between Supply and Price

There prevails a direct relationship between price and supply. So when the price increases the supply increases and when the price decreases the supply also decreases.When the price is higher the producers become encouraged to supply more. Cause the more price they charge their profit will be higher other factors remaining constant

Shifts in supply curve

As there is a direct relationship between price and supply, a decrease in supply shifts the supply curve to the left and an increase in supply shifts the supply curve to the right.

Factors affecting supply

The supply of a commodity is the amount of commodity a producer is willing to put in the market at a given time at a given price. The factors affecting supply are-

  • Price of the commodity
  • Price of factors of production
  • Price of related goods Technology
  • Impact of a change in aggregate supply

Suppose that increased efficiency and productivity together with lower input costs causes the short run aggregate supply curve to shift outwards.


Demand analysis

Law of Demand

A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease and vice versa. In other words, the higher the price, the lower the quantity demanded.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).

Relation between demand and Price

The relationship between price and the amount of a product people want to buy is what economists call the demand curve. This relationship is inverse or indirect because as price gets higher, people want less of a particular product. This inverse relationship is almost always found in studies of particular products, and it's very widespread occurrence has given it a special name: the law of demand. The word "law" in this case does not refer to a bill that the government has passed but to an observed regularity.1

There are various ways to express the relationship between price and the quantity that people will buy. Mathematically, one can say that quantity demanded is a function of price, with other factors held constant, or:

Qd = f(Price, other factors held constant)

6.www.ecoteacher.com (3/07/2010)

7. http://www.mindtools.com/pages/article/newSTR_69.htm (3/07/2010)

Shift in demand curve

When there is a change in an influencing factor other than price, there may be a shift in the demand curve to the left or to the right, as the quantity demanded increases or decreases at a given price. For example, if there is a positive news report about the product, the quantity demanded at each price may increase, as demonstrated by the demand curve shifting to the right:

Relationship between the total amounts spent on a good in the market and the price of the good. It is the percentage change in quantity divided by the percentage change in price. If a price decrease results in larger total expenditure and vice versa, the good is price elastic. If a price decrease results in less total expenditure or vice versa, the good is price inelastic.

The figure shows two different demand curves, D & D1. Change in price will cause a decline in D than the D1 curve. Assuming the initial supply curve S1 which intersect D & D1 in point a, at a price of P1 and a quantity of Q1. Now supply shifts to S1, and we get b the intersection point on the less elastic demand curve D, at which the price is P2 and quantity is Q2. On the other hand the new supply curve and the elastic demand curve intersect at point c, which gives us price P3 and quantity Q3. Here, the relative large rise in price level (P2) occurs relatively small fall in quantity (Q2). And relatively small rise in price level (P3) occurs relatively large rise in quantity (Q3).

8. http://www.netmba.com/econ/micro/demand/curve/ (3/07/2010)

Factors affecting demand

A number of factors may influence the demand for a product, and changes in one or more of those factors may cause a shift in the demand curve. Some of these demand-shifting factors are:

  • Customer preference
  • Prices of related goods
  • Complements - an increase in the price of a complement reduces demand, shifting the demand curve to the left.
  • Substitutes - an increase in the price of a substitute product increases demand, shifting the demand curve to the right.
  • Income
  • Number of potential buyers
  • Expectations of a price.
  • Impact of a shift in aggregate demand

When short run aggregate supply is perfectly elastic, any change in aggregate demand will feed straight through to a change in the equilibrium level of real national output. For example, when AD shifts out from AD1 to AD2 :the economy is able to meet this increased demand by expanding output. The new equilibrium level of national income is Y2. Conversely when there is a fall in total demand for goods and services (AD1 shifts inwards to AD3) we see a fall in real output.



Equilibrium is the point where the quantity demanded equals the quantity supplied. This means that there's no surplus of goods and no shortage of goods. A shortage occurs when demand is greater than supply - in other words, when the price is too low. A surplus occurs when the price is too high, and therefore consumers don't want to buy the product.

  • *Micro Economics Equilibrium

Demand curve shifts: When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted to the right. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2.

Supply curve shifts: When the suppliers' unit input costs change, or when technological progress occurs, the supply curve shifts. If the quantity supplied decreases, the opposite happens. If the supply curve starts at S2, and shifts leftward to S1, the equilibrium price will increase and the equilibrium quantity will decrease as consumers move along the demand curve to the new higher price and associated lower quantity demanded.

11. http://www.mindtools.com/pages/article/newSTR_69.htm(3/07/2010)

12. http://en.wikipedia.org/wiki/Supply_and_demand (3/07/2010)

  • *Macroeconomic equilibrium

Macroeconomic equilibrium for an economy in the short run is established when aggregate demand intersects with short-run aggregate supply. This is shown in the diagram.

At the price level Pe, the aggregate demand for goods and services is equal to the aggregate supply of output.

There may be occasions when in the short run, the economy cannot meet an increase in demand. This is more likely to occur when an economy reaches full-employment of factor resources. In this situation, the aggregate supply curve in the short run becomes increasingly inelastic. The diagram tracks the effect of this.

13. http://www.netmba.com/econ/micro/demand/curve/ (4/07/2010)

Profit maximization

Under the simplest version of the theory of the firm it is assumed that profit maximization is its primary goal. In this version of the theory, the firm's owner is the manager of the firm, and thus, the firm's owner-manager is assumed to maximize the firm's short-term profits. Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm and the time value of money. In this more complete model, the goal of maximizing short-term profits is replaced by goal of maximizing long-term profits, the present value of expected profits, of the business firm.

It is very important for managers to understand the mechanics of supply and demand in both long and short run in order to understand the economic constrains of profit maximization in any organization

  • The constrained profit maximization

Profit maximization is subject to various constraints faced by the firm. These constraints relate to resource scarcity, technology, contractual obligations, and laws and government regulations. In their attempt to maximize the present value of profits, business managers must consider not only the short-term and long-term implications of decisions made within the firm, but also various external constraints that may limit the firm's ability to achieve its organizational goals.

Profit maximization versus other motivations behind managerial decisions:

The critics argue that business managers are interested, at least partly, in factors other than the firm's profits. In particular, they may be interested in power, prestige, leisure, employee welfare, community well-being, and the welfare of the larger society. The act of maximization itself has been criticized; there is a feeling that managers often aim merely to "satisfice". Under the structure of a modern firm, it is hard to determine the true motives of managers. A modeern firm is frequently organized as a corporation in which shareholders are the legal owners of the firm, and the manager acts on their behalf. Under such a structure, it is difficult to determine whether a manager merely tries to satisfy the stockholders of the firm while pursuing other goals, rather than truly attempting to maximize the value of the firm. It is, for example, difficult to interpret company support for a charitable organization as an integral part of the firm's long-term value maximization.

Before arriving at the decision whether to maximize profits or to satisfice, managers have to analyze the costs and benefits of their decisions. Short-term firm-growth maximization strategies have often been found to be consistent with long-term value maximization behavior, since large firms have advantages in production, distribution, and sales promotion. Thus, many other goals that do not seem to be oriented to maximizing profits may be intimately linked to value or profit maximization-so much so that the value maximization model even provides an insight into a firm's voluntary participation in charity or other socially responsible behavior.


A manager in an organization need to consider the supply and demand chain in both short and long run in order to take decisions in managing works, having competitive advantage in market place, keeping pace with marketplace, and also to keep informed about facts like costs and prices, how production is determined, comparative economic systems, the distribution of income and poverty, the role of Government, public choice, the role of the entrepreneur, taxation, the Business cycle, wages, unions, and unemployment, trade and tariffs, money and banking etc. again profit maximization is the main goal of any organization for which a manager needs to understand the mechanism of supply and demand in both long and short run.



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