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Supply and demand

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In microeconomic theory supply and demand attempts to describe, explain, and predict the price and quantity of goods sold in competitive markets. It is one of the most fundamental economic models, ubiquitously used as a basic building block in a wide range of more detailed economic models and theories.

In general the theory claims that where goods are traded in a market at a price where consumers demand more goods than firms are prepared to supply, this shortage will tend to increase the price of the goods. Those consumers that are prepared to pay more will bid up the market price. Conversely prices will tend to fall when the quantity supplied exceeds the quantity demanded. This price/quantity adjustment mechanism causes the market to approach an equilibrium point, a point at which there is no longer any impetus to change. This theoretical point of stability is defined as the point where producers are prepared to sell exactly the same quantity of goods as the consumers want to buy.

The theory of supply and demand is important in the functioning of a market economy in that it explains the mechanism by which many resource allocation decisions are made.

Table of contents
1 Assumptions and Definitions
2 Simple supply and demand curves
3 Demand curve shifts
4 Supply curve shifts
5 Elasticity
6 Vertical supply curve
7 Other market forms
8 An example: Supply and demand in a 6 person economy
9 History of Supply and Demand
10 See also
11 External link and References

Assumptions and Definitions

The theory of supply and demand is usually developed assuming that markets are perfectly competitive. This means that there are many small buyers and sellers, each of which is unable to influence the price of the good on its own. This assumption is central to the simple understanding of supply and demand taught in introductory economics. In many actual economic transactions, the assumption fails because some individual buyers or sellers have enough market power to influence prices. In this situation, the simple microeconomic theory of supply and demand is incomplete and more sophisticated analysis is needed.

Demand

Demand (or quantity demanded) is the amount that will be bought at a given price. For example I may be willing to purchase 30 bags of potato chips in the next year if the price is $1 per bag. I may also be willing to purchase 10 bags in the next year if the price were $2. A demand schedule can be constructed that shows the quantity demanded at all relevant prices. It can be represented on a graph as a line or curve by plotting the quantity demanded at each price. It can also be described mathematically by a demand equation.

The main determinants of the quantity I am willing to purchase will typically be the price of the good, my level of income, my personal tastes, the price of substitue goods, and the price of complementary goods.

Supply

Supply is the quantity that producers are willing to make at a given price. For example, the chip manufacturer may be willing to produce 1 million bags of chips if the price is $1 and substantially more if the market price is $2.

The main determinants of the amount of chips a company is willing to produce will typically be the market price of the good and the cost of producing it. In fact, supply curves are constructed from the firm's long-run cost function.

Simple supply and demand curves

A typical supply curve and demand curve is illustrated in the diagram to the right.

Supply and demand graph

The slope of the demand curve (downward-to-the-right) indicates that a greater quantity will be demanded when the price is lower. On the other hand, the slope of the supply curve (upward-to-the-right) tells us that as the price goes up, producers are willing to produce more goods. The point where these curves intersect is the equilibrium point. At a price of P producers will be willing to supply Q units per period of time and buyers will demand the same quantity. P in this example, is the equilibriating price that equates supply with demand.

In the figures, straight lines are drawn instead of the more general curves. This is typical in analysis looking at the simplified relationships between supply and demand because the shape of the curve does not change the general relationships and lessons of the supply and demand theory. The shape of the curves far away from the equilibrium point are less likely to be important because they do not effect the market clearing price and will not effect it unless large shifts in the supply or demand occur. So straight lines for supply and demand with the proper slope will convey most of the information the model can offer. In any case, the exact shape of the curve is not easy to determine for a given market. The general shape of the curve, especially its slope near the equilibrium point, does however have an impact on how a market will adjust to changes in demand or supply. See the below section on elasticity.

The section below outlines how prices and quantities not at the equilibrium point tend to move towards the equilibrium.

Effects of being away from the equilibrium point

Oversupply
Assume that some organization (say government or industry cartel) has the ability to set prices. If the price is set too high, such as at P1 in the diagram to the right, then the quantity produced will be Qs. The quantity demanded will be Qd. Since the quantity demanded is less than the quantity supplied there will be an oversupply (also called surplus or excess supply). On the other hand, if the price is set too low, then too little will be produced to meet demand at that price. This will cause an undersupply problem (also called a shortage).

Now assume that individual firms have the ability to alter the quantities supplied and the price they are willing to accept, and consumers have the ability to alter the quantities that they demand and the amount they are willing to pay. Businesses and consumers will respond by adjusting their price (and quantity) levels and this will eventually restore the quantity and the price to the equilibrium.

Adjustment in the case of oversupply
In the case of too high a price and oversupply, (seen in the diagram at the left) the profit maximizing businesses will soon have too much excess inventory, so they will lower prices (from P1 to P) to reduce this. Quantity supplied will be reduced from Qs to Q and the oversupply will be eliminated. In the case of too low a price and undersupply, consumers will likely compete to obtain the good at the low price, but since more consumers would like to buy the good at the price that is too low, the profit maximizing firm would raise the price to the highest they can, which is the equilibrium point. In each case, the actions of independent market participants cause the quantity and price to move towards the equilibrium point.


Demand curve shifts

right When more people want something the quantity demanded at all prices will tend to increase. This can be referred to as an increase in demand. The increase in demand could also come from changing tastes, where the same consumers desire more of the same good than they previously did. Increased demand can be represented on the graph as the curve being shifted right, because at each price point, a greater quantity is demanded. An example of this would be more people suddenly wanting more coffee. This will cause the demand curve to shift from the initial curve D0 to the new curve D1. This raises the equilibrium price from P0 to the higher P1. This raises the equilibrium quantity from Q0 to the higher Q1. In this situation, we say that there has been an increase in demand which has caused an extension in supply.

Conversely, if the demand decreases, the opposite happens. If the demand starts at D1, and then decreases to D0, the price will decrease and the quantity supplied will decrease - a contraction in demand.

Notice that this is purely an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the demand is different.

Supply curve shifts

left When the suppliers' costs change the supply curve will shift. For example, assume that someone invents a better way of growing wheat so that the amount of wheat that can be grown for a given cost will increase. Producers will be willing to supply more wheat at every price and this shifts the supply curve S0 to the right, to S1 - an increase in supply. This causes the equilibrium price to decrease from P0 to P1. The equilibrium quantity increases from Q0 to Q1 as the quantity demanded increases at the new lower prices. Notice that in the case of a supply curve shift, the price and the quantity move in opposite directions.

Conversely, if the quantity supplied decreases, the opposite happens.  If the supply curve starts at S1, and then shifts to S0, the equilibrium price will increase and the quantity will decrease.

Notice that this is purely an effect of supply changing. The quantity demanded at each price is the same as before the supply shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the supply is different.

See also: Induced demand

Elasticity

Main article: Elasticity (economics)

An important concept in understanding supply and demand theory is elasticity. In this context, it refers to how supply and demand change in response to various stimuli. One way of defining elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arch elasticity because it calculates the elasticity over a range of values - This can be contrasted with point elasticity that uses differential calculus to determine the elasticity at a specific point). Thus it is a measure of relative changes.

Often, it is useful to know how the quantity supplied or demanded will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this effect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effecive price, how will this effect the quantity demanded?

If you do not wish to calculate elasticity, a simpler technique is to look at the slope of the curve. Unfortunately, this has units of measurement of quantity over monetary unit (For example, liters per euro, or battleships per million yen), which is not a convenient measure to use for most purposes. So, for example if you wanted to compare the effect of a price change of gasoline in Europe versus the United States, there is a complicated conversion between gallons per dollar and liters per euro. This is one of the reasons why economists often use relative changes in percentages, or elasticity. Another reason is that elasticity is more than just the slope of the fuction: It is the slope of a function in a coordinate space, that is, a line with a constant slope will have different elasticity at various points.

Lets do an example calculation. We have said that one way of calculating elasticity is the percentage change in quantity over the percentage change in price. So, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the elasticity is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not effect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example how much would the demand for a luxury car increase if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve, because at all price levels, a greater quantity of luxury cars would be demanded.

Another elasticity that is sometimes considered is the cross elasticity of demand which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -20%/10% or, -2.

Vertical supply curve

It is sometimes the case that the supply curve is vertical, that is the quantity supplied is fixed, no matter what the market price. For example, the amount of land in the world can be considered fixed. In this case, no matter how much someone would be willing to pay for one more acre of land, the extra cannot be created. Also, even if no one wanted all the land, it still would exist. These conditions create a vertical supply curve, giving it zero elasticity (ie. - no matter how large the change in price, the quantity supplied will not change).

In the short run near vertical supply curves are even more common. For example, if the Super Bowl is next week, increasing the number of seats in the stadium is almost impossible. The supply of tickets for the game can be considered vertical in this case. If the organizers of this event underestimated demand, then it may very well be the case that the price that they set is below the equilibrium price. In this case there will likely be people who paid the lower price who only value the ticket at that price, and people who could not get tickets, even though they would be willing to pay more. If some of the people who value the tickets less sell them to people who are willing to pay more (i.e. scalp the tickets), then the effective price will rise to the equilibrium price.

The graph below illustrates a vertical supply curve. When the demand 1 is in effect, the price will p1. When demand 2 is occurring, the price will be p2. Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price.

 Diagram of vertical supply curve

Other market forms

In a situation in which there are many buyers but a single monopoly supplier that can adjust the supply or price of a good at will, the monopolist will adjust the price so that his profit is maximised given the amount that is demanded at that price. This price will be higher than in a competitive market. A similar analysis using supply and demand can be applied when a good has a single buyer, a monopsony, but many sellers.

Where there are both few buyers or few sellers, the theory of supply and demand cannot be applied because both decisions of the buyers and sellers are interdependent - changes in supply can affect demand and vice versa. Game theory can be used to analyse this kind of situation. See also oligopoly.

The supply curve does not have to be linear. However, if the supply is from a profit maximizing firm, it can be proven that supply curves are not downward sloping (i.e. if the price increases, the quantity supplied will not decrease). Supply curves from profit maximizing firms can be vertical, horizontal or upward sloping.

Standard microeconomic assumptions cannot be used to prove that the demand curve is downward sloping. However, despite years of searching, no generally agreed upon example of a good that has an upward sloping demand curve has been found (also known as a giffen good). Non-economists sometimes think that this would not be the case for certain goods. For example, some people will buy a luxury car because it is expensive. In this case the good demanded is actually prestige, and not a car, so when the price of the luxury car decreases, it is actually changing the amount of prestige so the demand is not decreasing since it is a different good (see Veblen good). Even with downward sloping demand curves, it is possible that an increase in income may lead to a decrease in demand for a particular good, probably due to the existence of more attractive alternatives which become affordable: a good with this property is known as an inferior good.

An example: Supply and demand in a 6 person economy

Supply and demand can be thought of in terms of individual people interacting at a market. Suppose the following six people participate in this simplified economy:

There are many possible trades that would be mutually agreeable to both people, but not all of them will happen. For example, Cathy and Fred would be interested in trading with each other for any price between $25 and $30. If the price is above $30, Cathy is not interested, since the price is too high. If the price is below $25, Fred is not interested since the price is too low. However at the market, Cathy will discover that there are other sellers willing to sell at well below $25, so she will not trade with Fred at all. In an efficient market, each seller will get as high a price as possible, and each buyer will get as low a price as possible.

Imagine that Cathy and Fred are bartering over the price. Fred offers $25 for a sack of potatoes. Before Cathy can agree, Emily offers a sack of potatoes for $24. Fred is not willing to sell at $24, so he drops out. At this point, Dan offers to sell for $12. Emily won't sell for that amount so it looks like the deal might go through. At this point Bob steps in and offers $14. Now we have two people willing to pay $14 for a sack of potatoes (Cathy and Bob), but only one person (Dan) willing to sell for $14. Cathy notices this, and doesn't want to lose a good deal, so she offers Dan $16 for his potatoes. Now Emily also offers to sell for $16, so there are two buyers and two sellers at that price (note that they could have settled on any price between $15 and $20), and the bartering can stop. But what about Fred and Alice? Well, Fred and Alice are not willing to trade with each other since Alice is only willing to pay $10 and Fred will not sell for any amount under $25. Alice can't outbid Cathy or Bob to purchase from Dan so Alice will not be able to get a trade with them. Fred can't underbid Dan or Emily so he will not be able to get a trade with Cathy. In other words, a stable equilibrium has been reached.

A supply and demand graph could also be drawn from this. The demand would be:

The supply would be:

And here is the graph:

 graph  of discrete example

Supply and demand match when the quantity traded is two sacks and the price is between $15 and $20. Whether Dan sells to Cathy, and Emily to Bob, or the other way round, and what precisely is the price agreed cannot be determined. This is the only limitation of this simple model. When considering the full assumptions of perfect competition the price would be fully determined since there would be enough participants to determine the price. For example, if the "last trade" was between someone willing to sell at $15.50 and someone willing to pay $15.51, then the price could be determined to the penny. As more participants enter, the more likely there will be a close bracketing of the equilibrium price.

It is important to note that this example violates the assumption of perfect competition in that there are a limited number of market participants. However this simplification shows how the equilibrium price and quantity can be determined in an easily understood situation. The results are similar when unlimited market participants and the other assumptions of perfect competition are considered.

History of Supply and Demand

Attempts to determine how supply and demand interact began with Adam Smith's The Wealth of Nations first published in 1776. In this book, he mostly assumed that the supply price was fixed, but that the demand would increase or decrease as the price decreased or increased. David Ricardo in 1817 published the book Principles of Political Economy and Taxation in which the first idea of an economic model was proposed. In this, he more rigoursly laid down the idea of the assumptions that were used to build his ideas of supply and demand.

During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanely Jevons, Carl Menger, and Léon Walras. The key idea was that the price was set by the most expensive price, i.e. the price at the margin. This was a substantial improvement over Adam Smith's thoughts on determining the supply price.

Finally, most of the basics of the modern theory of supply and demand was finalized by Alfred Marshall and Léon Walras when they combined the ideas about supply and the ideas about demand and began looking at the equilbrium point where the two curves crossed. They also began looking at the effect of markets on each other.

Since the late 19th century, the theory of supply and demand has mainly been unchanged. Most of the work has been in examining the exceptions to the model (like oligarchy, transaction costs, non-rationality).

See also

External link and References

Topics in microeconomics
Scarcity | Opportunity cost | Supply and demand | Elasticity | Economic surplus | Aggregation of individual demand to total, or market, demand | Consumer theory | Production, costs, and pricing | Market form | Welfare economics | Market failure

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