Supply and Demand
Chapter Summary
On a long-ago episode of Saturday Night Live, a comedian (Don Novello, a.k.a. Father Guido Sarducci) got up and gave a very brief lecture on economics. He held up one index finger and said Supply. He held up the other index finger and said Demand. Then he brought them together to form an X and concluded Supply and Demand. Thats it. And he was right; the two crossing curves, supply and demand, are the foundation of all economics, and a powerful tool for understanding the real world.
The quantity demanded is the amount of a good that consumers want to buy at a given price, holding constant all other factors that influence purchases. Other factors that influence purchases include tastes, information, prices of other goods, income, and government rules and regulations.
The demand function shows the mathematical relationship between the quantity demanded , the price of the product, and other factors that influence purchases. A demand curve plots the demand function, again holding constant other factors. Demand curves are always graphed with the price per unit on the vertical axis and the quantity (number of units per time period) on the horizontal axis. One of the most important finding of empirical economics is the law of demand: consumers demand more of a product when the price is lower, holding all else constant. The law of demand implies that demand curves slope downward, or that the derivative of quantity with respect to price is negative.
A change in the quantity demanded that is due to a change in price is called a movement along the demand curve. If some factor other than price causes a change in the quantity demanded at the old price, then there is a shift in the demand curve and it is necessary to draw a new demand curve. To find the demand curve for a group, simply add up the quantity that each individual consumer demands at each price.
The quantity supplied is the amount of a good that firms want to sell at a given price, holding constant all other factors that influence firms supply decisions. Other factors that influence supply decisions include costs of production, technology, and government rules and regulations.
The supply function shows the relationship between the quantity supplied, the price of the product, and other factors that influence the number of units supplied. A supply curve shows the quantity supplied at each possible price, again holding constant other factors that influence supply decisions. Like demand curves, supply curves are graphed with the price per unit on the vertical axis and the quantity on the horizontal axis. Most supply curves for goods and services slope upwardwhen the price is higher, firms are willing to sell more.
A change in the quantity supplied by firms that is due to a change in price is referred to as a movement along the supply curve. If some factor other than price causes a change in the quantity supplied at the old price, then there is a shift in the supply curve. Among the factors that determine the position of a supply curve are costs of production, technology, the prices of other things that the firms could be making, and government rules and regulations. The total quantity supplied by an industry is found by adding together the quantity supplied by each firm at each price. One way in which governments can influence the total supply of a good on the market is by setting quotas, limits on the amount of a foreign-produced good that can be imported.
An equilibrium exists if no market participant wants to change its behavior. In a market, equilibrium occurs at the price and quantity where the demand curve and the supply curve intersect. Market forcesactions of consumers and firmswill drive the price and quantity to their equilibrium levels. If the price is initially lower than the equilibrium price, there will be excess demand; consumers will want to buy more than suppliers want to sell. Frustrated consumers will offer to pay firms more than the initial price and/or firms, noticing these disappointed consumers, will raise their prices. Both actions will drive up the price toward the equilibrium. If the price is initially above the equilibrium price, there will be excess supplythe consumers will want to buy less than the suppliers want to sell. In order to sell all that they have made, firms will cut the pricerather than paying storage costs, letting the product spoil, or having it remain unsold. At the equilibrium price, firms are willing to sell exactly the quantity that consumers are willing to buy and no one has an incentive to pay more or cut the price. The equilibrium price is often called the market clearing price, because at that price, there is neither excess supply nor excess demand.
Once an equilibrium is reached, it can persist indefinitely, but if a change in some determinant of supply or demand causes either (or both) curves to shift, the market will move to a new equilibrium. A shift of the demand curve causes a movement along the supply curve. A shift of the supply curve causes a movement along the demand curve.
Assuming that the demand curve slopes downward and that the supply curve slopes upward, the result of demand or supply curve shifts is predictable. Analysis of how variables such as price and quantity react to changes in environmental or exogenous variables is called comparative statics, comparing a static equilibrium to the new (static) equilibrium that results from the change.
When demand rises (shifts outward), the equilibrium price and quantity will rise. When demand falls (shifts inward), the equilibrium price and quantity fall. When supply falls (shifts inward), the equilibrium price will rise and equilibrium quantity will fall. When supply rises (shifts outward), the equilibrium price will fall and equilibrium quantity will rise. Both the size of the change in the environmental variable and the shape of supply and demand curves have an impact on the magnitude of the changes.
Elasticity measures the sensitivity of one variable to changes in another variable, or more precisely, elasticities measure the percentage change in one variable in response to a given percentage change in another variable. All elasticities take the form
E =
where the change in the variable on the bottom causes the change in the variable on top.
The price elasticity of demand, , measures the responsiveness of quantity demanded to a change in price and takes the form
where Q is the quantity demanded, and p is the price. Because demand curves slope downward, the elasticity of demand is always negative. If the elasticity of demand is between 0 and 1, then it is inelastic or unresponsive, since the percentage change in price generates a smaller percentage change in the quantity demanded. If the elasticity of demand is less than , then it is elastic or responsive, since the percentage change in price yields a larger percentage change in the quantity demanded.
The elasticity of demand varies along most demand curves. Two exceptions are a horizontal demand curve, which is perfectly elastic (the elasticity of demand is negative infinity) and a vertical demand curve, which is perfectly inelastic. A vertical demand curve has an elasticity of demand of zeroas the price rises, the quantity demanded does not change at all. Along a linear demand curve, demand is elastic above the midpoint, unitary at the midpoint, and inelastic below the midpoint. Constant-elasticity demand curves have the exponential form Q = Ap(.
Two other demand-side elasticities are the income elasticity of demand and the cross-price elasticity of demand. The income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. Income elasticities may be positive (normal goods) or negative (inferior goods). The cross-price elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in the price of some other good. Cross-price elasticities may be positive (substitutes), negative (complements), or zero (unrelated goods).
The price elasticity of supply, (, measures the response of quantity supplied due to a change in price. It takes the form
where Q is the quantity supplied, and p is the price. The sign of the price elasticity of supply depends on the slope of the supply curve, which could be positive or negative. If a supply response is larger than the change in price (in terms of percentage change) it is said to be elastic (((1, in absolute value). If it is smaller ( ( 1, in absolute value), it is inelastic. As with demand curves, supply curves can be perfectly elastic, perfectly inelastic, or have a constant elasticity of supply.
Demand elasticities depend crucially on the ability to find substitutes, which often varies with time. In general, there are more opportunities for substitution in the long run, so for most goods, demand is more elastic in the long run than in the short run. Likewise, almost all supply curves become more elastic over time, as firms have time to make major output adjustments by building new production facilities.
Government imposition of taxes affects market equilibrium. Specific or unit taxes are collected per unit of output sold. Ad valorem taxes are based on a percentage of total spending on the good. A tax that is levied on producers shifts the supply curve upward, and a tax that is levied on consumers shifts the demand curve downward. Both producers and consumers will generally pay part of the tax, no matter who is legally required to pay the tax.
For a specific tax,(, imposed on producers, the shift in supply raises the market price and creates a wedge between the new price the consumers pay, p, and the new price the suppliers receive, p . The incidence of the tax is determined by the relative elasticities of supply and demand. The portion of a specific tax that falls on consumers equals /( ), where is the elasticity of supply and is the elasticity of demand. (Remember that the demand elasticity is a negative number.) Thus, if the demand elasticity is twice as big as the supply elasticity, the consumers will pay one-third of the tax. Whoever is more responsive (higher elasticity) is able to more easily respond to a higher price (by reducing quantity demanded or supplied) and thus pays less of the tax. If supply (demand) is perfectly inelastic, producers (consumers) will pay all of the tax. If supply (demand) perfectly elastic, producers (consumers) will end up paying none of the tax. Analysis of ad valorem taxes yields similar results.
A tax changes the market equilibrium price and quantity, but other government policies may prevent the market from reaching equilibrium. A price ceiling is a maximum price set by the government. If the ceiling is set below the market equilibrium, it will cause a shortage (a persistent excess demand)if it is enforced and if buyers and sellers do not find a way to get around it. Shortages mean that sellers select buyers using some criterion other than who will pay the most, such as who stands in line the longest or who the seller likes the most. A price floor is a minimum price set by the government. If the floor is set above the market equilibrium price, it will cause excess supply. One example of this is unemployment caused by the minimum wage.
The supply and demand model is most applicable in perfectly competitive markets. In such markets, everyone is a price taker (when no consumer or firm can affect the market price); when firms sell identical products; when everyone is fully informed about the price and quality of goods; and when transactions costs are low. This model has proved to be appropriate and useful for understanding agricultural, financial, labor, construction, service, wholesale, retail, and other markets.
Key Concepts and Formulas
A demand function is a mathematical relationship between the quantity demanded of a good, the price of the product, and other factors that influence purchases. A demand curve shows the amount of a good or service that consumers want to buy at each possible price.
A supply function is a mathematical relationship between the quantity supplied of a good, the price of the product, and other factors that influence production. A supply curve shows the amount of a good or service that firms want to sell at each possible price.
When only price changes there is a movement along a demand (or supply) curve.
Changes in factors other than the goods price can cause its demand (or supply) curve to shift.
Market equilibrium occurs at the price and quantity where the supply curve and the demand curve intersect.
• The price elasticity of demand, , measures the responsiveness of quantity demanded, Q, due to a change in price, p.
• A response is elastic if the percentage change in one variable causes a percentage change in another variable that is larger in magnitude. It is inelastic if the percentage change in the second variable is smaller in magnitude.
• Elasticity of supply, , measures the responsiveness of quantity supplied, Q, due to a change in price, p. (Q/Q)/(p/p) (Q/p)(p/Q) (percentage change in quantity supplied)/(percentage change in price).
• Vertical demand and supply curves are perfectly inelastic (elasticity 0). Horizontal demand and supply curves are perfectly elastic.
• The incidence of the tax is determined by the relative elasticities of supply, , and demand, . The portion of a specific tax that falls on consumers equals /( ).
• Price ceilings and floors do not shift demand or supply curves, but they can cause movements along these curves and block the market from reaching equilibrium.