Supply and demand

Supply and demand
Name	Supply and demand
Caption	A graphical representation of the model showing supply and demand curves.
Uses	Analysis of market prices and quantities
Related	Microeconomics, Partial equilibrium

Supply and demand is a foundational model in microeconomics that explains price determination in a competitive market. It describes the relationship between the quantity of a commodity that producers wish to sell and the quantity that consumers wish to buy. The model posits that the market price adjusts to bring the quantity supplied and quantity demanded into balance, a state known as market equilibrium.

Basic principles

The model rests on two primary concepts. The law of demand states that, all else being equal, as the price of a good rises, the quantity demanded by consumers falls, a relationship often explained by the income effect and substitution effect. Conversely, the law of supply states that as the price increases, the quantity supplied by producers also increases, as higher prices can cover higher marginal costs of production. These laws assume ceteris paribus, holding factors like consumer income, tastes and preferences, and prices of related goods constant for demand, and technology, input prices, and government regulation constant for supply. The interaction of these forces is central to the theories of Alfred Marshall and Léon Walras.

Graphical representation

The model is most commonly depicted using two-dimensional graphs with Cartesian coordinates. The demand curve is typically drawn sloping downward from left to right, plotting price against quantity demanded. The supply curve slopes upward, plotting price against quantity supplied. These curves are foundational tools in economic analysis, with their intersection point being of critical importance. The axes and curves were popularized in the work of Alfred Marshall in his text Principles of Economics. Shifts in these curves, caused by changes in their underlying determinants, are a primary focus of comparative statics.

Market equilibrium

The point where the demand curve and supply curve intersect is called the market equilibrium. At this equilibrium price, the quantity supplied exactly equals the quantity demanded, so there is no excess supply or excess demand (shortage). If the market price is above equilibrium, a surplus occurs, prompting producers to lower prices. If the price is below equilibrium, a shortage occurs, leading to upward price pressure from competing consumers. This self-correcting mechanism is often described as the invisible hand, a concept associated with Adam Smith in The Wealth of Nations. The stability of this equilibrium was formally analyzed by Kenneth Arrow and Gérard Debreu.

Elasticity

The responsiveness of quantity demanded or supplied to changes in price or other factors is measured by elasticity. Price elasticity of demand gauges how much quantity demanded changes with price, crucial for understanding tax incidence and consumer surplus. Price elasticity of supply measures the responsiveness of quantity supplied. Other key measures include income elasticity of demand, which relates demand changes to shifts in consumer income, and cross-price elasticity of demand, which examines the relationship between the demand for one good and the price of another, such as substitutes or complements. The concept was significantly developed by Alfred Marshall.

Applications and examples

The model is applied to analyze diverse real-world markets. In agricultural economics, it explains price volatility for crops like wheat or coffee due to weather shocks. In labor economics, it models wage determination, where workers supply labor and firms demand it. Government interventions, such as price ceilings (e.g., rent control in New York City) and price floors (e.g., minimum wage laws), create disequilibrium outcomes like shortages or surpluses. The model also analyzes the effects of sales taxes, subsidies, and tariffs on markets for goods like gasoline or steel. The OPEC attempts to influence the global crude oil market by coordinating supply.

Limitations and critiques

The standard model makes several simplifying assumptions that limit its direct applicability. It typically assumes perfect competition, with many buyers and sellers, perfect information, and homogeneous products, conditions rarely met in reality. Behavioral economics, pioneered by figures like Daniel Kahneman and Amos Tversky, challenges the model's assumption of perfectly rational consumers. Institutional economics emphasizes the role of social institutions and power structures ignored by the model. The Cambridge capital controversy raised deep theoretical questions about the aggregation of capital necessary for supply curves. Furthermore, the model struggles with goods that have externalities, are public goods, or where transaction costs are significant, areas studied by Ronald Coase and Elinor Ostrom.

Category:Microeconomics Category:Economic models