Demand and supply are dependent on the trade quantity and value of exchange.This is in line with the traditional literature of economics. When the value of exchange goes up, demand for the quantity goes down. This is a basic psychological aspect of any human being.More about this psychology can be understood from this previous post which talks about "BENEFITS & COSTS OF A FALLING DOLLAR" .The utility functions of the human beings in the foundation of this particular aspect. We always try to perform a cost and benefit analysis while procuring anything.This is because we always try to receive the benefits more than the cost incurred.For this reason, the demand curve always slopes downward.It means that, with the rise in price, demand for the quantity goes down. The law of diminishing marginal utility explains this phenomenon. Perceived utility of a particular quantity of good or service goes down with rising in price. The value of this utility reaches zero at the maxima of the cumulated perceived utility.Thus, the law of diminishing marginal utility explains the foundation of cost-benefit analysis.
For supply curve, the situation is just the opposite.A seller always wants to receive the best value of exchange out of the trade.So, a seller will always want to receive a higher marginal benefitwith the rise in quantity sold. This psychological aspect makes the supply curve upward sloping.Yet, we assume that other external factors are constant for demand and supply conditions. Economists call this condition as the “Ceteris Paribus” condition.
A trade becomes successful, when the demand and supply curves meet each other. Economists call that meeting point of two curves as the equilibrium point.The buyer and the seller agree upon the price and quantity at this point. At this point, the market reaches the equilibrium.
For explicating demand and supply, we will now look at Figure 1. In this figure, DD is the demand curve, and SS is the supply curve.These curves intersect each other at point E, and this is the equilibrium point. At this point, P is the equilibrium price, and Q is the equilibrium quantity.
Now, let us look at the demand curve DD. It is visible from this curve that the demanded quantity falls to rise in price, and rises to fall in price.This is in the similar lines with the law of diminishing marginal utility.We have assumed that external factors are constant here. If there is an external shock, which can increase the demand, then DD will shift upwards.Also, if there is an external shock, which can decrease the demand, then DD will shift downwards. These are demand shocks.An increase in the tax rate can reduce the amount of disposable income, and it can reduce the demand. This is an example of negative demand shock. Introduction of a policy for increasing the wage rate increases the disposable income.It can increase the demand, and it is a positive demand shock.
Now, let us look at the supply curve SS.It is visible from this curve that the selling quantity falls to fall in price, and rises to rise in price.We have assumed that external factors are constant here. If there is an external shock, which can increase the supply, then SS will shift upwards.Also, if there is an external shock, which can decrease the supply, then SS will shift downwards.These are supply shocks. Due to heavy rain, supply of crops will go down. This is an example of negative supply shock.Reduction in corporate tax rate will boost the production and supply. This is an example of positive supply shock.
If we just look at the crude oil price scenario, then the demand and supply conditions may be clear.The price of crude oil is about to hit twenty dollars per barrel. A sudden economic slowdown in the Chinese market has caused a slump in the crude oil demand.As China has been one of the major buyers of crude oil, their economic slowdown caused the crude oil price to fall.But, it is not possible to reduce the supply at the same pace.Thus, the demand in the Chinese marketis determining the equilibrium price of crude oil.