Supply and demand
In microeconomic theory, the theory of supply and demand explains how the price and quantity of goods sold in markets are determined.
In general where goods are traded in a market, prices of goods tend to rise when the quantity demanded exceeds the quantity supplied at that price, leading to a shortage, and conversely that prices tend to fall when quantity supplied exceeds the quantity demanded. This causes the market to approach an equilibrium point at which quantity supplied is equal to the quantity demanded. Price is thus seen as a function of supply curves and demand curves.
The theory of supply and demand is important in the functioning of a market economy in that it explains the mechanism by which most resource allocation decisions are made.
The theory of supply and demand is usually developed assuming that markets are perfectly competitive. This means that there are many small buyers and sellers, each of which is unable to influence the price of the good on its own.
This can be illustrated with the following graph:
The demand curve is the amount that will be bought at a given price. The supply curve is the quantity that producers are willing to make at a given price. As you can see, more will be purchased when the price is lower (the quantity goes up). On the other hand, as the price goes up, producers are willing to produce more goods. Where these cross is the equilibrium. This will create a price of P and a quantity of Q since that is where the two lines cross.
In the figure straight lines are drawn instead of the more general curves. See also Price elasticity of demand.
When more people want something the demand curve will shift right. An
example of this would be more people suddenly wanting more coffee. This
will cause the demand curve to shift from the initial curve D0 to the new curve D1. This raises the equilibrium price from P0 to the higher P1. This raises the equilibrium quantity from Q0 to the higher Q1. 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 D1, and then decreases to D0, the price will decrease and the quantity supplied will decrease - a contraction in supply.
When the suppliers' costs change the supply curve will shift. For
example, if someone invents a better way of growing wheat, then the
amount of wheat that can be grown for a given price will increase.
This creates a shift from a original supply curve S0 to a new
lower supply curve S1 - a decrease in supply. This causes the equilibrium price to
decrease from P0 to P1. The equilibrium quantity increases
from Q0 to Q1 as the quantity demanded increases - an extension in demand. Notice that the price and the quantity move
in opposite directions in a supply curve shift.
Conversely, if the supply increases, the opposite happens. If the supply
curve starts at S1, and then shifts to S0, the price will
increase and the quantity will decrease as there is a contraction in demand.
See also: Induced demand
If the price is set too high, such as at P1, then the quantity produced will be Qs. The quantity demanded will be Qd. Since the quantity demanded is less than the quantity supplied there will be a oversupply problem. If the price is too low, then too little will be produced to meet demand at that price. This will cause a undersupply problem. Businesses' responses to both these problems restore the quantity and the price to the equilibrium. In the case of oversupply, the businesses will soon have too much excess inventory, so they will lower prices to reduce this.
The graph below illustrates a vertical supply curve. When the
demand 1 is in effect, the price will p1. When
demand 2 is occurring, the price will be p2. Notice
that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only effect price.
In a situation in which there are many buyers but a single monopoly supplier can adjust the supply and price of a good at will, the monopolist will adjust the price so that his profit is maximised given the amount that is demanded at that price. A similar analysis using supply and demand can be applied when a good has a single buyer, a monopsony, but many sellers.
Where there are both few buyers or few sellers, the theory of supply and demand cannot be applied because both decisions of the buyers and sellers are interdependent - changes in supply can affect demand and vice versa. Game theory can be used to analyse this kind of situation. See also oligopoly.
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.
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 this would not be the case for certain goods. 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.Simple supply and demand curves
Demand curve shifts
Supply curve shifts
Effects of being away from the equilibrium point
Vertical supply curve
Other market forms
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