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1. Introduction. Definition of Supply and Demand
The market process is generally modeled using the economic concepts of supply and demand. The plans/desires of consumers are embedded in the concept of demand and the plans/desires of producers in the concept of supply. The plans of these two types of economic actors are brought together in markets, which are the entities in which transactions occur. Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy.
The concept of demand represents the market activity of consumers. Demand is defined as the quantity of a good or service that consumers will be both willing and able to purchase at any given price during a specific period of time, holding all other factors constant. Demand is, therefore, a relationship between price and quantity demanded. Many factors other than price affect the amount consumers choose to purchase, and these factors are what is being held constant within the concept of demand.
Demand can be illustrated in a schedule that shows how many units of a good or service consumers will purchase at several distinct prices. Table 1 shows how many units of a good (widgets) consumers will purchase at a number of different prices. This relationship between price and quantity demanded can also be represented graphically. A demand curve represents the maximum price that consumers would be willing to pay for a particular quantity of the good. Consumers are willing to purchase something because they value that product more than its opportunity cost. The opportunity cost is the value of the best alternative they could purchase with the same money; that is, when a consumer chooses to spend $2 on a hamburger, he or she has decided that the hamburger provides more satisfaction (at that moment in time) than anything else that could be bought with that $2. Thus, the demand curve represents the value of the product to the consumer. The area under the demand curve provides a measure of the total value that consumers receive from consuming that amount of the product.
The nature of this relationship between price and quantity demanded is so consistent that it is called the law of demand. This law states that the relationship defined by the concept of demand is an inverse or indirect one. When prices rise, other factors held constant, consumers will purchase less of the good, and vice versa. The rationale for the law is that when the price of a product changes relative to the price of other products, consumers will change their purchasing patterns by buying less of the now higher-priced good and purchasing more of other goods which are now relatively less expensive that satisfy the same basic wants. Goods that satisfy the same basic wants are called substitutes. For example, if the price of beef rises relative to the price of pork, chicken, and turkey, consumers will shift some of their purchases from beef to pork, chicken, and turkey.
Supply can be defined as the relationship between the price of a good or service and the quantity producers are willing and able to make available for sale in a given period of time, holding other things constant. A supply schedule showing how many widgets producers will make available for sale at several distinct prices is also shown in Table 1. Supply represents graphically the minimum price that consumers are willing to accept in order to make a given amount of the good or service available for sale. As such, it is the opportunity cost to society of producing that particular good.
The law of supply states that this relationship is a direct one. When the price of a good rises, holding other factors constant, producers will be willing to supply more of the product. The rationale for this law is that resource owners will want to use their resources in the most valuable way possible. For example, if the market price of corn rises relative to that of wheat, farmers will choose to plant more of the land available to them in corn and less in wheat.
Table 1
Widgets
Quantity Supplied Price Quantity Demanded
50 $13 10
40 $11 20
30 $ 9 30
20 $ 7 40
10 $ 5 50
2. Model of Supply and Demand. Market Equilibrium
The laws of supply and demand state that the equilibrium market price and quantity of a commodity is at the intersection of consumer demand and producer supply. Here, quantity supplied equals quantity demanded, that is, equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding. If the price for a good is below equilibrium, consumers demand more of the good than producers are prepared to supply. This defines a shortage of the good. A shortage results in the price being bid up. Producers will increase the price until it reaches equilibrium. If the price for a good is above equilibrium, there is a surplus of the good. Producers are motivated to eliminate the surplus by lowering the price. The price falls until it reaches equilibrium.
Figure 1. The intersection of supply and demand curves determines equilibrium price (P0) and
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