Supply and demand

A supply schedule, depicted graphically as a supply curve, is a table that shows the relationship between the price of a good and the quantity supplied by producers. 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 is less than the market price they receive.

A rise in the cost of raw materials would decrease supply, shifting the supply curve to the left because at each possible price a smaller quantity would be supplied. One may also think of this as a shift up in the supply curve, because the price must rise for producers to supply a given quantity. A fall in production costs would increase supply, shifting the supply curve to the right and down.

Mathematically, a supply curve is represented by a supply function, giving the quantity supplied as a function of its price and as many other variables as desired to better explain quantity supplied. The two most common specifications are:

1) linear supply function, e.g., the slanted line

${\displaystyle Q(P)=3P-6}$, and

2) the constant-elasticity[1] supply function (also called isoelastic or log-log or loglinear supply function), e.g., the smooth curve

${\displaystyle Q(P)=5P^{0.5}}$

which can be rewritten as

${\displaystyle \log Q(P)=\log 5+0.5\log P}$

By its very nature, the concept of a supply curve assumes that firms are perfect competitors, having no influence over the market price. This is because each point on the supply curve answers the question, "If this firm is faced with this potential price, how much output will it sell?" If a firm has market power—in violation of the perfect competitor model—its decision on how much output to bring to market influences the market price. Thus the firm is not "faced with" any given price, and a more complicated model, e.g., a monopoly or oligopoly or differentiated-product model, should be used.

Economists distinguish between the supply curve of an individual firm and the market supply curve. The market supply curve shows the total quantity supplied by all firms, so it is the sum of the quantities supplied by all suppliers at each potential price (that is, the individual firms' supply curves are added horizontally).

Economists distinguish between short-run and long-run supply curve. Short run refers to a time period during which one or more inputs are fixed (typically physical capital), and the number of firms in the industry is also fixed (if it is a market supply curve). Long run refers to a time period during which new firms enter or existing firms exit and all inputs can be adjusted fully to any price change. Long-run supply curves are flatter than short-run counterparts (with quantity more sensitive to price, more elastic supply).

Common determinants of supply are:

1. Prices of inputs, including wages
2. The technology used, productivity
3. Firms' expectations about future prices
4. Number of suppliers (for a market supply curve)

A demand schedule, depicted graphically as a demand curve, represents the amount of a certain good that buyers are willing and able to purchase at various prices, assuming all other determinants of demand are held constant, such as income, tastes and preferences, and the prices of substitute and complementary goods. Generally, consumers will buy an additional unit as long as the marginal value of the extra unit is more than the market price they pay. According to the law of demand, the demand curve is always downward-sloping, meaning that as the price decreases, consumers will buy more of the good.

Mathematically, a demand curve is represented by a demand function, giving the quantity demanded as a function of its price and as many other variables as desired to better explain quantity demanded. The two most common specifications are linear demand, e.g., the slanted line

${\displaystyle Q(P)=32-2P}$

and the constant-elasticity demand function (also called isoelastic or log-log or loglinear demand function), e.g., the smooth curve

${\displaystyle Q(P)=3P^{-2}}$

which can be rewritten as

${\displaystyle \log Q(P)=\log 3-2\log P}$

As a matter of historical convention, a demand curve is drawn with price on the vertical y-axis and demand on the horizontal x-axis. In keeping with modern convention, a demand curve would instead be drawn with price on the x-axis and demand on the y-axis, because price is the independent variable and demand is the variable that is dependent upon price.

Just as the supply curve parallels the marginal cost curve, the demand curve parallels marginal utility, measured in dollars.[2] 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 at a certain time.

The demand curve is generally downward-sloping, but for some goods it is upward-sloping. Two such types of goods have been given definitions and names that are in common use: Veblen goods, goods which because of fashion or signalling are more attractive at higher prices, and Giffen goods, which, by virtue of being inferior goods that absorb a large part of a consumer's income (e.g., staples such as the classic example of potatoes in Ireland), may see an increase in quantity demanded when the price rises. The reason the law of demand is violated for Giffen goods is that the rise in the price of the good has a strong income effect, sharply reducing the purchasing power of the consumer so that he switches away from luxury goods to the Giffen good, e.g., when the price of potatoes rises, the Irish peasant can no longer afford meat and eats more potatoes to cover for the lost calories.

As with the supply curve, by its very nature the concept of a demand curve requires that the purchaser be a perfect competitor—that is, that the purchaser have no influence over the market price. This is true because each point on the demand curve answers the question, "If buyers are faced with this potential price, how much of the product will they purchase?" But, if a buyer has market power (that is, the amount he buys influences the price), he is not "faced with" any given price, and we must use a more complicated model, of monopsony.

As with supply curves, economists distinguish between the demand curve for an individual and the demand curve for a market. The market demand curve is obtained by adding the quantities from the individual demand curves at each price.

Common determinants of demand are:

1. Income
2. Tastes and preferences
3. Prices of related goods and services
4. Consumers' expectations about future prices and incomes
5. Number of potential consumers
6. Advertising

Cournot's Recherches (1838)

Jenkin's Graphical Representation (1870)

Marshall's Principles (1890)

Figure 2. Early supply and demand curves

Since supply and demand can be considered as functions of price they have a natural graphical representation. Demand curves were first drawn by Augustin Cournot in his Recherches sur les Principes Mathématiques de la Théorie des Richesses (1838) – see Cournot competition. Supply curves were added by Fleeming Jenkin in The Graphical Representation of the Laws of Supply and Demand... of 1870. Both sorts of curve were popularised by Alfred Marshall who, in his Principles of Economics (1890), chose to represent price – normally the independent variable – by the vertical axis; a practice which remains common.

If supply or demand is a function of other variables besides price, it may be represented by a family of curves (with a change in the other variables constituting a shift between curves) or by a surface in a higher dimensional space.

Generally speaking, an equilibrium is defined to be the price-quantity pair where the quantity demanded is equal to the quantity supplied. It is represented by the intersection of the demand and supply curves. The analysis of various equilibria is a fundamental aspect of microeconomics:

Market equilibrium: A situation in a market when the price is such that the quantity demanded by consumers is correctly balanced by the quantity that firms wish to supply. In this situation, the market clears.[3]

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:

When 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 to the right. At each price point, a greater quantity is demanded, as from the initial curve D₁ to the new curve D₂. 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.) The increase in demand has caused an increase in (equilibrium) quantity. The increase in demand could come from changing tastes and fashions, incomes, price changes in complementary and substitute goods, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity. Note in the diagram that the shift of the demand curve, by causing a new equilibrium price to emerge, resulted in movement along the supply curve from the point (Q₁, P₁) to the point (Q₂, P₂).

If the demand decreases, then the opposite happens: a shift of the curve to the left. If the demand starts at D₂, and decreases to D₁, the equilibrium price will decrease, and the equilibrium quantity will also decrease. The quantity supplied at each price is the same as before the demand shift, reflecting the fact that the supply curve has not shifted; but the equilibrium quantity and price are different as a result of the change (shift) in demand.

Supply curve shifts:

When technological progress occurs, the supply curve shifts. 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 consumers move along the demand curve to the new lower price. As a result of a supply curve shift, the price and the quantity move in opposite directions. If the quantity supplied decreases, the opposite happens. If the supply curve starts at S₂, and shifts leftward to S₁, the equilibrium price will increase and the equilibrium quantity will decrease as consumers move along the demand curve to the new higher price and associated lower quantity demanded. The quantity demanded at each price is the same as before the supply shift, reflecting the fact that the demand curve has not shifted. But due to the change (shift) in supply, the equilibrium quantity and price have changed.

The movement of the supply curve in response to a change in a non-price determinant of supply is caused by a change in the y-intercept, the constant term of the supply equation. The supply curve shifts up and down the y axis as non-price determinants of demand change.

Partial equilibrium, as the name suggests, takes into consideration only a part of the market to attain equilibrium.

Jain proposes (attributed to George Stigler): "A partial equilibrium is one which is based on only a restricted range of data, a standard example is price of a single product, the prices of all other products being held fixed during the analysis."[4]

The supply-and-demand model is a partial equilibrium model of economic equilibrium, where the clearance on the market of some specific goods is obtained independently from prices and quantities in other markets. In other words, the prices of all substitutes and complements, as well as income levels of consumers are constant. This makes analysis much simpler than in a general equilibrium model which includes an entire economy.

Here the dynamic process is that prices adjust until supply equals demand. It is a powerfully simple technique that allows one to study equilibrium, efficiency and comparative statics. The stringency of the simplifying assumptions inherent in this approach makes the model considerably more tractable, but may produce results which, while seemingly precise, do not effectively model real world economic phenomena.

Partial equilibrium analysis examines the effects of policy action in creating equilibrium only in that particular sector or market which is directly affected, ignoring its effect in any other market or industry assuming that they being small will have little impact if any.

Hence this analysis is considered to be useful in constricted markets.

Léon Walras first formalized the idea of a one-period economic equilibrium of the general economic system, but it was French economist Antoine Augustin Cournot and English political economist Alfred Marshall who developed tractable models to analyze an economic system.