3.1.2 Demand and supply
Important notes to teachers and students:
This section uses causal loops to illustrate and explain complex market systems dynamics. These models provide a more complex understanding of market relationships than the standard linear supply and demand market diagrams (see research paper on this issue here). However, you may not want to use this section to teach demand and supply if your students have to take a high stakes standardised exam based on linear demand / supply analysis. Still, there are some interesting insights here that you may want to use, even if you stick with linear models.
This section is 2-3 times longer than most other sections of the book. It will take longer for students to read and needs several lessons of work to engage with the ideas.
Helpful prior knowledge and learning objectives
Helpful prior learning:
Section 1.1.1 The economy and you, which explains what an economy is and how it is relevant to students’ lives
Section 1.1.2 The embedded economy, which explains the relationship between the economy and society and Earth’s systems
Section 1.3.6 Households, markets, state and commons, which explains four provisioning institutions in the economy and their interconnection
Section 3.1.1 The market as a system, which describes market parts and their relationships, and the connection between the household and the rest of the economy.
Section S.1 Systems thinking, which explains what a system is and why systems thinking is useful. (coming soon)
Section S.x Feedback loops and tipping points, which explains the roles of reinforcing and balancing feedback loops in amplifying or dampening change. (coming soon)
Learning objectives:
define demand and analyse the factors that affect demand
define supply and analyse the factors that affect supply
explain how changes in demand and supply affect prices in markets through shifts in power between consumers and producers
explain how price changes provide feedback in markets
Imagine holding a simple pencil in your hand. Have you ever considered how many different people and resources come together to make it? Even something as seemingly simple as a pencil involves a complex network of relationships between individuals and organisations around the world.
The I, Pencil video below, based on an essay of the same title, shows how the “invisible hand” of supply and demand drives market exchanges that produce the goods and services we rely on every day.
As you watch, make sure you keep in mind that markets are embedded in social and ecological systems. Markets don’t exist on their own, but rely on many more invisible factors to function, like laws, unpaid care, culture and social norms, as well as healthy ecosystems, which are not fully acknowledged in the video as it praises market forces.
What is demand and what factors affect it?
Demand refers to the quantity of a product that consumers are willing and able to purchase. Demand can be affected by different factors.
How price changes affect demand
The relationship between price and demand is typically inverse: as prices increase, the demand decreases, and as prices decrease, demand increases (Figure 1).
Figure 1. The relationship between price and demand is inverse, represented by the - symbol; as price increases demand decreases and as price decreases, demand increases.
You may have experienced this yourself. If a product that you bought previously becomes more expensive, you may be less likely to buy it. Why is this so?
At higher prices, you have to spend more money to get the product. This means you have less money to spend on other things you may need or want. Thus, the opportunity cost of buying the product increases and you may be less willing to buy it. The reverse is also true.
At higher prices, you may be less able to buy the product because you cannot afford it. The reverse is also true.
This inverse relationship between price and demand is known as the law of demand. However, it is important to know that this is not a ‘law’ like the laws of physics. It is more accurate to say that it is a pattern, which usually holds but not always.
How changes in non-price factors affect demand
Several other factors can impact the willingness and ability to buy a product:
tastes and preferences: changes in consumer tastes and preferences can impact demand. There are many factors that can change your tastes and preferences. Your rising awareness of protecting ecosystems may increase your demand for refurbished electronic devices, and decrease your demand for new devices. However, slick advertising may increase people’s demand for fast fashion or travel (Figure 2). Consumer tastes and preferences don’t exist on their own. They are shaped by social norms and the efforts of businesses to persuade us that we need or want certain products, which can contribute to unnecessary aspirational consumption, like buying things to look cool or for people to think you are successful.
Figure 2. Advertising may increase demand for a popular destination so much that it is no longer appealing (Maya Beach, Ko Phi Phi, Thailand)
(Credit: Diego Delso, CC BY-SA 4.0)
prices of related goods: The demand for a good can be affected by the prices of related goods. Substitute products have the same use. When the price of coffee increases, people may switch to buying tea, so demand for tea increases (Figure 3). Complement products are goods that are used together, like coffee and coffee filters (Figure 4). When the price of coffee increases, people buy less of it and will also buy less of its complement coffee filters. Demand for coffee filters decreases.
Figure 3. Coffee and tea are substitutes, products with the same or similar use that can replace one another
(Credit: Karolina Grabowska, feyza ebrar Pexels licence )
Figure 4. Coffee and coffee filters are complements, they are used together
(Credit: Karolina Grabowska, Pexels licence and Hay Cranen, CC BY 4.0)
expectations of future prices or product availability: If consumers expect the price of a product to increase in the future, they may decide to purchase it now, increasing current demand. On the other hand, if consumers expect prices to decrease in the future, they may wait to buy it, decreasing current demand. Early on in the Covid-19 pandemic, many consumers panicked and bought toilet paper and other necessity goods because they feared that supply disruptions would make them unavailable.
income: changes in incomes affect what and how much people buy. As people’s incomes rise, they may buy more of certain types of goods, like electronic devices. These are called normal products. However, as incomes rise, demand may decline for other products, which economists call inferior products. Canned food (in favour of fresh food) may be an example.
population: since 1950, the global population has more than tripled, from 2.49 billion people to more than 8 billion (Figure 5). The United Nations predicts that the global population will continue to grow until the 2080s, reaching more than 10 billion people. This population growth is likely to increase demand for most types of products.
Figure 5.Global population has more than tripled since 1950 and is projected to grow to 10 billion by the 2080s
(Credit: Our World in Data)
other factors: now that you have an idea how some factors affect demand, see if you can generalise how the following additional factors would affect demand for the relevant market:
government policies: consider bans on advertising for aeroplane travel, laws requiring bicycle helmets, taxes on fossil fuels, subsidies for train travel;
planned obsolescence: businesses may produce their products in a way that they only last a short time, break easily, or are difficulty to repair so that people have to buy replacements more frequently
seasonal changes: hot/cold, rainy/dry seasonal weather
climate change: think about demand for flood, fire or other insurance; demand for air conditioners, demand for homes in coastal regions
ageing populations: which products might experience increases or decreases in demand?
Figure 6 captures some of the factors described above in a systems diagram.
Figure 6. The price and non-price factors that affect demand.
Note: + symbol means a positive relationship (as one increases the other increases, as one decreases, the other decreases)
- symbol indicates an inverse relationship (as one increases, the other decreases; as one decreases, the other increases)
What is supply and what factors affect it?
Supply refers to the quantity of a good or service that producers are willing and able to offer for sale.
How price changes affect supply
The relationship between price and supply is usually direct: as prices increase, supply increases, and as prices decrease, supply decreases (Figure 7). This direct relationship is known as the law of supply. As with the law of demand, this is more of a pattern than a law like you have in physics.
Figure 7. The relationship between price and supply is direct or positive, represented by the + symbol; as price increases supply increases and as price decreases, supply decreases
How changes in non-price factors affect supply
Several factors can impact the willingness and ability of businesses to supply goods, thus increasing or decreasing supply:
cost of production: Changes in the production cost, such as wages, raw materials, energy, and taxes on products, can impact supply. For example, if energy costs increase, some firms may not be able to earn enough revenue to cover costs, or their profits may be lower, so they may decide not to produce and sell their goods. On the other hand, if costs of production decrease, firms may decide to produce and sell more of their products because they have more money to produce their products and their profits will be higher;
climate change: rising global temperatures make it more difficult and costly to produce products. More severe storms, floods and fire may damage factories, or reduce the material resources available for businesses to produce their goods. Hotter temperatures may limit the ability of workers to work, especially outdoors (Figure 8). The heat may also negatively affect farming and food production;
Figure 8. Construction workers will need to spend less time working outdoors due to dangerously hot conditions from climate change
(Credit: Moin Uddin, CC BY-NC 2.0)
technological advances: Improvements in technology can reduce the amount of resources needed per unit of production, lowering costs of production, and increasing efficiency. This enables producers to supply more. For instance, advancements in agricultural technology have increased the supply of wheat (Figure 9) because it now requires less inputs (water, fertiliser, pesticides) per unit of wheat, and is less costly to produce each unit. The impact of technology on supply is important to understand because improvements in technology usually result in more output, material use and ecological damage, rather than less as most people assume (rebound effect or Jevons paradox);
Figure 9. Technology advances have increased global wheat production since 1961, but this may not continue due to climate change and ecosystem damage
(Credit: Our World in Data, adapted from FAO data)
number of sellers: The more sellers there are in a market, the greater the supply of a good or service. On the other hand, if some sellers exit the market, the supply will decrease;
expectations about future prices: If producers expect higher prices in the future, they may hold back some of their current supply to sell later at a higher price. This expectation can reduce the current supply available in the market, increasing prices. On the other hand, if producers expect lower prices in the future, they may try to sell more of their product now, which would decrease prices. Ironically, the actions that sellers take in response to their expectations can actually cause the price changes they expect. This is a cause of reinforcing feedback loops that can destabilise markets, discussed a little later in this section.
Figure 10 captures some of the factors described above in a systems diagram.
Figure 10. The price and non-price factors affecting supply
Note: + symbol means a positive relationship (as one increases the other increases, as one decreases, the other decreases)
- symbol indicates an inverse relationship (as one increases, the other decreases; as one decreases, the other increases)
How do changes in demand and supply affect prices in markets?
There are relationships in the other direction too. Changes in demand and supply impact the price.
How changes in demand impact prices
When demand for a product increases while supply remains constant, the seller has more power to ask for a higher price, so prices rise if the seller takes advantage of this power. The extent of this power is related to a concept called elasticity, which is discussed in Section 3.1.3.
Conversely, if demand decreases, prices tend to fall as sellers have less power and need to lower their prices to attract buyers. This positive relationship between changes in demand and prices is shown below with the arrow from demand to prices and the + symbol (Figure 11).
Figure 11. The relationship between demand and price is direct or positive, represented by the + symbol; as demand increases price increases and as demand decreases, price decreases.
Consider the cocoa market. If global demand for chocolate increases, the demand for cocoa beans, a raw material in chocolate, increases. Power has shifted to the cocoa sellers who can ask for higher prices for their product. However, if global demand for chocolate declines, so will demand for cocoa beans. The market power shifts to the buyers (the chocolate producers) and sellers will have to lower their prices to sell all their beans.
How changes in supply impact prices
The same power shifts occur if supply changes. If the supply of a product increases while demand remains constant, prices usually decrease. Sellers have less power and need to lower their prices to attract buyers for their products.
On the other hand, if supply decreases, prices rise as the power shifts to the seller who can ask for more money for their product. This inverse relationship between changes in supply and prices is shown below with the arrow from supply to prices and the - symbol (Figure 12).
Figure 12. The relationship between supply and price is inverse, represented by the - symbol; as supply increases price decreases and as supply decreases, price increases
Global warming is playing an increasing role in the global cocoa market, as well as other important food markets. Global warming is reducing supplies of these crops due to increased extreme heat, drought and flooding. This shifts power to the cocoa sellers who can ask for higher prices for their beans, as was the case in 2024 (Figure 13). However, it is important to note that this does not necessarily mean that cocoa farmers earn more income. In the case of cocoa and many other food crops, farmers do not see the benefit of higher prices because there are only one or a few buyers for their beans. The buyers have the power and the farmers may have little choice about who to sell to. This situation is explored further in Section 3.2.3 on market power.
Pricing is an ethical issue
It’s important to remember that price changes in markets are not some automatic force of nature as they are often portrayed in economic models and narratives. Prices are set by humans and pricing decisions are a choice. This is true even where businesses use algorithms to change prices in response to market conditions, called dynamic pricing. Hotels increasingly use such algorithms to automatically raise prices as more of its rooms are booked, but the decision to program the algorithm that way comes from a human decision to exercise market power to increase profits.
Economists often argue that higher prices may help to get products to those who are most willing and able to pay them. While this may be acceptable for non-essential goods and services, there are ethical questions that arise when sellers use market power to raise prices for goods and services that are essential for meeting human needs, like water, food or housing. Higher prices may limit access to people who are not able to pay the price. Thus, market pricing is often linked to ethical questions related to power and discussions about how markets can be shaped to ensure that people have access to the things they need regardless of their ability to pay.
How do prices provide feedback in markets?
Changes in prices impact demand and supply, and changes in demand and supply affect prices. You can see these market dynamics together in the simple causal loop diagram in Figure 14.
Prices are a signal and an incentive, two forms of feedback (Section Sx - coming soon), to producers and consumers to change the quantities they buy or sell, respectively. This feedback can help to stabilise markets, called balancing feedback (B). But under certain conditions, price changes can also cause reinforcing feedback (R) which can cause destabilising market bubbles.
Figure 14. Market dynamics between supply, demand and prices
Price changes provide balancing feedback
Price decreases are a signal and incentive for producers to decrease the quantity of the product they supply to the market. At the same time, these lower prices are a signal and incentive for consumers to buy more of the product. Both impacts put upward pressure again on prices and stabilise the market.
Conversely, price increases are a signal and incentive for producers to increase the quantity of the product they supply to the market. At the same time, higher prices are a signal and incentive for consumers to buy less of the product. Both of these impacts put downward pressure again on prices and help to stabilise the market.
You can see this impact with the cocoa market, illustrated in Figure 15. Start with an increase in prices and follow the arrows and relationships to supply and demand to see how market prices should stabilise again.
Figure 15. Market dynamics between supply, demand and prices in the cocoa market
In theory, price changes in the cocoa market should cause changes to supply and demand to bring prices back down again. However, there might be conditions that prevent this from happening - can you think of conditions that might prevent supply and demand from changing in response to changes in price as expected? After you take a few minutes to think, click below for more ideas.
On the supply side:
Climate change could prevent suppliers from producing more cocoa because of drought or excessive heat
Farmers may not see higher incomes from cocoa price increases, which often go to speculators or to middlemen, so the price feedback may not reach the people who actually grow the cocoa
Cocoa trees take years to grow, so even where farmers get the price signal, it will take them a long time to react to it
Farmers may not have access to financial and land resources to increase production of cocoa
On the demand side:
Rising global incomes could keep demand for chocolate, which uses cocoa, increasing even as prices for the cocoa increase.
If chocolate manufacturers expect the price of cocoa to continue rising, they may buy even more now, increasing demand despite the higher prices (discussed below).
Price changes can provide reinforcing feedback
Reinforcing feedback loops amplify changes within a system, causing rapid growth or decline (Section Sx - coming soon). In markets, reinforcing feedback loops caused by consumer and producer expectations of future prices can amplify price increases and decreases.
Consider the housing market in Figure 16. When housing prices increase, people may expect housing prices to rise even further in the future, a positive relationship marked by the + symbol. These expectations increase demand for housing now, again a positive relationship marked by a + symbol. This increased demand increases prices up even further, reinforcing the original price increase. This can cause a market bubble, where price increases are disconnected from some normal measure of value.
Figure 16. Reinforcing feedback loop for a housing market, when people expect prices to continue to rise. This causes a house price bubble.
Eventually this can lead to a tipping point and a market crash, a very rapid decline in demand and prices in a reinforcing feedback loop in the opposite direction. Falling prices lead to expectations that prices will fall further, causing demand and prices to decline further. Such market bubbles have been common in housing markets and stock markets around the world in recent decades.
Markets are very complex systems whose prices provide powerful signals and incentives to producers and consumers. Though price changes can stabilise market activity, they do not always work well. And we must always remember that changing prices is a human choice, not a force of nature. Pricing is always and everywhere an ethical issue.
Activity 3.1.2
Concept: Systems
Skills: Thinking skills (transfer and critical thinking)
Time: varies, depending on the option
Type: Individual, pairs, and/or group
Option 1: Factors affecting demand and supply
Time: 30-40 minutes
Figure 17 shows all the information presented in this section about the factors affecting demand and supply and their relationships.
Examine the diagram with a partner, talking through the relationships. It can help to consider a real product, so you can use bicycles, or another product that you choose.
Figure 17. Market dynamics between supply, demand, prices and non-price factors
Remember that the + symbol means that the two variables move in the same direction; as one increases, the other increases, as one decreases the other decreases). The - symbol means that the two variables move in the opposite direction; as one increases, the other decreases and as one decreases, the other increases.
Consider the following situations and talk through or write down how each situation would impact the market for cars:
Average incomes rise in a country (and cars are a normal good)
New technologies make building cars more efficient
People believe that the price of cars will increase in the future
The price of electric bicycles decreases
The local government allocates more street space for bicycle lanes and bicycle parking, reducing the street space and parking for cars
Population increases
The state increases taxes on petrol (gas)
Option 2: Discussion - Should advertising for high-CO2 emitting products be banned?
Time: 20-40+ minutes, depending on whether students are given time to research information and arguments
Some cities, like Edinburgh, Scotland and the Hague in the Netherlands, are starting to ban advertising for goods and services with a high carbon footprint in city-owned spaces to lower market demand for them. When announcing its decision to ban advertising for high CO2 emissions products, the City of Edinburgh explained that reaching its climate targets "requires a shift in society’s perception of success, and the advertising industry has a key role to play in promoting low-carbon behaviours. Conversely, the promotion of high-carbon products is incompatible with net zero objectives.”
What do you think? Should governments ban advertising for goods and services with high CO2 emissions to reduce demand for them? If you believe that advertising bans for such goods are a good idea, how far should they go? For example, should there be bans on advertising for all non-necessary goods and services?
Use a discussion format or process that you are familiar with to prepare for and carry out a discussion of this question.
Figure 18. Advertising affects people’s tastes and preferences. Some cities like Edinburgh, Scotland are banning ads for high CO2 emitting products to change social norms.
(Credit: Gail Frederick, CC BY 2.0)
Option 3: Dynamic pricing
Time: 25-30 minutes
Read the Harvard Business Review article linked below, which explains dynamic pricing and its benefits.
Dynamic Pricing: What is it and why it’s important
Use the information from this section to make counter arguments to the article’s justification for dynamic pricing.
Based on the article’s justification, how might you retitle the article to better capture its perspective?
If you’re interested you can read this article about the anger caused by the band Oasis using dynamic pricing for a reunion concert in the UK. Aside from harming the goodwill of people towards the band, the situation has also raised concerns from antitrust regulators there.
Option 4: How language affects social norms
Time: 20 minutes
In this section, you were introduced to the idea that income can impact demand for products. Economists use the term normal goods to refer to products that people consume more of when their income rises, and the term inferior goods to refer to products that people consume less of when their income rises. It’s “normal” to purchase more goods when your income rises, and only “inferior” goods are purchased less when income rises.
Individually, or in a small group or as a class, consider the following question:
To what extent does this use of language affect social norms around consuming products as incomes rise?
Ideas for longer activities and projects are listed in Subtopic 3.5 Taking action
Checking for understanding
Further exploration
Get savvy with systems - 4/7 Doughnut Economics - a short animation from the Doughnut Economics Action Lab (DEAL) that explains the limitations of market models of supply and demand. These regenerative economics materials avoid these models in order to encourage more complex systems thinking. Difficulty level: easy
The chocolate price spike: what’s happening to global cocoa production? - an exploration of the factors causing the 2024 increase in cocoa prices from Hannah Ritchie of Our World in Data. Difficulty level: medium
What causes economic bubbles? - A TedED video about the causes of market bubbles, using the tulip mania in the 1600s as an example. Difficulty level: easy
Supply Shock | What Money Can't Buy #4 - In this video from the Institute for New Economic Thinking, political philosopher Micheal Sandel explores the role and appropriateness of markets in allocating essential goods and services. Difficulty level: medium
It worked with cigarettes. Let's ban ads for climate-wrecking products - an article from the New Scientist arguing in favour of banning advertisements for high-CO2 emissions goods and services. Difficulty level: medium
Sources
Blink, J., & Dornton, I. (2020). Economics: Course Companion. Oxford: Oxford University Press.
The CORE Econ Team (2023). The Economy 2.0: Microeconomics. Unit 7. https://www.core-econ.org/the-economy/microeconomics/07-firm-and-customers-01-winning-brands.html
The CORE Econ Team (2023). The Economy 2.0: Microeconomics. Unit 8. https://www.core-econ.org/the-economy/microeconomics/08-supply-demand-01-american-civil-war.html
Jägerskog, A. (2020). “Using Visual Representations to Enhance Students’ Understanding of Causal Relationships in Price”. Scandinavian Journal of Educational Research. 65. 1-18. 10.1080/00313831.2020.1788146. https://www.researchgate.net/publication/343092493_Using_Visual_Representations_to_Enhance_Students'_Understanding_of_Causal_Relationships_in_Price
Kognity (2022). IB DP Economics HL FE2024. Stockholm: Kognity.
Meadows, D. H. (2015). Thinking in Systems. Chelsea Green Publishing.
Raworth, K. (2017). Doughnut economics: seven ways to think like a 21st century economist. London: Penguin Random House
van Bavel, B. (2016). The Invisible Hand. Oxford: Oxford University Press.
Terminology
Link to Quizlet interactive flashcards and terminology games for Section 3.1.2 Demand and supply
supply: the quantity of a product that producers are willing and able to supply at various prices
demand: the quantity of a product that consumers are willing and able to purchase at various prices
market: a system where people buy and sell goods and services for a price.
system: a set of interdependent parts that organise to create a functional whole
care: the act of providing what is necessary for the health, welfare, upkeep, and protection of someone or something
culture: the beliefs, values, attitudes, behaviours and traditions shared by a group of people and transmitted from one generation to the next
norm: a social rule for accepted and expected behaviour, can be stated or unstated
ecosystem: the interaction of groups of organisms with each other and their physical environment
product: something that a business produces for sale, a good (tangible) or service (intangible)
consumer: someone who buys and uses resources and products ot meet needs
price: an amount that must be paid to access a good or service; can be money or some other medium of exchange
opportunity cost: what is given up to get something else
law of demand: inverse relationship between price and demand
preference: a greater liking for one alternative over another or others
aspirational consumption: buying products in order to increase self-esteem and social status
substitute product: a product that serves the same purpose as another product in the market
complement product: a product that is used with or whose demand is positively related to another product
income: money received from work or investments
normal product: a product whose demand increases as income increases
inferior product: a product whose demand decreases as income increases
tax: payment from individuals or organisations to the government, used to provide public infrastructure and services
fossil fuel: a non renewable energy source including coal, oil, and natural gas, formed over millions of years in the Earth's crust from decomposed plants and animals
subsidy: a payment made by the state to a business or individual to encourage certain behaviour
planned obsolescence: a deliberate strategy to increase sales of new products by making products that require frequent replacing due to changes in design, lack of spare parts for repair, or poor quality materials
climate change: a change in the temperature and precipitation patterns in an area, in recent times due to human economic activities
law of supply: direct or positive relationship between price and supply
production cost: the amount of money needed to produce a product
wage: payment for work
raw material: a basic material that is used to produce goods
energy: the ability to do work or cause change
revenue: the money earned from selling a product
profit: total revenue minus total cost
efficiency: the ratio of resource inputs compared to outputs
fertiliser: a chemical or natural substance added to soil or land to increase its fertility
pesticide: a chemical that kills pests
rebound effect: a situation where efficiency gains in an input are counteracted by increased consumption and production, which can offset the efficiency gains to some degree
Jevons paradox: a situation where efficiency gains in an input are counteracted by increased consumption and production, resulting in even greater use of the input
reinforcing feedback: a situation where change in a system causes further changes that amplify the original change which can lead to tipping points in a system
power: the ability to influence events or the behaviour of other people
elasticity: a measure of how much the quantity demanded or supplied of a product changes in response to some facto
global warming: the rise in the average temperature of Earth's air and oceans (due to human activities)
market power: the ability of a firm to influence the price of their product in a market, as well as other market conditions
algorithm: a process or set of rules to be followed in calculations or other problem-solving operations, especially by a computer
dynamic pricing: varying the price for a product or service to reflect changing market conditions, in particular the charging of a higher price at a time of greater demand
ethical: relating to beliefs about what is morally right and wrong
feedback: when outputs of a system circle back to impact inputs to the same system
balancing feedback: a situation where feedback produces change in the opposite direction
market bubbles: a period when prices rise rapidly, outpacing the true worth, or intrinsic value, of something
incentive: something that motivates or encourages someone to do something
speculator: a person who buys stocks, property, or other assets in the hope of making a profit
amplify: to increase
value: ideas about what is important or good
tipping point: a condition where even a small further change can push a system into a different state
market crash: a sudden and significant decline in the value of an asset in a market
complex system: a system composed of many components which may interact with each other in unpredictable ways
carbon footprint: a measure of the amount of carbon dioxide released into the atmosphere as a result of the activities of a particular individual, organisation, or community