Supply
and demand is an economic model of price determination in a market. It
concludes that in a competitive market, the unit price for a particular
good will vary until it settles at a point where the quantity demanded
by consumers (at current price) will equal the quantity supplied by
producers (at current price), resulting in an economic equilibrium of
price and quantity.
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The price P of a product is determined by a balance between production at each
price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product |
The four basic laws of supply and demand are:
If demand increases and supply remains unchanged, then it leads to higher equilibrium price and quantity.
If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and quantity.
If supply increases and demand remains unchanged, then it leads to lower equilibrium price and higher quantity.
If supply decreases and demand remains unchanged, then it leads to higher price and lower quantity.
The graphical representation of supply and demand
The
supply-demand model is a partial equilibrium model representing the
determination of the price of a particular good and the quantity of that
good which is traded. Although it is normal to regard the quantity
demanded and the quantity supplied as functions of the price of the
good, the standard graphical representation, usually attributed to
Alfred Marshall, has price on the vertical axis and quantity on the
horizontal axis, the opposite of the standard convention for the
representation of a mathematical function.
Determinants
of supply and demand other than the price of the good in question, such
as consumers' income, input prices and so on, are not explicitly
represented in the supply-demand diagram. Changes in the values of these
variables are represented by shifts in the supply and demand curves. By
contrast, responses to changes in the price of the good are represented
as movements along unchanged supply and demand curves.
Supply schedule
The
supply schedule, depicted graphically as the supply curve, represents
the amount of some good that producers are willing and able to sell at
various prices, assuming ceteris paribus, that is, assuming all
determinants of supply other than the price of the good in question,
such as technology and the prices of factors of production, remain the
same.
Under
the assumption of perfect competition, supply is determined by marginal
cost. Firms will produce additional output as long as the cost of
producing an extra unit of output is less than the price they will
receive.
By
its very nature, conceptualizing a supply curve requires that the firm
be a perfect competitor—that is, that the firm has no influence over the
market price. This is because each point on the supply curve is the
answer to the question "If this firm is faced with this potential price,
how much output will it be able to and willing to sell?" If a firm has
market power, so its decision of how much output to provide to the
market influences the market price, then the firm is not "faced with"
any price, and the question is meaningless.
Economists
distinguish between the supply curve of an individual firm and the
market supply curve. The market supply curve is obtained by summing the
quantities supplied by all suppliers at each potential price. Thus in
the graph of the supply curve, individual firms' supply curves are added
horizontally to obtain the market supply curve.
Economists
also distinguish the short-run market supply curve from the long-run
market supply curve. In this context, two things are assumed constant by
definition of the short run: the availability of one or more fixed
inputs (typically physical capital), and the number of firms in the
industry. In the long run, firms have a chance to adjust their holdings
of physical capital, enabling them to better adjust their quantity
supplied at any given price. Furthermore, in the long run potential
competitors can enter or exit the industry in response to market
conditions. For both of these reasons, long-run market supply curves are
flatter than their short-run counterparts.
The determinants of supply follow:
Production costs
The technology used in production
The price of related goods
Firm's expectations about future prices
Number of suppliers
Demand schedule
The
demand schedule, depicted graphically as the demand curve, represents
the amount of some good that buyers are willing and able to purchase at
various prices, assuming all determinants of demand other than the price
of the good in question, such as income, tastes and preferences, the
price of substitute goods, and the price of complementary goods, remain
the same. Following the law of demand, the demand curve is almost always
represented as downward-sloping, meaning that as price decreases,
consumers will buy more of the good.
Just
as the supply curves reflect marginal cost curves, demand curves are
determined by marginal utility curves. Consumers will be willing to buy a
given quantity of a good, at a given price, if the marginal utility of
additional consumption is equal to the opportunity cost determined by
the price, that is, the marginal utility of alternative consumption
choices. The demand schedule is defined as the willingness and ability
of a consumer to purchase a given product in a given frame of time.
As
described above, the demand curve is generally downward-sloping. There
may be rare examples of goods that have upward-sloping demand curves.
Two different hypothetical types of goods with upward-sloping demand
curves are Giffen goods (an inferior but staple good) and Veblen goods
(goods made more fashionable by a higher price).
By
its very nature, conceptualizing a demand curve requires that the
purchaser be a perfect competitor—that is, that the purchaser has no
influence over the market price. This is because each point on the
demand curve is the answer to the question "If this buyer is faced with
this potential price, how much of the product will it purchase?" If a
buyer has market power, so its decision of how much to buy influences
the market price, then the buyer is not "faced with" any price, and the
question is meaningless.
As
with supply curves, economists distinguish between the demand curve of
an individual and the market demand curve. The market demand curve is
obtained by summing the quantities demanded by all consumers at each
potential price. Thus in the graph of the demand curve, individuals'
demand curves are added horizontally to obtain the market demand curve.
The determinants of demand follow:
1. Income
2. Tastes and preferences
3. Prices of related goods and services
4. Buyer's expectations about future prices
5. Number of Buyers
Microeconomics
Equilibrium
Equilibrium
is defined to the price-quantity pair where the quantity demanded is
equal to the quantity supplied, represented by the intersection of the
demand and supply curves.
Market Equilibrium:
A
situation in a market when the price is such that the quantity that
consumers wish to demand is correctly balanced by the quantity that
firms wish to supply.
Comparative static analysis:
Examines the likely effect on the equilibrium of a change in the external conditions affecting the market.
Changes in market equilibrium
Practical
uses of supply and demand analysis often center on the different
variables that change equilibrium price and quantity, represented as
shifts in the respective curves. Comparative statics of such a shift
traces the effects from the initial equilibrium to the new equilibrium.
Demand curve shifts
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An outward (rightward) shift in demand increases both equilibrium price and quantity
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When
consumers increase the quantity demanded at a given price, it is
referred to as an increase in demand. Increased demand can be
represented on the graph as the curve being shifted to the right. At
each price point, a greater quantity is demanded, as from the initial
curve D1 to the new curve D2. In the diagram, this raises the
equilibrium price from P1 to the higher P2. This raises the equilibrium
quantity from Q1 to the higher Q2. A movement along the curve is
described as a "change in the quantity demanded" to distinguish it from a
"change in demand," that is, a shift of the curve. In the example
above, there has been an increase in demand which has caused an increase
in (equilibrium) quantity. The increase in demand could also come from
changing tastes and fashions, incomes, price changes in complementary
and substitute goods, market expectations, and number of buyers. This
would cause the entire demand curve to shift changing the equilibrium
price and quantity. Note in the diagram that the shift of the demand
curve, by causing a new equilibrium price to emerge, resulted in
movement along the supply curve from the point (Q1, P1) to the point Q2,
P2).
If
the demand decreases, then the opposite happens: a shift of the curve
to the left. If the demand starts at D2, and decreases to D1, the
equilibrium price will decrease, and the equilibrium quantity will also
decrease. The quantity supplied at each price is the same as before the
demand shift, reflecting the fact that the supply curve has not shifted;
but the equilibrium quantity and price are different as a result of the
change (shift) in demand.
The
movement of the demand curve in response to a change in a non-price
determinant of demand is caused by a change in the x-intercept, the
constant term of the demand equation.
Supply curve shifts
Main article: Supply (economics)
When
the suppliers' unit input costs change, or when technological progress
occurs, the supply curve shifts. For example, assume that someone
invents a better way of growing wheat so that the cost of growing a
given quantity of wheat decreases. Otherwise stated, producers will be
willing to supply more wheat at every price and this shifts the supply
curve S1 outward, to S2—an increase in supply. This increase in supply
causes the equilibrium price to decrease from P1 to P2. The equilibrium
quantity increases from Q1 to Q2 as consumers move along the demand
curve to the new lower price. As a result of a supply curve shift, the
price and the quantity move in opposite directions.
If
the quantity supplied decreases, the opposite happens. If the supply
curve starts at S2, and shifts leftward to S1, the equilibrium price
will increase and the equilibrium quantity will decrease as consumers
move along the demand curve to the new higher price and associated lower
quantity demanded. The quantity demanded at each price is the same as
before the supply shift, reflecting the fact that the demand curve has
not shifted. But due to the change (shift) in supply, the equilibrium
quantity and price have changed.
The
movement of the supply curve in response to a change in a non-price
determinant of supply is caused by a change in the y-intercept, the
constant term of the supply equation. The supply curve shifts up and
down the y axis as non-price determinants of demand change.
Elasticity
Elasticity (economics)
Elasticity
is a central concept in the theory of supply and demand. In this
context, elasticity refers to how strongly the quantities supplied and
demanded respond to various factors, including price and other
determinants. One way to define elasticity is the percentage change in
one variable (the quantity supplied or demanded) divided by the
percentage change in the causative variable. For discrete changes this
is known as arc elasticity, which calculates the elasticity over a range
of values. In contrast, point elasticity uses differential calculus to
determine the elasticity at a specific point. Elasticity is a measure of
relative changes.
Often,
it is useful to know how strongly the quantity demanded or supplied
will change when the price changes. This is known as the price
elasticity of demand or the price elasticity of supply, respectively. If
a monopolist decides to increase the price of its product, how will
this affect the amount of their good that customers purchase? This
knowledge helps the firm determine whether the increased unit price will
offset the decrease in sales volume. Likewise, if a government imposes a
tax on a good, thereby increasing the effective price, knowledge of the
price elasticity will help us to predict the size of the resulting
effect on the quantity demanded.
Elasticity
is calculated as the percentage change in quantity divided by the
associated percentage change in price. For example, if the price moves
from $1.00 to $1.05, and as a result the quantity supplied goes from 100
pens to 102 pens, the quantity of pens increased by 2%, and the price
increased by 5%, so the price elasticity of supply is 2%/5% or 0.4.
Since
the changes are in percentages, changing the unit of measurement or the
currency will not affect the elasticity. If the quantity demanded or
supplied changes by a greater percentage than the price did, then demand
or supply is said to be elastic. If the quantity changes by a lesser
percentage than the price did, demand or supply is said to be inelastic.
If supply is perfectly inelastic;that is, has zero elasticity, then
there is a vertical supply curve.
Short-run
supply curves are not as elastic as long-run supply curves, because in
the long run firms can respond to market conditions by varying their
holdings of physical capital, and because in the long run new firms can
enter or old firms can exit the market.
Elasticity
in relation to variables other than price can also be considered. One
of the most common to consider is income. How strongly would the demand
for a good change if income increased or decreased? The relative
percentage change is known as the income elasticity of demand.
Another
elasticity 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 complements and
substitute goods. Complements 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 divided by the causative percentage change in the price
of the other 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
-2.0.
In
a frictionless economy, the price and quantity in any market would be
able to move to a new equilibrium position instantly, without spending
any time away from equilibrium. Any change in market conditions would
cause a jump from one equilibrium position to another at once. In real
economic systems, markets don't always behave in this way, and markets
take some time before they reach a new equilibrium position. This is due
to asymmetric, or at least imperfect, information, where no one
economic agent could ever be expected to know every relevant condition
in every market. Ultimately both producers and consumers must rely on
trial and error as well as prediction and calculation to find the true
equilibrium of a market.
Vertical supply curve (perfectly inelastic supply)
When
demand D1 is in effect, the price will be P1. When D2 is occurring, the
price will be P2. The equilibrium quantity is always Q, and any shifts
in demand will only affect price.
If
the quantity supplied is fixed in the very short run no matter what the
price, the supply curve is a vertical line, and supply is called
perfectly inelastic.
Other markets
 |
When demand D1 is in effect, the price will beP1. When D2 is occurring, the price will be P2.
The equilibrium quantity is always Q, and any shifts in demand will only affect price. |
The
model is commonly applied to wages, in the market for labor. The
typical roles of supplier and demander are reversed. The suppliers are
individuals, who try to sell their labor for the highest price. The
demanders of labor are businesses, which try to buy the type of labor
they need at the lowest price. The equilibrium price for a certain type
of labor is the wage rate.
A
number of economists (for example Pierangelo Garegnani, Robert L.
Vienneau, and Arrigo Opocher & Ian Steedman), building on the work
of Piero Sraffa, argue that that this model of the labor market, even
given all its assumptions, is logically incoherent. Michael
Anyadike-Danes and Wyne Godley argue, based on simulation results, that
little of the empirical work done with the textbook model constitutes a
potentially falsifying test, and, consequently, empirical evidence
hardly exists for that model. Graham White argues, partially on the
basis of Sraffianism, that the policy of increased labor market
flexibility, including the reduction of minimum wages, does not have an
"intellectually coherent" argument in economic theory.
This
criticism of the application of the model of supply and demand
generalizes, particularly to all markets for factors of production. It
also has implications for monetary theory not drawn out here.
In
both classical and Keynesian economics, the money market is analyzed as
a supply-and-demand system with interest rates being the price. The
money supply may be a vertical supply curve, if the central bank of a
country chooses to use monetary policy to fix its value regardless of
the interest rate; in this case the money supply is totally inelastic.
On the other hand, the money supply curve is a horizontal line if the
central bank is targeting a fixed interest rate and ignoring the value
of the money supply; in this case the money supply curve is perfectly
elastic. The demand for money intersects with the money supply to
determine the interest rate.
Empirical estimation
Demand
and supply relations in a market can be statistically estimated from
price, quantity, and other data with sufficient information in the
model. This can be done with simultaneous-equation methods of estimation
in econometrics. Such methods allow solving for the model-relevant
"structural coefficients," the estimated algebraic counterparts of the
theory. The Parameter identification problem is a common issue in
"structural estimation." Typically, data on exogenous variables (that
is, variables other than price and quantity, both of which are
endogenous variables) are needed to perform such an estimation. An
alternative to "structural estimation" is reduced-form estimation, which
regresses each of the endogenous variables on the respective exogenous
variables.
Macroeconomic uses of demand and supply
Demand
and supply have also been generalized to explain macroeconomic
variables in a market economy, including the quantity of total output
and the general price level. The Aggregate Demand-Aggregate Supply model
may be the most direct application of supply and demand to
macroeconomics, but other macroeconomic models also use supply and
demand. Compared to microeconomic uses of demand and supply, different
(and more controversial) theoretical considerations apply to such
macroeconomic counterparts as aggregate demand and aggregate supply.
Demand and supply are also used in macroeconomic theory to relate money
supply and money demand to interest rates, and to relate labor supply
and labor demand to wage rates.
History
The
power of supply and demand was understood to some extent by several
early Muslim economists, such as Ibn Taymiyyah who
illustrates:[verification needed]
"If
desire for goods increases while its availability decreases, its price
rises. On the other hand, if availability of the good increases and the
desire for it decreases, the price comes down."
John
Locke's 1691 work Some Considerations on the Consequences of the
Lowering of Interest and the Raising of the Value of Money. includes an
early and clear description of supply and demand and their relationship.
In this description demand is rent: “The price of any commodity rises
or falls by the proportion of the number of buyer and sellers” and “that
which regulates the price of goods is nothing else but their quantity
in proportion to their rent.”
The
phrase "supply and demand" was first used by James Denham-Steuart in
his Inquiry into the Principles of Political Oeconomy, published in
1767. Adam Smith used the phrase in his 1776 book The Wealth of Nations,
and David Ricardo titled one chapter of his 1817 work Principles of
Political Economy and Taxation "On the Influence of Demand and Supply on
Price".
In
The Wealth of Nations, Smith generally assumed that the supply price
was fixed but that its "merit" (value) would decrease as its "scarcity"
increased, in effect what was later called the law of demand. Ricardo,
in Principles of Political Economy and Taxation, more rigorously laid
down the idea of the assumptions that were used to build his ideas of
supply and demand. Antoine Augustin Cournot first developed a
mathematical model of supply and demand in his 1838 Researches into the
Mathematical Principles of Wealth, including diagrams.
During
the late 19th century the marginalist school of thought emerged. This
field mainly was started by Stanley Jevons, Carl Menger, and Léon
Walras. The key idea was that the price was set by the most expensive
price, that is, the price at the margin. This was a substantial change
from Adam Smith's thoughts on determining the supply price.
In
his 1870 essay "On the Graphical Representation of Supply and Demand",
Fleeming Jenkin in the course of "introduc ing the diagrammatic method
into the English economic literature" published the first drawing of
supply and demand curves therein, including comparative statics from a
shift of supply or demand and application to the labor market. The model
was further developed and popularized by Alfred Marshall in the 1890
textbook Principles of Economics.
Criticism
At
least two assumptions are necessary for the validity of the standard
model: first, that supply and demand are independent; and second, that
supply is "constrained by a fixed resource"; If these conditions do not
hold, then the Marshallian model cannot be sustained. Sraffa's critique
focused on the inconsistency (except in implausible circumstances) of
partial equilibrium analysis and the rationale for the upward-slope of
the supply curve in a market for a produced consumption good. The
notability of Sraffa's critique is also demonstrated by Paul A.
Samuelson's comments and engagements with it over many years, for
example:
"What
a cleaned-up version of Sraffa (1926) establishes is how nearly empty
are all of Marshall's partial equilibrium boxes. To a logical purist of
Wittgenstein and Sraffa class, the Marshallian partial equilibrium box
of constant cost is even more empty than the box of increasing cost.".
Aggregate
excess demand in a market is the difference between the quantity
demanded and the quantity supplied as a function of price. In the model
with an upward-sloping supply curve and downward-sloping demand curve,
the aggregate excess demand function only intersects the axis at one
point, namely, at the point where the supply and demand curves
intersect. The Sonnenschein-Mantel-Debreu theorem shows that the
standard model cannot be rigorously derived in general from general
equilibrium theory.
The model of prices being determined by supply and demand assumes perfect competition. But:
"economists
have no adequate model of how individuals and firms adjust prices in a
competitive model. If all participants are price-takers by definition,
then the actor who adjusts prices to eliminate excess demand is not
specified".
Goodwin,
Nelson, Ackerman, and Weissskopf write: "If we mistakenly confuse
precision with accuracy, then we might be misled into thinking that an
explanation expressed in precise mathematical or graphical terms is
somehow more rigorous or useful than one that takes into account
particulars of history, institutions or business strategy. This is not
the case. Therefore, it is important not to put too much confidence in
the apparent precision of supply and demand graphs. Supply and demand
analysis is a useful precisely formulated conceptual tool that clever
people have devised to help us gain an abstract understanding of a
complex world. It does not - nor should it be expected to - give us in
addition an accurate and complete description of any particular real
world market."
Economies of scale: Mass production
The
intent of mass production is to produce in extremely large quantities
at the lowest possible cost so as to drive down price and create demand.
There is also a learning curve with the production of most new products
that exhibits a similar phenomenon of lowering costs, which in turn
drives demand.
In
the case of mass production, both the assumptions of supply and demand
being independent and constraints on supply are not applicable. The
price response to the change in supply curve is valid, but the price
response to the change in demand curve is not. The lowered price in
response to increased demand is because the incremental cost of
production is less than the average cost, assuming that there is excess
capacity, which is the condition of most manufactured goods today. In
typical business cycles, prices do increase as maximum capacity is
approached; however, this usually results in an expansion of capacity
using more efficient processes, leading to even lower prices in the next
cycle.
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