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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 decreases, 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.
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 suppied 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 restores the quantity and the price to the equilibrium. In the case of oversupply, the businesses will soon have too much execess inventory, so they will lower prices to reduce this.
It is sometimes the case that the supply curve is vertical. For example, the amount of land in the world can be considered fixed. In this case, no matter how much someone would be willing to pay for one more acre of land, the extra can not be created. Also, even if no one wanted all the land, it still would exist. These conditions create a vertical supply curve. In the short run near vertical supply curves are even more common. For example, if the Super Bowl is next week, increasing the number of seats in the stadium is almost impossible. The supply of tickets for the game can be considered vertical in this case. If the organizers of this event underestimated demand, then it may very well be the case that the price that they set is below the equilibrium price. In this case there will likely be people who paid the lower price who only value the ticket at that price, and people who could not get tickets, even though they would be willing to pay more. If some of
the people who value the tickets less sell them to people who are willing to pay more (i.e. scalp the tickets), then the effective price will rise to the equilibrium price.
The below graph illustrates a vertical supply curve. When the demand 1 is in effect, the price will p1. When demand 2 is occuring, 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 sellers 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 or horizontal or upward sloping.
Standard microeconomic assumptions can not 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.
The above discussion of supply and demand can be thought of in terms of individual people interacting at a market. Suppose the following people exist:
There are many possible trades that would be mutually agreeable to both people, but not all of them will happen. For example, Cathy would be willing to trade with Fred for any price between $25 and $30. If the price is above $30, Cathy is not interested, since the price is too high. If the price is below $25, Fred is not interested since the price is too low. Of course, just because a trade is possible, doesn't mean it will happen. Each of the sellers will try and get as high of a price as possible, and each of the buyers will try and get as low of a price as possible.
Imagine that Cathy and Fred are bartering over the price. Fred offers $25 dollars for a sack of potatoes. Cathy is just about ready to agree when Emily offers to sell a sack of potatoes for $24 dollars. Fred is not willing to sell at $24 dollars, so he drops out. At this point, Dan can offer to sell for $12. Emily won't sell for that amount so it looks like the deal might go through. At this point however, Bob steps in and offers $14 dollars. At this point, we have two people who are willing to pay $14 dollars for a sack of potatoes (Cathy and Bob), but only one person (Dan) willing to sell for $14 dollars. So the price must go up because Cathy and Bob are both willing to pay more than $14 dollars. As soon as the price hits $15 dollars, Emily will be willing to sell so there are now two people willing to pay $15 dollars and two people willing to sell at $15 dollars so the trades can happen. But what about Fred and Alice? Well, Fred and Alice are not willing to trade with each other since Alice is only willing to pay $10 and Fred will not sell for any amount under $25. Alice can't outbid Cathy or Bob to try and purchase from Dan so Alice will not be able to get a trade with them. Fred can't underbid Dan or Emily so he will not be able to get a trade with Cathy. In otherwords, a stable equilbrium has been reached.
A supply and demand graph could also be drawn from this. The demand would be:
The supply would be:
And here is the graph:
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