ColombiaLink.com – SUPPPLY AND DEMAND

See
also: List of Economic Topics

SUPPPLY
AND DEMAND
– microeconomics


The
supply and demand model describes how prices vary as a result of a balance between
product availability at each price (supply) and the desires of those with purchasing
power at each price (demand). The graph depicts an increase in demand from D1
to D2 along with the consequent increase in price and quantity required to reach
a new market-clearing equilibrium point on the supply curve (S).

In
microeconomic theory, the partial equilibrium supply and demand economic model
originally developed by Alfred Marshall attempts to describe, explain, and predict
changes in the price and quantity of goods sold in competitive markets. The model
represents a first approximation for describing a market that is not perfectly
competitive. It formalizes the theories used by some economists before Marshall
and is one of the most fundamental models of some modern economic schools, widely
used as a basic building block in a wide range of more detailed economic models
and theories. The theory of supply and demand is important for some economic schools
understanding of a market economy in that it is an explanation of the mechanism
by which many resource allocation decisions are made. However, unlike general
equilibrium models, supply schedules in this partial equilbrium model are fixed
by unexplained forces.

In
general, the theory claims that when goods are traded in a market at a price where
consumers demand more goods than firms are prepared to supply, this shortage (or
excess demand) will tend to lead to increases in the price of the goods. Those
consumers who 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
(i.e., when there is a glut, market surplus, or excess supply). This price/quantity
adjustment mechanism causes the market to approach an equilibrium point, at which
the market clears and 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 consumers want to buy, so there is no endogenous
force causing prices to change.

Assumptions
and definitions

The
theory of supply and demand usually assumes 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 in each market on his own. This assumption
is central to the simple form of supply and demand theory that is 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. However the simple theory presented
here does apply, and accurately describes many real life market interactions.
In many other cases it is a good first order approximation to some of the major
effects in the market.

Mainstream
economics does not assume a priori that markets are preferable to other forms
of social organization. In fact, much analysis is devoted to cases where so-called
market failures lead to resource allocation that is suboptimal by some standard.
In such cases, economists may attempt to find policies that will avoid waste;
directly by government control, indirectly by regulation that induces market participants
to act in a manner consistent with optimal welfare, or by creating ‘missing’ markets
to enable efficient trading where none had previously existed. This is studied
in the field of collective action.

Demand

Demand
is the quantity that consumers are willing and able to buy at a given price over
a period of time. For example, a consumer may be willing to purchase 30 bags of
potato chips in the next year if the price is $1 per bag, and may be willing to
purchase only 10 bags if the price is $2 per bag. A demand schedule can be constructed
that shows the quantity demanded at each given price. 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 one is willing to purchase will typically be the price of the
good, one’s level of income, personal tastes, the price of substitute goods, and
the price of complementary goods.

Supply

Supply
is the quantity that producers are willing to sell 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 schedule.

Simple
supply and demand curves

Mainstream
economic theory centers on creating a series of supply and demand relationships,
describing them as equations, and then adjusting for factors which produce “stickiness”
between supply and demand. Analysis is then done to see what “trade offs”
are made in the “market” which is the negotiation between sellers and
buyers. Analysis is done as to what point the ability of sellers to sell becomes
less useful than other opportunities. This is related to “marginal”
costs – or the price to produce the last unit that can be sold profitably, versus
the chance of using the same effort to engage in some other activity.

Graph
of simple supply and demand curves

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
affect the market clearing price and will not affect 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.

It
should be noted that on supply and demand curves both are drawn as a function
of price. Neither is represented as a function of the other. Rather the two functions
interact in a manner that is representative of market outcomes. The curves also
imply a somewhat neutral means of measuring price. In practice any currency or
commodity used to measure price is also the subject of supply and demand.

Effects
of being away from the equilibrium point

Now
consider how prices and quantities not at the equilibrium point tend to move towards
the equilibrium. 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.

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

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 supply. 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

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

Market
‘clearance’

The
market ‘clears’ at the point where all the supply and demand at a given price
balance. That is, the amount of a commodity available at a given price equals
the amount that buyers are willing to purchase at that price. It is assumed that
there is a process that will result in the market reaching this point, but exactly
what the process is in a real situation is an ongoing subject of research. Markets
which do not clear will react in some way, either by a change in price, or in
the amount produced, or in the amount demanded. Graphically the situation can
be represented by two curves: one showing the price-quantity combinations buyers
will pay for, or the demand curve; and one showing the combinations sellers will
sell for, or the supply curve. The market clears where the two are in equilibrium,
that is where the curves intersect. In a general equilibrium model, all markets
in all goods clear simultaneously and the ‘price’ can be described entirely in
terms of tradeoffs with other goods. For a century most economists believed in
Say’s Law, which states that markets, as a whole, would always clear and thus
be in balance.

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 affect 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 affect 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 function: 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 affect 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 a piece 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 be 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.

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.
While it is possible for industry supply curves to be downward sloping, supply
curves for individual firms are never downward 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 certain goods would have such
a curve. 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: