Supply and demand

Supply and demand is a fundamental economic model used to determine prices in a market. It describes how the availability of a product relates to the desire for that product. In a perfectly competitive market, the unit price of a good will change until it reaches a specific point. This point is called the market-clearing price. At this price, the quantity demanded by buyers equals the quantity supplied by sellers. This state of balance is known as economic equilibrium.

The supply side of the model focuses on the producers. A supply schedule is a table showing the relationship between price and quantity supplied. In a competitive market, supply is often determined by marginal cost. This is the cost of producing one extra unit of a good. Firms will continue to produce more items as long as the market price is higher than this extra cost. If the cost of raw materials increases, the supply curve shifts to the left. This means producers supply less at every price point. Conversely, if production costs fall, the supply curve shifts to the right or downward.

Demand represents the behavior of the consumers. A demand schedule shows how much of a good buyers are willing and able to purchase at various prices. The law of demand states that the demand curve is generally downward-sloping. This means that as the price of a good decreases, consumers typically buy more of it. This happens because buyers will purchase an extra unit as long as its marginal value exceeds the market price. However, some exceptions exist. Veblen goods are items that become more attractive at higher prices due to fashion or signaling. Giffen goods are inferior staples, like potatoes, where a price rise might actually increase demand. This happens because the higher price reduces a consumer's overall purchasing power, forcing them to buy more of the staple to replace lost calories.

Economists distinguish between different types of supply and demand. There is the supply curve for an individual firm and the market supply curve. The market supply curve is the sum of all individual firms' quantities at each price. We also distinguish between the short run and the long run. In the short run, at least one input, such as physical capital, remains fixed. In the long run, all inputs can be adjusted, and new firms can enter or existing firms can exit the market. Because of this flexibility, long-run supply curves are usually flatter and more elastic than short-run curves.

History shows how these mathematical models were developed over time. Augustin Cournot first drew demand curves in 1838. Later, in 1870, Fleeming Jenkin added supply curves to the concept. These ideas were popularized by Alfred Marshall in his 1890 book, Principles of Economics. Marshall chose to represent price on the vertical y-axis. This convention remains common in many modern textbooks today.

Market equilibrium can change when external factors cause the curves to shift. If demand increases, the demand curve shifts to the right. This shift typically results in a higher equilibrium price and a higher equilibrium quantity. This can be caused by changes in consumer tastes, incomes, or the number of buyers. If demand decreases, the curve shifts to the left, leading to a lower price and lower quantity.

This model is used in both microeconomics and macroeconomics. Microeconomics looks at individual markets and firms. It examines how a firm with market power, such as a monopoly, might influence prices. Macroeconomics uses the aggregate demand-aggregate supply model. This looks at the total output and price levels of an entire economy. However, the Sonnenschein-Mantel-Debreu theorem suggests that market-wide curves can be complex. It shows that aggregate demand functions do not always follow the same rules of individual rationality. This means that large-scale markets might not always move toward a single, stable equilibrium point.