Reducing the supply of a good leads to an increase in the demand for complementary goods

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:43

The law of supply and demand is the basis of a market economy. Without his understanding it is impossible to explain how it functions. Therefore, it is with the study of the concepts of supply and demand that any course in economic theory begins. Since the type of management in most modern countries of the world is a market one, knowledge of this fundamental law will be useful for any person. It allows us to understand that a reduction in the supply of a good leads to an increase in demand for its substitutes and a fall in complementary goods. But there are also exceptions. Today's article will be devoted to this topic.

Brief

In general, the lower the price, the more consumers are willing to buy. So in simple words you can formulate the law of demand. The higher the price, the more producersready to release the goods. This is the law of supply. Thus, we can conclude that, all other things being equal, the lower the price of a good, the greater the quantity consumers are willing to buy and the less producers are willing to produce. The law of supply and demand was first formulated by Alfred Marshall in 1890.

The law of supply and demand

The point where the two curves intersect indicates the equilibrium quantity of the good and its market price. In it, demand equals supply. This is a state of good balance. However, if it had always been like this, the economy would not have developed, because crises are progressive in nature, although they bring with them significant socio-economic shocks.

But back to the demand. It represents the amount of a good that a consumer is willing to purchase at a given price level. The magnitude of demand reflects not just the desire, but the willingness to buy a certain amount of the product. In addition to price, it is also affected by the level of income of the population, the size of the market, fashion, the availability of substitutes, and inflation expectations. The exception to the rule that demand increases when market value falls are Giffen goods, which we will discuss below.

As for the offer, it characterizes not only the desire, but also the readiness of the manufacturer to offer his product for sale on the market at a given price level. This is due to the invariability of costs per unit of goods, subject to an increase in profits. In addition to price, the supply is affected by the availability of substitutes, complements, the level of technology, taxes,subsidies, inflation and socio-economic expectations, market size.

The concept of elasticity

This indicator characterizes fluctuations in aggregate demand or supply caused by changes in the price level. If a decrease in the latter causes a larger percentage change in sales, then demand is said to be elastic. That is, in this case, we can say that this is the degree of sensitivity of consumers to the pricing policy of manufacturers.

However, you need to understand that elasticity can also be related to the level of income of buyers. If the latter and the quantity demanded change by the same percentage, then the factor under consideration is equal to one. The economic literature often talks about perfectly and perfectly inelastic demand.

For example, consider the consumption of bread and s alt. The demand for these goods is perfectly inelastic. This means that an increase or decrease in their price has no effect on the amount demanded for them. Knowing the degree of elasticity is of great practical importance for manufacturers. There is no particular point in raising the price of bread and s alt. But a sharp decrease in the price of a product with a high elasticity of demand will lead to higher profits.

This is exactly how it is profitable to operate in a highly competitive market, because buyers will instantly defect to the seller, whose products are cheaper. For goods with low elasticity of demand, the considered pricing policy is unacceptable, since the slightly changed sales volume does not compensate for the lost profit.

Coefficientelasticity of supply is calculated as the quotient of the change in the quantity of goods produced divided by the increase or decrease in price (both indicators must be expressed as a percentage). It depends on the characteristics of the release process, its duration and the ability of goods for long-term storage. If the increase in supply exceeds the increase in prices, then it is called elastic.

However, you need to understand that the manufacturer does not always have the opportunity to quickly reorganize. It is impossible to increase the number of produced cars in a week, although the price of them may well rise sharply. In this case, we can talk about inelastic supply. Also, the coefficient under consideration will be low for goods that cannot be stored for a long time.

Graphic

The demand curve shows the relationship between the price level in the market and the amount of goods that consumers are willing to buy. This part of the graph displays the inversely proportional relationship between these quantities. The supply curve shows the relationship between the price level in the market and the volume of goods that producers are willing to sell. This part of the graph displays a directly proportional relationship between these quantities.

Coordinates of the intersection of these two lines reflect the equilibrium volume of goods and the price that will be established on the market. This chart is sometimes referred to as "Marshall's scissors" because of its appearance. A shift in the supply curve to the right-down means that the producer has reduced costs per unit of goods. Therefore, he agrees tolower prices.

Reducing costs is often due to the introduction of new technologies or improved organization of production. The shift of the supply curve to the left-up, on the contrary, characterizes the deterioration of the economic situation. At each old price level, the producer will be willing to produce a smaller quantity of the good. A decrease in the supply of a good leads to an increase in demand for substitute goods and a decrease in demand for complementary products. But is it always that simple?

Independent Goods

This group includes goods whose cross elasticity of demand is equal to zero. These are the benefits that do not complement or replace one another. An example of such goods is a car and bread.

Complements

This group of goods includes goods that complement one another or are consumed simultaneously.

An example of a complementary good is a car and gasoline. These are complementary products. The cross elasticity of their demand is less than zero. This means that a reduction in the supply of a good leads to a decrease in the quantity purchased of another. The demand for complementary goods always moves in the same direction. If the price of one of these products rises, then consumers start buying less of the other.

In the case of complementary goods, it cannot be said that a reduction in the supply of a good leads to an increase in demand for the second. Why do we need gasoline if we can't afford to buy a car. Since these are complementary goods, an increase in the price of one of them leads to a decrease in the demand foranother. And how does this affect the economy as a whole? The price was raised by the sellers of one product, and the decrease in revenue is also observed among the producers of its complements.

Substitutes

This group includes products that replace each other. Examples of substitutes are, for example, various brands of tea. Similar products have similar characteristics and satisfy a specific need of buyers. Their cross elasticity is greater than zero. This means that a decrease in the supply of a good leads to an increase in the demand for its substitutes.

A drop in the price of one type of tea will cause many consumers to abandon the brand they are used to and switch to it if it meets all quality parameters.

Thus, similar products compete with each other, forcing manufacturers to seek to reduce the cost of their release. However, there are also exceptions related to demonstrative behavior, which we will discuss later.

Essentials and luxury goods

The so-called inferior or inferior goods are allocated into a separate group. Their peculiarity is that the demand for them decreases with an increase in the income of the population. The richer people are, the less they tend to buy them. A special case is the so-called Giffen effect.

However, inferior goods are not essential goods. The latter are products, the demand for which does not depend on the level of income. Their share inspending decreases, but absolute consumption itself remains the same. Their income elasticity is less than unity. Separately, you need to consider luxury items. Their consumption is increasing at a faster rate than income is growing.

Giffen Products

This concept is related, like the next one, to the concept of price elasticity. This category of goods includes, for example, bread and potatoes for Russia, and rice and pasta for China. The Giffen effect explains why an increase in price can lead to an increase in demand.

Indeed, the increase in the cost of potatoes leads to a stir in the market. Although, it would seem, it would be more rational to abandon it in favor of, for example, pasta or cereals. However, this is not the case in practice.

The Veblen Effect

This concept explains another possible deviation of practice from theory. In this case, the price of the goods decreases, which leads not to an increase, but to a decrease in demand. The Veblen effect is associated with conspicuous consumption.

Therefore, an increase in the price of these goods leads to an increase in their consumption. Often this happens with luxury goods, in particular works of art. This is another exception to the law of supply and demand. Their purchase is due to their status, therefore, a high price is more preferable for buyers.