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SUPPLY AND DEMAND
Abigail Rose S. Diaz BSMA-2
- Supply and Demand is also the name of an album by Amos Lee
In microeconomic theory the partial equilbrium supply and demand economic model originally developed by Alfred Marshall attempts to describe, explain, and predict the price and quantity of goods sold in competitive markets. It is one of the most fundamental models, 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 in the functioning of a market economy in that it explains the mechanism by which many resource allocation decisions are made. However, unlike general equilibrium models, supply schedules in this partial equilbrium model are fixed, as the long run reciprocal relationship between demand and supply is ignored.
In general, the theory claims that where goods are traded in a market at a price where consumers demand more goods than firms are prepared to supply, this shortage will tend to increase the price of the goods. Those consumers that 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. This price/quantity adjustment mechanism causes the market to approach an equilibrium point, a point at which 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 the consumers want to buy.
[edit] Supply curve
The supply curve is the relationship between the quantity of goods producers will sell in a market at any given price. For example, potato growers may be willing to sell one million kilograms of potatoes if the price is $0.75 per kilogram. If the price rose to $0.90 per kilogram, potato growers would likely sell a greater quantity. The main determinants of supply will be the market price of the good and the cost of producing it. The supply curve for a given firm is derived directly from its marginal cost curve where the price is greater than or equal to the minimum cost on the average variable cost curve. Supply curves are represented as upward-sloping due of the law of diminishing marginal returns.
[edit] Demand curve
Demand is economic want backed up by purchasing power. i.e., it is the plan, or relationship, expressing different amounts of a product buyers are willing and able to buy at possible prices, assuming all other non-price factors remain the same. For example, a consumer may be willing to purchase 2 lb of potatoes if the price is $0.75 per lb. However, the same consumer may be willing to purchase only 1 lb if the price is $1.00 per lb. A demand schedule shows the quantity demanded at any 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.
The shape of the aggregated demand curve can be convex or concave, possibly depending on income distribution.
The capacity to buy is sometimes used to characterise demand as being merely an alternate form of supply.
[edit] Special cases of a demand curve
As described above, the demand curve is generally downward sloping. There may be rare examples of goods that have upward sloping demand curves. A good whose demand curve has an upward slope is known as a Giffen good.
The existence of Giffen goods cannot be explained by conspicuous consumption, since an increase in stature associated with buying an expensive product means that more than just price is variable. In fact the actual existence of a Giffen good is debatable. Examples of conspicuous consumption are clearly subjective, but might include the Bugatti Veyron. The social phenomenon often referred to as 'Bling' can also be thought of in this way. And it consumes demand and supply without error
[edit] Simple supply and demand curves
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.
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 at which 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 equilibrating 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.
[edit] 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 D1 to the new curve D2. This raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. 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 D2 and then decreases to D1, the price will decrease and the quantity demanded 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 Q1 and Q2). The reason that the equilibrium quantity and price are different is the demand is different.
[edit] 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 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, the opposite happens. If the supply curve starts at S1 and then shifts to S2, 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 Q1 and Q2). The reason that the equilibrium quantity and price are different is the supply is different.
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.
[edit] 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. 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 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 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] History of supply and demand
Attempts to determine how supply and demand interact began with Adam Smith's The Wealth of Nations, first published in 1776. In this book, he mostly assumed that the supply price was fixed but that the demand would increase or decrease as the price decreased or increased. David Ricardo in 1817 published the book Principles of Political Economy and Taxation, in which the first idea of an economic model was proposed. In this, he more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand.
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.
Finally, most of the basics of the modern school theory of supply and demand were finalized by Alfred Marshall and Léon Walras, when they combined the ideas about supply and the ideas about demand and began looking 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).
[edit] Criticism of Marshall's theory of supply and demand
Marshall's theory of supply and demand runs counter to the ideas of economists from Adam Smith and David Ricardo through the creation of the marginalist school of thought. Although Marshall's theories are dominant in universities today, other economists have disagreed with it. One theory counter to Marshall is that price is already known in a commodity before it reaches the market, negating his idea that some abstract market is conveying price information. The only thing the market communicates is whether or not an object is exchangeable or not (in which case it would change from an object to a commodity). This would mean that the producer creates the goods without already having customers — blindly producing, hoping that someone will buy them ("buy" meaning exchange money for the commodities). Modern producers often have market studies prepared well in advance of production decisions; however, misallocation of factors of production can still occur.
Keynesian economics also runs counter to the theory of supply and demand. In Keynesian theory, prices can become "sticky" or resistant to change, especially in the case of price decreases. This leads to a market failure. Modern supporters of Keynes, such as Paul Krugman, have noted this in recent history, such as when the Boston housing market dried up in the early 1990s, with neither buyers nor sellers willing to exchange at the price equilibrium.
Gregory Mankiw's work on the irrationality of actors in the markets also undermines Marshall's simplistic view of the forces involved in supply and demand.
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