The Relationship Between Demand Increase and Price in the Marketplace

There is a common belief that as demand for a product increases and there is a shortage of raw material or necessary components, the price naturally goes up. This notion forms the basis for understanding market dynamics and the allocation of finite resources. However, it is important to delve deeper into the complexities of supply and demand to truly grasp the nuanced relationship between demand and price.

Understanding Supply and Demand

Before we can understand why prices rise, we should first understand the initial assumption: that the marginal cost curve is U-shaped. This means that it initially costs a lot to produce the first unit, but as more units are produced, the unit cost decreases until a certain point, after which costs start to rise again due to production limitations. Consequently, in the initial phase of increased demand, prices are expected to drop, reflecting the lower marginal costs. But as production limits are reached and scarcity sets in, prices will start to rise again.

However, it is crucial to recognize that real-world markets are far more intricate than the simplified curve suggests. Goods are not clearly categorized, and demand and supply functions are not straightforward. Markets are constantly evolving, and the effect of increased demand on price can be either an increase or a decrease, depending on the specific market and current circumstances. In short, whether increased demand leads to price increases or decreases is an empirical question, not a universally applicable rule.

The Role of Supply and Demand in Allocation

When supply is limited but demand is high, something must determine who gets the scarce resource. Think of it in terms of auctions: a limited number of goods are up for grabs among a larger group of interested parties. The price bidding process ensures that the "lucky" few get the goods while the rest are left without. This same principle applies to real-world scenarios where a limited number of houses may be sought by a larger number of people.

In such scenarios, the final sale price acts as an economic signal. It indicates to producers that the market is ready for higher supply. For instance, if the price of houses continues to rise, it could motivate developers to build more houses to meet the demand. Conversely, a price cap could result in a surplus, where there are too many houses on the market and not enough buyers, leading to wasted resources.

The Significance of Economic Signals and Subsidies

Economic signals, like the rising price in our previous examples, are crucial for resource allocation. They guide resources to areas where they are most needed and away from areas where they are not. This mechanism ensures that the economy functions efficiently and that resources are directed towards the most valuable uses.

However, government interventions such as price controls and subsidies can disrupt this natural process. Setting price caps can drive out resources from the market, leading to shortages and reduced supply. On the other hand, setting higher prices to benefit sellers, such as through minimum wages or subsidies, can attract new resources to the market and waste resources on less effective uses. Therefore, understanding and respecting the natural dynamics of supply and demand is crucial for economic administration and market maintenance.

By recognizing the intricate relationship between demand and price and the role of supply and demand in resource allocation, we can better understand how markets operate and the importance of allowing economic signals to guide resource distribution.