Demand and Supply -- A First Look
The material in chapter 4 covers the most widely used model in economics, the model of demand and supply. This model allows us to see how the price system operates to allocate scarce resources among alternative uses. Graphs are used extensively to show how demand and supply interact in markets to determine equilibrium price.
Demand
Every market has a demand side and a supply side. The demand side of the market for a particular commodity can be represented by a market demand schedule or demand curve. This shows the amount of the commodity that buyers plan to purchase at various prices (effective demand; cf., want vs. demand). For example, some years ago the U.S. Department of Agriculture (USDA) estimated the following demand schedule for wheat in the U.S.:
| P Farm price per bushel | Qd Quantity of wheat demanded per year (millions of bushels) |
| $3 | 1,850 |
| $4 | 1,650 |
| $5 | 1,500 |
The data from the demand schedule, represented graphically with P on the vertical axis and Q on the horizontal axis, constitutes a demand curve for wheat (DD).
Wheat is demanded for a variety of reasons, including to produce bread and other food products for domestic use, for feed, and for export purposes. The market demand curve shows the total demand, including all of these components, at each price (cf., horizontal summation of the demand curves of individual households and firms).
Every demand curve pertains to a particular period. Here the period is a year, but it could be a month or a week. Note that the length of the time period influences the shape and position of the demand curve.
The demand curve for wheat slopes downward to the right (from NW to SE). That is, the quantity of wheat demanded increases as the price falls. This reflects the law of demand, which states that other things being equal, the higher the price of a good, the smaller is the quantity demanded.
As the price of wheat (or any other commodity) falls, the benefits relative to the costs of wheat (or good X) consumption increase. Some consumers who previously didn't buy wheat will now do so, as they find it worthwhile at the lower price. Some previous wheat consumers will increase their wheat purchases. Consumers will buy more wheat, and less of other commodities that are substitutes for wheat -- e.g., corn used for animal feed.
Substitution is thus a key here, as may be seen by thinking about substitutes like steak and hamburger, or heating oil and natural gas. In the presence of substitutes, then, we have an inverse relationship between price and quantity demanded, and this is reflected in the downward-sloping demand curve. [In mathematical notation, we'd say that Qd = f(P), and f' < 0).]
Price is not the only factor that influences quantity demanded. Additional determinants of consumers' buying plans include:
1. income (positively related to demand);
2. the prices of related commodities (demand is positively related to the price of substitutes and negatively related to the price of complements);
3. the number of consumers in the market (greater population translates into greater demand, other things equal);
4. the preferences of consumers (changes in preferences can influence demand -- cf., advertising); and
5. expectations about future prices (expectations of higher relative prices in the future tend to increase demand in the present). [note money price/relative price distinction.]
Changes in any or all of these five factors will result in corresponding changes in the quantity demanded of a good, at all prices. That is, changes in the above factors will result in a shifting of the demand curve.
Supply
The supply side of the market for a particular commodity can be represented by a market supply schedule or supply curve. This shows the amount of the commodity that producers plan to sell at various prices. For our wheat example, we have the following USDA-estimated supply schedule for wheat in the U.S.:
| P Farm price per bushel | Qs Quantity of wheat supplied per year (millions of bushels) |
| $3 | 1,600 |
| $4 | 1,900 |
| $5 | 2,200 |
The market supply curve (SS) shows the total supply that will be offered on the market at each price, during a particular time period. As with demand, the length of the time period influences the shape and position of the curve.
Note that the supply curve for wheat slopes upward to the right. That is, as the price of wheat increases producers will be willing to supply more wheat, other things equal. Parkin notes that this upward slope of the supply curve reflects rising opportunity cost (which we saw with the production possibility frontier). Further, producers have a greater incentive to grow and supply wheat when its price is high (higher profits).
Hence, we have the law of supply: other things equal, the higher the price of a good the greater is the quantity supplied.
[Mathematically, Qs = f(P), f' > 0).]
As was the case with demand, so too with supply we find that price is not the only factor that influences the quantity supplied. Additional determinants of suppliers' plans include:
1. the costs of factors of production (higher costs will reduced the quantity supplied at every price);
2. the prices of related outputs (higher prices for substitutes in production will tend to reduce supply of a good);
3. technology (technological progress typically results in lower costs of production and hence increased supply);
4. expected future prices (an increase in the expected future price of a good will reduce the present supply); and
5. the number of suppliers (more producers result in an increase in supply).
Changes in any of these five factors will result in a shift in the supply curve.
Equilibrium Price
The two sides of a market, demand and supply, interact to determine the equilibrium price of a commodity. We can define an equilibrium as a situation where there is no tendency for change. Hence, if in a particular market there is no tendency for the price to change, that is an equilibrium price -- a price that can be maintained.
Consider our demand and supply schedules for wheat, and the corresponding curves:
| P | Qd | Qs | Qd-Qs |
| $3 | 1,850 | 1,600 | 250 |
| $4 | 1,650 | 1,900 | -250 |
| $5 | 1,500 | 2,200 | -700 |
Now let's examine the consequences of different prices in the market. At a price of $5 per bushel, there would be 1500 million bushels demanded (as shown by the demand schedule and the demand curve), and there would be 2200 million bushels supplied. There is a mismatch between Qd and Qs, representing an excess supply (surplus) of 700 million bushels per year.
In such a situation, farmers would not be able to sell all of their wheat and wheat inventories would begin to build up. In order to get rid of unwanted inventories, sellers would begin to offer their wheat at lower prices. That is, excess supply results in downward pressure on the market price. At $4 a bushel the excess supply will have diminished (from 700 million to 250 million bushels), but since there is still excess supply there will still be downward pressure on the price of wheat.
If, by contrast, the price of wheat were $3 per bushel, then Qd would equal 1850 million bushels, Qs would equal 1600 million bushels, and there will again be a mismatch between the two. Now, however, we have a situation of excess demand, or shortage. Competition among buyers for scarce supplies of wheat will encourage sellers to raise prices -- i.e., excess demand results in upward pressure on the market price.
Clearly, none of the above prices -- $3, 4, or 5 per bushel -- is an equilibrium price, since market conditions with these prices all lead to changes in the market price. Equilibrium occurs at the price where quantity demanded equals quantity supplied; where there is neither excess demand nor excess supply. The equilibrium price is the only stable price, and it is the only price for which there will not be a mismatch between Qd and Qs.
Graphically, the equilibrium price in a market is the price at which the supply and demand curves intersect. The equilibrium quantity is the quantity corresponding to the point of intersection of the demand and supply curves. In our wheat example, the equilibrium price is approximately $3.50 per bushel, and the equilibrium quantity is about 1750 million bushels.
The actual market price will move to the equilibrium price in a competitive market. Markets with price ceilings (as with rent control) or price floors (as with the minimum wage) may have a price not equal to the equilibrium, but there will then be either a shortage or a surplus.
The Effects of Shifts in Demand Curves and Shifts in Supply Curves on Equilibrium Price and Quantity
We saw earlier that demand curves may shift in response to numerous factors: income, prices of substitutes and complements, population, preferences (tastes), and expectations about future prices. Likewise, supply curves shift in response to changes in the costs of factors of production, the prices of related outputs (substitutes in production), technology, expected future prices, and the number of suppliers.
Such shifts have clear implications for equilibrium price and equilibrium quantity:
1. An increase in demand (shift to the right of the demand curve) causes an increase in both the equilibrium price and the equilibrium quantity exchanged.
2. A decline in demand (shift to the left) reduces the equilibrium price and the equilibrium quantity exchanged.
3. An increase in supply (shift to the right of the supply curve) results in a decrease in the equilibrium price and an increase in the equilibrium quantity exchanged.
4. A decrease in supply (shift to the left) causes an increase in the equilibrium price and a decrease in the equilibrium quantity.
These are sometimes called the laws of supply and demand, and their applications are almost limitless. In each of these cases, a change in supply or demand means that the previous equilibrium price is no longer an equilibrium. This in turn, produces a shortage or surplus, and the response of buyers and sellers to the shortage or surplus eventually will bring about a new equilibrium price and equilibrium quantity.
Finally, we should note what happens when both supply and demand change (as is likely to occur when we consider the behavior of markets over time). Consider, for example, the market for hand calculators over the course of the past 20 years. During this period both incomes and population have grown, resulting in an increase in demand. This should, by itself, increase price and quantity in the market. At the same time, the technology used to produce calculators has improved dramatically, resulting in an increase in supply. By itself, this should result in a lower price and higher quantity.
If we put the two changes together (increases in both demand and supply), it should be clear that quantity will increase. However, theory cannot tell us what will happen to price, since the two effects work in opposing directions. In fact, the price has dropped dramatically, indicating that the shift in supply has been distinctly larger than the shift in demand.
© 1996 David Shapiro
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