Supply and demand is an economic model based of price determination in a market. It concludes 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 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 goods that producers are willing and able to sell at various prices, 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.
Demand schedule
The demand schedule, depicted graphically as the demand curve, represents the amount of goods 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, personal tastes, 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).
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.
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
Main article: Demand curveWhen 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 outward. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2 . More people wanting coffee is an example. 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 fads, incomes, complementary and substitute price changes, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity.
If the demand decreases , then the opposite happens: an inward shift of the curve. If the demand starts at D2 , and decreases to D1 , the price will decrease, and the quantity will decrease. This is 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 equilibrium quantity, price and demand are different. At each point, a greater amount is demanded (when there is a shift from D1 to D2).
The demand curve "shifts" because a non-price determinant of demand has changed. Graphically the shift is due to a change in the x-intercept. A shift in the demand curve due to a change in a non-price determinant of demand will result in the market's being in a non-equilibrium state. If the demand curve shifts out the result will be a shortage — at the new market price quantity demanded will exceed quantity supplied. If the demand curve shifts in, there will be a surplus — at the new market price quantity supplied will exceed quantity demanded. The process by which a new equilibrium is established is not the province of comparative statics — the answers to issues concerning when, whether and how a new equilibrium will be established are issues that are addressed by stochastic models — economic dynamics.
Supply curve shifts
Main article: Supply (economics)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 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 the quantity demanded extends at the new lower prices. In a supply curve shift, the price and the quantity move in opposite directions.
If the quantity supplied decreases at a given price, the opposite happens. If the supply curve starts at S2 , and shifts inward to S1 , demand contracts , the equilibrium price will increase, and the equilibrium quantity will decrease. This is 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 equilibrium quantity, price and supply changed.
When there is a change in supply or demand, there are three possible movements. The demand curve can move inward or outward. The supply curve can also move inward or outward.
Elasticity
Main article: Elasticity (economics)Elasticity is a central concept in the theory of supply and demand. In this context, elasticity refers to how supply and demand respond to various factors, including price as well as other stochastic principles. One way to define elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arc elasticity , which calculates the elasticity over a range of values, in contrast with point elasticity , which uses differential calculus to determine the elasticity at a specific point). 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?
Elasticity corresponds to the slope of the line and is often expressed as a percentage. In other words, the units of measure (such as gallons vs. quarts, say for the response of quantity demanded of milk to a change in price) do not matter, only the
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