The Basics of Supply and Demand

One of the best ways to appreciate the relevance of economics is to begin with the basics of supply and demand. Supply-demand analysis is a fundamental and powerful tool that can be applied to a wide variety of interesting and important problems. To name a few: understanding and predicting how changing world economic conditions affect market price and production; evaluating the impact of government price controls, minimum wages, price supports, and production incentives; and determining how taxes, subsidies, tariffs, and import quotas affect consumers and producers.

We begin with a review of how supply and demand curves are used to describe the market mechanism. Without government intervention (e.g., through the imposition of price controls or some other regulatory policy), supply and demand will come into equilibrium to determine the market price of a good and the total quantity produced. What that price and quantity will be depends on the particular characteristics of supply and demand. And how price and quantity vary over time depends on how supply and demand respond to other economic variables, such as aggregate economic activity and labor costs, which are themselves changing.

We will therefore discuss the characteristics of supply and demand and how those characteristics may differ from one market to another. Then we can begin to use supply and demand curves to understand a variety of phenomena-why the prices of some basic commodities have fallen steadily over a long period, while the prices of others have experienced sharp gyrations; why shortages occur in certain markets; and why announcements about plans for future government policies or predictions about future economic conditions can affect markets well before those policies or conditions become reality.

Besides understanding qualitatively how market price and quantity are determined and how they can vary over time, it is also important to learn how they can be analyzed quantitatively. We will see how simple "back of the envelope" calculations can be used to analyze and predict evolving market conditions, and how markets respond both to domestic and international macro-economic fluctuations and to the effects of government interventions. We will try to convey this understanding through simple examples and by urging you to work through some exercises at the end of the chapter.

Let us begin with a brief review of the basic supply-demand diagram as shown in Figure 2.1. The vertical axis shows the price of a good, P, measured in dollars per unit. This is the price that sellers receive for a given quantity supplied and that buyers will pay for a given quantity demanded. The horizontal axis shows the total quantity demanded and supplied, Q, measured in number of units per period.

The supply curve S tells us how much producers are willing to sell for each price that they receive in the market. The curve slopes upward because the higher the price, the more firms are usually able and willing to produce and sell. For example, a higher price may enable existing firms to expand production in the short run by hiring extra workers or by having existing workers

2.1 The Market Mechanism



FIGURE 21 Supply and Demand. The market dears at price Po and quantity Qo. At the higher price Pi a surplus develops, so price falls. At the lower price P2 there is a shortage, so price is bid up.

work overtime (at greater cost to the firm),and in the long run by increasing the size of their plants. A higher price may also attract into the market new firms that face higher costs because of their inexperience and that therefore would have found entry into the market uneconomical at a lower price.

The demand curve D tells us how much consumers are willing to buy for each price per unit that they must pay. It slopes downward because consumers are usually ready to buy more if the price is lower. For example, a lower price may encourage consumers who have already been buying the good to consume a larger quantity, and it may enable other consumers who previously might not have been able to afford the good to begin buying it.

The two curves intersect at the equilibrium, or market- clearing, price and quantity. At this price P0, the quantity supplied and the quantity demanded are just equal (to Qa), The market mechanism is the tendency in a free market for the price to change until the market clears (i.e., until the quaiitity supplied and the quantity demanded are equal). At this point there is neither shortage nor excess supply, so there is also no pressure for the price to change further. Supply and demand might not always be in equilibrium, and some markets might not clear quickly when conditions change suddenly, but the tendency is for markets to clear.

To understand why markets tend to clear, suppose the price were initially above the market clearing level, say. in Figure 2.1. Then producers would try to produce and sell more than consumers were willing to buy. A surplus would accumulate, and to sell this surplus or at least prevent it from growing, producers would begin to lower their prices. Eventually price would fall, quantity demanded would increase, and quantity supplied would decrease until the equilibrium price P0 was reached.

The opposite would happen if the price were initially below Po, say, at P2. A shortage would develop because consumers would be unable to purchase all they would like at this price. This would put upward pressure on price as consumers tried to outbid one another for existing supplies and producers reacted by increasing price and expanding output. Again, the price would eventually reach P0.

When we draw and use supply and demand curves, we are assuming that at any given price, a given quantity will be produced and sold. This makes sense only if a market is at least roughly competitive. By this we mean that both sellers and buyers should have little market power (i.e., little ability individually to affect the market price). Suppose instead that supply were controlled by a single producer-a monopolist. In this case there would no longer be a simple one-to-one relationship between price and quantity supplied. The reason is that a monopolist's behavior depends on the shape and position of the demand curve. If the demand curve shifted in a particular way, it might be in the monopolist's interest to keep the quantity fixed but change the price, or keep the price fixed and change the quantity. (How this could occur is explained in Chapter 10.) So when we work with supply and demand curves, we implicitly assume that we are referring to a competitive market.

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