Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy.

Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand. The relationship between demand and supply underlie the forces behind the allocation of resources. In market economy theories, demand and supply theory will allocate resources in the most efficient way possible. How? Let us take a closer look at the law of demand and the law of supply. A. The Law of Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

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).

B. The Law of Supply Like the law of demand, 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 a higher price 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. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.) Time and Supply Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent. Get Trend Analysis Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand. C. Supply and Demand Relationship Now that we know the laws of supply and demand, let's turn to an example to show how

supply

and

demand

affect

price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied. If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high. D. Equilibrium When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply. E. Disequilibrium

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. 1. Excess Supply If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high. 2. Excess Demand Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.

F. Shifts vs. Movement For economics, the movements and shifts in relation to the supply and demand curves represent very different market phenomena: 1. Movements A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

2. Shifts A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.

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PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities THE CIRCULAR FLOW OF ECONOMIC ACTIVITY There are two basic activities undertaken in any economy: production and consumption. The firms perform the production and consumption while households undertake consumption. To be able to produce, firms need the economic resources consisting of land, labor, andcapital LAND it is one of the factors of production which include land used for agriculture or industrialpurposes as well as natural resources taken for above or below the soil. Natural resources consistof energy resources like fossil fuel and geothermal emissions, non-energy resources like gold,diamond, and limestone, air and water and many others. LABOR refers to that basic factor of production which are productive services embodied inhuman physical effort, skill, and intellectual powers, and others. It consist of human time spent inproduction like driving buses, feeding cattle, singing in night clubs, acting in movies, or repairinghousehold appliances. CAPITAL durable goods produced in order to produce other goods. It consists of buildings,plant and machinery, roads, computers, ships, electric guitars, table tennis, tennis balls, etc. STOCK AND FLOW OF CONCEPTS Stock refers to the measure of quantity at a point of time e.g. wealth as of December 31, 2001F l o w r e f e r s t o t h e m e a s u r e o f m o v e m e n t o f q u a n t i t y o f o v e r a p e r i o d o f t i m e e . g . s a v i n g s (P1000/year) or consumption at P100,000/yearWhen economic resources are used in the production of goods and services, employmentof these resources occurs. A price is paid to resource owners whenever these resources are usedin production. Rent is paid to the landowner, interest to the capitalist, and wage to labor. Thegoods and services produced by these firms are consumed by households. T h e i n t e r a c t i o n b e t w e e n h o u s e h o l d s a n d f i r m s r e g a r d i n g p r o d u c t i o n , c o n s u m p t i o n , employment and income generation results to the circular flow of goods and services in theeconomy. THE CIRCULAR FLOW OF GOODS, SERVICES AND INCOME The basic aspects of economy which include production and consumption are subject tothe stock and flow concepts which are circular in nature. THE PRODUCTION PROCESS The process of producing goods and services involves households and firms in a circular flow. Asshown again, the economic rsources of land, labor, and capital are provided by the householdsand used by the producing firms. These firms, in turn, produce goods and services which aredelivered to households for consumption. THE FLOW OF GOODS AMONG PRODUCING FIRMSWithin the circular flow of the production process is another flow which happens among differenttypes of business firms. This flow involves raw materials, intermediate goods and final goods.RAW MATERIALS

 unprocessed goods like wood, sand and ironINTERMEDIATE GOODS partially processed goods and still needsprocessing before it can be finally consumed likesteel bars, flour and microchips 1 Entrepreneurial Ability land, labor, and capital will remain as they are until someone taps them toproduce the required goods and services. Actual production needs the ability of an entrepreneur to decideon and implement the right combination of the first three factors of production.1 PRINCIPLES OF ECONOMICS: Circular Flow of Economic ActivitiesFINAL GOODS processes goods ready for consumptionlike breadAccording to the type of goods they produce, firms may be classified as follows:1.Raw Materials Producers like those engaged in producing agricultural products used inmanufacturing (fish, wood, sugar)2.Intermediate Goods producers like those producing construction materials, guitar strings,and food seasoning3.Final Goods Producers like those producing chocolate bars, refrigerators, and bicycles THE FLOW OF OUTPUT BETWEEN FIRMS AND HOUSEHOLDSAs shown, the output of raw materials producers are delivered to intermediate goods producers,whose output, in turn are delivered to final goods producers. The consumers become recipientsof the goods produced by the final goods producers.GOODS AND INCOME FLOW AMONG HOUSEHOLDS AND VARIOUS TYPES OF PRODUCERSHouseholds provide producerswith the economic resourcesrequired. These resources aredistributed among the varioustypes of producers. The producers,in turn, remit payments tohouseholds for the use of resources.When the goods are finallyprocessed, these are delivered tothe households, which in turn,remit their payments to theconcerned producers.INCOME FLOWWhen money is spent by households for consumption and by firms forproduction, a circular flow of income is created. The expenditure of oneunit becomes the unit of another unit.Income takes two distinct circular flows as follows 2 / 3 : 2 The services of land, labor and capital are bought by firms for use in production. Money is paid to the households. In turn, householdsbuy goods and services. Money is paid by households to firms. 3 Purchases are made between firms. The output of RM firms are sold to IG firms which in turn sell their output to FG firms. The finalgoods are sold to households for consumption. 2

PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities THE CONCEPT OF EQUILIBRIUM The economy will be in equilibrium if the amount received by firms from households isequal to the amount received by households from firms. Disequilibrium happens when eitherhouseholds or firms do not spend all their incomes. If households, for one reason or another,reduce their purchases, firms will receive a reduced amount of income resulting to their inabilityto maintain current levels of purchases of economic resources, some laborers will lose their

job,and some land and physical capital will become idle. The result is a corresponding reduction inthe income of households. THE EFFECT OF SAVING AND INVESTMENTSIf the total output of firms arepurchased by the households and the totaleconomic resources are bought by firms,there is equilibrium in the market. In reality,however, households allocate a part of theirincomes for future use like providing moneyfor old age. As a result, disequilibriumhappens because firms are hard-pressed todispose all their output. The circular flow willtend to contract. To prevent this fromhappening, some other means for disposingthe unsold portion of the output must betapped.Investment is a way of disposing unsold output. Firms spend money to procure goods andservices for the purpose of increasing their productive capacity in the future. In effect, firmsspend money now to minimize their expenditures for capital outlay in the future. When thesavings of households are matched by investments expenditures of firms, disequlibrium isnegated and the circular flow of income will tend to normalize.FLOW IN A MARKET WITH GOVERNMENT AND FOREIGN COUNTRIESIn an economy like the Philippines, there are two important sectors that interact with thehouseholds and firms: the government and foreign countries. T h e g o v e r n m e n t s e c t o r w h i c h p e r f o r m s n e c e s s a r y f u n c t i o n s b u y s t h e economic resources of land, labor, and capital from households. Land is used byt h e g o v e r n m e n t t o l o c a t e i t s b u i l d i n g a n d f a c i l i t i e s ; l a b o r i s h i r e d t o f i l l u p various positions in the different government agencies; capital is borrowed toproduce the necessary facilities and services. Payments in the form of wages,r e n t s , a n d i n t e r e s t a r e r e m i t t e d t o t h e h o u s e h o l d s b y t h e g overnment.Government money, however, is spent not only in bu y i n g t h e e c o n o m i c resources from households but also the goods and services produced by firms.Payments are also remitted to these firms. The goods and services purchased by the government come in a wide variety of forms: from office supplies totransport equipment and from consultancy to janitorial services.Households purchase goods and services from other countries, like tran sportation equipment, books,computer programs, etc. The corresponding payments are sent to the exporting foreign countries.Local firms sell goods and services like agricultural products to foreign countries. Payments are remitted to thelocal firms by foreign buyers

Circular Flow of Economic Activity

BY TEJVAN PETTINGER ON SEPTEMBER 10, 2009 IN ECONOMICS

Readers Question I am having trouble understanding the circular flow of economics. Could you explain it in simple terms, like how is it involved in my life, I dont get the connection to the product and factor markets The circular flow of income is a simple model to explain basic economic transactions. To start off, consider 2 groups of people

Households people like yourself Firms companies like BMW, Vodafone e.t.c. Householders (people like you or me) could get a job in a factory making cars. This leads to an output of goods. In return workers get income (wages) from the firm. With this income we can buy the goods firms are producing. This is Expenditure. Thus in a closed economy with no saving, tax or imports. Total Output should be the same as Total Income and Total Expenditure.

Note: Factor markets is markets like labour markets. Product markets are the production of goods like cars Therefore, this is the very basic circular flow of income. To this circular flow you could add a government which collects taxes from firms and households and spends money in the form of benefits and subsidies. Also you could add a foreign dimension.

Goods and services could be exported Money comes into economy Goods and services could be imported Money leaves the economy

Diagram to Show Circular Flow of Income

Circular Flow

Also, we dont spend all the money we receive, but will save some in banks. Firms could borrow from banks to invest.