Supply & Demand

Supply and Demand: An Introduction

§      Eighteenth-century economics tried to explain differences in the prices of goods by focusing on differences in their cost of production.  But this approach cannot explain why a conveniently located house sells for more than one that is less conveniently located.  Early nineteenth-century economists tried to explain price differences by focusing on differences in what buyers were willing to pay.  But this approach cannot explain why the price of a lifesaving appendectomy is less than that of a surgical facelift. 

§      Alfred Marshall’s model of supply and demand explains why neither cost of production nor value to the purchaser (as measured by willingness to pay) is, by itself, sufficient to explain why some goods are cheaper and others are expensive.  To explain variations in price, we must examine the interaction of cost and willingness to pay.  As we’ve seen in this chapter, goods differ in price because of the differences in their respective supply and demand curves. 

§      The demand curve is a downward-sloping line that tells what quantity buyers will demand at any given price.  The supply curve is an upward sloping line that tells what quantity sellers will offer at any given price.  Market equilibrium occurs when the quantity buyers demand at the market price is exactly the same as the quantity that sellers offer.  The equilibrium price-quantity pair is the one that which the demand and supply curve intersect.  In equilibrium, market prices measures both the value of the last unit sold to buyers and the cost of the resources required to produce it. 

§      When the price of a good lies above its equilibrium value, there is an excess supply of that good.  Excess supply motivates sellers to cut their prices, and price continues to fall until the equilibrium price is reached.  When price lies below its equilibrium, there is excess demand.  With excess demand, frustrated buyers are motivated to offer higher prices, and the upward pressure on prices persists until equilibrium is reached.  A remarkable feature of the market system is that, relying only a tendency of people to respond in self-interested way to market price signals, it somehow manages to coordinate the actions of literally billions of buyers and sellers worldwide.  When excess demand or excess supply occurs, it tends to be small and brief, except in markets where regulations prevent full adjustment of prices. 

§      The efficiency of markets in allocating resources does not eliminate social concerns about how goods and services are distributed among different people.  For example, we often lament the fact many buyers enter the market with too little income to buy even the most basic goods and services.  Concern for the well-being of the poor has motivated many governments to intervene in a variety of ways to alter the outcomes of market forces.  Sometimes these interventions take the form of laws that peg prices below their equilibrium levels.  Such laws almost invariably generate harmful, if unintended, consequences.  Programs like rent-control laws, for example, lead to severe housing shortages, black marketeering, and a rapid deterioration of the relationship between landlords and tenants. 

§      If the difficulty is that the poor have too little money, the best solution is to discover ways of boosting their incomes directly.  The law of supply and demand cannot be repealed by the legislature.  But legislatures do have the capacity to alter underlying forces that govern the shape and position of supply and demand schedules. 

§      The basic supply and demand model is a primary tool of the economic naturalist.  Changes in the equilibrium price of a good, and in the amount of it traded in the marketplace, can be predicted on the basis of shifts in its supply or demand curves.  The following four rules hold for any good with a downward-sloping demand curve and an upward-sloping supply curve:

§         An increase in demand will lead to an increase in equilibrium price and quantity.

§         A reduction in demand will lead to a reduction in equilibrium price and quantity. 

§         An increase in supply will lead to a reduction in equilibrium price and an increase in equilibrium quantity. 

§         A decrease in supply will lead to an increase in equilibrium price and a reduction in equilibrium quantity. 

§      Incomes, tastes, population, expectations, and the prices of substitutes and complements are among the factors that shift demand schedules.  Supply schedules, in turn, are primarily governed by such shifts as technology, input prices, expectations, the number of sellers, and especially for agricultural products, the weather.

§      When the supply and demand curves for a good reflect all significant costs and benefits associated with the production and consumption for that good, the market equilibrium price will guide people to produce and consume the quantity of the good that result in the largest possible economic surplus.  This conclusion, however, does not apply if others, beside buyers, benefit from the good (as when someone benefits from his neighbor’s purchase of a vaccination against measles), or if others besides sellers bear costs because of the good (as when its production generates pollution).  In such cases, market equilibrium does not result in the greatest gain for all.