Supply and demand

In microeconomic theory, the partial equilibrium supply and demand economic model originally developed by Alfred Marshall attempts to describe, explain, and predict changes in the price and quantity of goods sold in competitive markets. The model is only a first approximation for describing an imperfectly competitive market. It formalizes the theories used by some economists before Marshall and is one of the most fundamental models of some modern economic schools, widely used as a basic building block in a wide range of more detailed economic models and theories. The theory of supply and demand is important for some economic schools' understanding of a market economy in that it is an explanation of the mechanism by which many resource allocation decisions are made. However, unlike general equilibrium models, supply schedules in this partial equilibrium model are fixed by unexplained forces.

Simple supply and demand curves

Mainstream economic theory centers on creating a series of supply and demand relationships, describing them as equations, and then adjusting for factors which produce "stickiness" between supply and demand. Analysis is then done to see what "trade offs" are made in the "market", which is the negotiation between sellers and buyers. Analysis is done as to what point the ability of sellers to sell becomes less useful than other opportunities. This is related to "marginal" costs, or the price to produce the last unit that can be sold profitably, versus the chance of using the same effort to engage in some other activity.

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The slope of the demand curve (downward to the right) indicates that a greater quantity will be demanded when the price is lower. On the other hand, the slope of the supply curve (upward to the right) tells us that as the price goes up, producers are willing to produce more goods. The point where these curves intersect is the equilibrium point. At a price of P producers will be willing to supply Q units per period of time and buyers will demand the same quantity. P in this example, is the equilibrating price that equates supply with demand.

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In the figures, straight lines are drawn instead of the more general curves. This is typical in analysis looking at the simplified relationships between supply and demand because the shape of the curve does not change the general relationships and lessons of the supply and demand theory. The shape of the curves far away from the equilibrium point are less likely to be important because they do not affect the market clearing price and will not affect it unless large shifts in the supply or demand occur. So straight lines for supply and demand with the proper slope will convey most of the information the model can offer. In any case, the exact shape of the curve is not easy to determine for a given market. The general shape of the curve, especially its slope near the equilibrium point, does however have an impact on how a market will adjust to changes in demand or supply. (See the below section on elasticity.)

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It should be noted that on supply and demand curves both are drawn as a function of price. Neither is represented as a function of the other. Rather the two functions interact in a manner that is representative of market outcomes. The curves also imply a somewhat neutral means of measuring price. In practice any currency or commodity used to measure price is also the subject of supply and demand.

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Effects of being away from the equilibrium point

Consider how prices and quantities not at the equilibrium point tend to move towards the equilibrium. Assume that some organization (say government or industry cartel) has the ability to set prices. If the price is set too high, such as at P1 in the diagram to the right, then the quantity produced will be Qs. The quantity demanded will be Qd. Since the quantity demanded is less than the quantity supplied there will be an oversupply (also called surplus or excess supply). On the other hand, if the price is set too low, then too little will be produced to meet demand at that price. This will cause an undersupply problem (also called a shortage).

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Now assume that individual firms have the ability to alter the quantities supplied and the price they are willing to accept, and consumers have the ability to alter the quantities that they demand and the amount they are willing to pay. Businesses and consumers will respond by adjusting their price (and quantity) levels and this will eventually restore the quantity and the price to the equilibrium.

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In the case of too high a price and oversupply (seen in the diagram at the left), the profit-maximizing businesses will soon have too much excess inventory, so they will lower prices (from P1 to P) to reduce this. Quantity supplied will be reduced from Qs to Q and the oversupply will be eliminated. In the case of too low a price and undersupply, consumers will likely compete to obtain the good at the low price, but since more consumers would like to buy the good at the price that is too low, the profit-maximizing firm would raise the price to the highest they can, which is the equilibrium point. In each case, the actions of independent market participants cause the quantity and price to move towards the equilibrium point.

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