Supply and demand
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In economics, supply and demand describe market relations between prospective sellers and buyers of a good. The supply and demand model determines price and quantity sold in the market. The model is fundamental in microeconomic analysis of buyers and sellers and of their interactions in a market. It is also used as a point of departure for other economic models and theories. The model predicts that in a competitive market, price will function to equalize the quantity demanded by consumers and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity. The model incorporates other factors changing such equilibrium as reflected in a shift of demand or supply.
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[edit] Fundamental theory
Strictly considered, the model applies to a type of market called perfect competition in which no single buyer or seller has much effect on prices and prices are known. The quantity of a product supplied by the producer and the quantity demanded by the consumer are dependent on the market price of the product. The law of supply states that quantity supplied is related to price. It is often depicted as directly proportional to price: the higher the price of the product, the more the producer will supply, ceteris paribus. The law of demand is normally depicted as an inverse relation of quantity demanded and price: the higher the price of the product, the less the consumer will demand, cet. par. "Cet. par." is added to isolate the effect of price. Everything else that could affect supply or demand except price is held constant. The respective relations are called the 'supply curve' and 'demand curve', or 'supply' and 'demand' for short.
The laws of supply and demand state that the equilibrium market price and quantity of a commodity is at the intersection of consumer demand and producer supply. Here quantity supplied equals quantity demanded (as in the enlargeable Figure), that is, equilibrium. Equilibrium implies that price and quantity will remain there if it begins there. If the price for a good is below equilibrium, consumers demand more of the good than producers are prepared to supply. This defines a shortage of the good. A shortage results in the price being bid up. Producers will increase the price until it reaches equilibrium. Conversely, if the price for a good is above equilibrium, there is a surplus of the good. Producers are motivated to eliminate the surplus by lowering the price. The price falls until it reaches equilibrium.
[edit] Supply schedule
The supply schedule is the relationship between the quantity of goods supplied by the producers of a good and the current market price. It is graphically represented by the supply curve. It is commonly represented as directly proportional to price.[1] The positive slope in short-run analysis can reflect the law of diminishing marginal returns, which states that beyond some level of output, additional units of output require larger doses of the variable input. In the long run (such that plant size or number of firms is variable), a positively-sloped supply curve can reflect diseconomies of scale or fixity of specialized resources (such as farm land or skilled labor).
For a given firm in a perfectly competitive industry, if it is more profitable to produce at all, profit is maximized by producing to where price is equal to the producer's marginal cost curve. Thus, the supply curve for the entire market can be expressed as the sum of the marginal cost curves of the individual producers.[2]
Occasionally, supply curves do not slope upwards. A well known example is the backward bending supply curve of labour. Generally, as a worker's wage increases, he is willing to supply a greater amount of labor (working more hours), since the higher wage increases the marginal utility of working (and increases the opportunity cost of not working). But when the wage reaches an extremely high amount, the laborer may experience the law of diminishing marginal utility in relation to his salary. The large amount of money he is making will make further money of little value to him. Thus, he will work less and less as the wage increases, choosing instead to spend his time in leisure.[3] The backwards-bending supply curve has also been observed in non-labor markets, including the market for oil: after the skyrocketing price of oil caused by the 1973 oil crisis, many oil-exporting countries decreased their production of oil.[4]
Another example of a nontraditional supply curve is the supply curve for utility production companies. Because a large portion of their total costs are in the form of fixed costs, the marginal cost (supply curve) for these firms is often depicted as a constant.
Another postulated variant of a supply curve is that for child labor. Supply will increase as wages increase, but at a certain point a child's parents will pull the child from the child labor force due to cultural pressures and a desire to concentrate on education. The supply will not increase as the wage increases, up to a point where the wage is high enough to offset these concerns. For a normal demand curve, this can result in two stable equilibrium points - a high wage and a low wage equilibrium point.[5]
[edit] Demand schedule
The demand schedule, depicted graphically as the demand curve, represents the amount of a good that buyers are willing and able to purchase at various prices, assuming all other non-price factors remain the same. The demand curve is almost always represented as downwards-sloping, meaning that as price decreases, consumers will buy more of the good.[1]
Just as the supply curves reflect marginal cost curves, demand curves be described as marginal utility curves.[6]
The main determinants of individual demand are the price of the good, level of income, personal tastes, the price of substitute goods, and the price of complementary goods.
The shape of the aggregate demand curve can be convex or concave, possibly depending on income distribution.
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 a Giffen good (a type of inferior, but staple, good) and a Veblen good (a good made more fashionable by a higher price).
[edit] 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 eqilibrium to the new equilibrium.
[edit] Demand curve shifts
People increasing the quantity demanded at a given price is be referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted right, because at each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. An example of this would be more people suddenly wanting more coffee. 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. In standard usage, a movement along a given demand curve can be 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 in increase in ( (equilbrium) quantity. The increase in demand could also come from changing tastes, incomes, product information, fashions, and so forth.
Conversely, if the demand decreases, the opposite happens: a lefward shift of the curve. If the demand starts at D2 and then decreases to D1, the price will decrease and the quantity will decrease. 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 Q1 and Q2). The reason that the equilibrium quantity and price are different is the demand is different. At each point a greater amount is demanded (when there is a shift from D1 to D2).
[edit] Supply curve shifts
When the suppliers' costs change for a given output, the supply curve shifts in the same direction. For example, assume that someone invents a better way of growing wheat so that the cost of wheat that can be grown for a given quantity will decrease. Otherwise stated, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 to the right, 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 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 at a given price, the opposite happens. If the supply curve starts at S2 and then shifts leftward to S1, the equilibrium price will increase and the quantity will decrease. This is purely an effect of supply changing. The quantity demanded at each price is the same as before the supply shift (at both Q1 and Q2). The reason that the equilibrium quantity and price are different is the supply changed.
There are only 4 possible movements to a demand/supply curve diagram. The demand curve can move to the left and right, and the supply curve can also move only to the left or right. If they do not move at all then they will stay in the middle where they already are.
See also: Induced demand
[edit] Elasticity
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 arc elasticity because it calculates the elasticity over a range of values, in contrast 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 demanded or supplied 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 effective 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.
Let's 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 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 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.
[edit] Vertical supply curve (Perfectly Inelastic Supply)
It is sometimes the case that a 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. If land is considered in this way, then it warrants a vertical supply curve, giving it zero elasticity (i.e., no matter how large the change in price, the quantity supplied will not change). On the other hand, the supply of useful land can be increased in response to demand — by irrigation. And land that otherwise would be below sea level can be kept dry by a system of dikes, which might also be regarded as a response to demand. So even in this case, the vertical line is a bit of a simplification.
In the short run near vertical supply curves are more common. For example, if India vs Pakistan cricket match 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.
Supply-side economics argues that the aggregate supply function – the total supply function of the entire economy of a country – is relatively vertical. Thus, supply-siders argue against government stimulation of demand, which would only lead to inflation with a vertical supply curve.[7]
[edit] Other markets
The model of supply and demand also applies to various specialty markets.
The model applies to wages, which are determined by the market for labor. In this instance, the typical roles of supplier and consumer are reversed. The suppliers are individuals, who attempt to sell their labor for the highest price. Conversely, the consumers of labors are businesses, which attempt to buy the type of labor they need at the lowest price. The equilibrium price for a certain type of labor is the wage.[8]
The model is also held to apply to interest rates, which are determined by the money market. In the short term, the money supply is a vertical supply curve, which the central bank of a country can control through monetary policy. The demand for money intersects with the money supply to determine the interest rate.[9]
[edit] 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 maximized 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 analyze 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.
[edit] Empirical estimation
The demand and supply relations in a market can be statistically estimated from price and quantity data using the simultaneous system estimation ("structural estimation") method in econometrics. An alternative to "structural estimation" is Reduced form estimation. 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.
[edit] History
The phrase "supply and demand" was first used by James Denham-Steuart in his Inquiry into the Principles of Political Economy, 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".[10]
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 on the Mathematical Principles of the Theory of Wealth.
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.
The model was further developed and popularized by Alfred Marshall in the 1890 textbook Principles of Economics.[10] Along with Léon Walras, Marshall looked at the equilibrium 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).