Supply and demand are the foundations of economics and the backbone of the market economy. These market forces have been used for many years for explaining consumer behaviour and providing guidance for government policies. However, supply and demand have fallacies and at times fail to describe firms and consumers' decision making.
The supply and demand model reflects conventional economic theory. Conventional economic is based on an individual maximising a utility function in which utility is a function of the quantity of goods and services consumed by that individual (McDonald, 2008). Conventional economics assumes that the consumer makes rational economic decisions, however this is not always the case. Human decision making is highly complex and sophisticated and this is not taken into account in the supply and demand model. After the 2008 financial crisis which was not predicted by conventional economic, Behavioural economics became a fast growing area of economics. Behavioural economics is an approach to economic analysis that incorporates psychological insights into individual behaviour to explain economic decisions. Its main objective is to explain choices. From the study conducted by M. McDonald on human behaviour towards fairness we can see that assumption of conventional economics, where the consumer is only concerned about the amounts of goods and services they themselves get to consume, is not consistent. The experiment showed that consumers are very susceptible to the decision making environment. Furthermore, consumers demand can be easily manipulated by non-pricing factors, this is not reflected in the supply and demand model. Marketing plays a major role in influencing consumers' demand for a good or service. In Ariely's book this concept is shown very clearly when he talks about the black pearls market. Initially there was no demand for black pearls, but after his marketing efforts black pearls were on the necks of New York's most famous divas.
Another reason why the supply and demand model does not explain decision making is because it does not include information asymmetry. Asymmetric information means that in an economic transaction one party has more information than the other. According to Conventional economics consumers make rational and informed decision. Due to asymmetric information, consumers are not able to make rational decisions. As a result of this market failure arise. An example of a market in which asymmetric information is highly involved is health care. However, this is partly because of the nature of the market, becoming a physician takes years of training. Doctors have more knowledge regarding the disease, medicines and treatment than the patient and may not disclose this information. This creates a moral hazard; the doctor is in a position in which could exploit the patient in order to increase his profit. The doctor could prescribe expensive drugs, and run unnecessary clinical tests. As a result of this the patient cannot question the billing. If there is more symmetric information, just by using generic drugs, health care costs can be reduced by at least 50% in developing countries (Ghosh, 2008). This would help millions of people to have access to medications in the developing world. Unfortunately for poor and uneducated people is very difficult to expand their knowledge and gain some bargaining power. One way to reduce the effects of information asymmetry in markets is through government intervention. The government should make health care a public good, however this may lead to under provision due to the free rider problem. This may lead to further market failure.
The market forces of supply and demand do not take into account externalities. Externalities are the costs or benefits imposed on or enjoyed by an individual, institution or community because of the actions of others. Education is thought to have played a major role in the development of society as it has substantially contributed to economic and technological growth. A large number of educated citizens is not only beneficial for the individuals but also for the country as a whole. Some benefits include better skilled labour force, higher productivity and increased foreign direct investment. These are examples of positive externalities; they have positive effects on third parties not involved in the economic transaction. Since externalities are not included in the market forces, some goods and services may be under or over provided by the market.
Moreover, the supply and demand model fails to consider the market power of firms.
In conclusion the demand and supply model contains various fallacies, however creating a model that truly reflects reality and consumers' behaviour would be extremely complex.
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