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at each price (demand D). The graph depicts an increase in demand from D1 to D2, along with a consequent increase in price and quantity Q sold of the product.]] 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. FUNDAMENTAL THEORY Strictly considered, the model applies to a type of market called . 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. 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.Note that unlike most Graph s, supply and demand curves are plotted with the independent variable (price) on the vertical axis and the dependent variable (quantity supplied or demanded) on the horizontal axis. 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.1 Occasionally, supply curves do not slope upwards. A well known example is the , many oil-exporting countries decreased their production of oil.2 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.Basu, Kaushik. "The Economics of Child Labor", Scientific American , October, 2003. 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. Just as the supply curves reflect marginal cost curves, demand curves be described as Marginal Utility curves.3 The main determinants of individual demand are the price of the good, level of income, personal tastes, the price of Substitute Good s, and the price of Complementary Good s. 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). 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. Demand curve shifts See Also: Demand curve 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). 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 ELASTICITY See Also: 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 ''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, Liter s per Euro , or Battleship s 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 Gallon s 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 Good s'''. 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 (PERFECTLY INELASTIC SUPPLY) |
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