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[[Image:Supply-and-demand.svg|thumb|right|240px|The theory of supply and demand describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). The graph depicts an increase in demand from D<sub>1</sub> to D<sub>2</sub> along with the consequent increase in price and quantity required to reach a new market-clearing equilibrium point on the supply curve (S).]]
Because of their importance  to the development of economic theory, an appreciation of the concepts of '''supply and demand''' is essential to the understanding of economic theory. This article seeks to explain their significance in non-technical terms and to provide a simple introduction to the law of supply and demand, with links to more detailed explanations.


In [[microeconomics|microeconomic]] [[theory]], the partial [[economic equilibrium|equilibrium]] '''supply and demand''' [[model (economics)|economic model]] originally developed by [[Antoine Augustin Cournot]] <ref name=COURNOTHET>[http://cepa.newschool.edu/het/profiles/cournot.htm Antoine Augustin Cournot, 1801-1877]</ref> (published in his book ''Researches into the Mathematical Principles of Wealth'' [[1838]]) and thirty years later broadly publicized by [[Alfred Marshall]] <ref name=MARSHALLHET>[http://cepa.newschool.edu/het/profiles/marshall.htm Alfred Marshall, 1842-1924]]</ref> attempts to describe, explain, and [[prediction|predict]] changes in the [[price]] and quantity of [[good (economics)|goods]] sold in [[perfect competition|competitive]] [[market]]s. 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 [[economics|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.
Definitions of the terms used in the article that are shown in italics can be found on the Related Articles subpage, and a selection of the diagrams and mathematical equations that are conventionally used for teaching purposes can be found on the Tutorials subpage.


To understand this concept, the theories of the '''Law of Demand''' and '''Law of Supply''' need to be put into account.
==Origins and applications==
 
The proposition that prices are determined by supply and demand is so familiar that it seems like a statement of the obvious. In fact,  it was not generally accepted, even by eminent intellectuals such as [[Adam Smith]], [[John Stuart Mill]] and [[David Ricardo]], until the idea was popularised by [[Alfred Marshall]] towards the end of the nineteenth century.<ref>[http://www.econlib.org/library/Marshall/ Alfred Marshall ''Principles of Economics'' Book V Macmillan 1964]</ref> <ref> For previous beliefs, see the article on [[history of economic thought]]</ref> Since then  there has been general acceptance of the proposition that demand rises in response to a reduction in price, that  supply rises in response to an increase in price, and that price somehow settles to a level where demand is equal to supply.
'''Law of Demand''': As prices fall for a particular good or service, the demand for that item will increase. Vice-versa.
That proposition has come to be been termed "the law of supply and demand" and is often thought to be  as firmly established as the law of gravity. In fact it is what Marshall termed "a statement of a tendency", depending upon particular premises about human behaviour, and some economists have questioned its logical consistency <ref> For an account of some accusations  of inconsistency, see the tutorials subpage of this article</ref>. It has nevertheless survived in general use as a robust statement that reflects widespread experience. In economics,  it has served as a tool that has been used in the construction of other theories, and it has generated a terminology that has been widely used in discussions among economists.
 
'''Law of Supply''': As the price of a particular good or service increases, the supply for that item will also be increased. Vice-versa.
 
 
==Supply==
 
'''Supply''' is the amount of output available in the market. i.e., it is the plan expressing quantities of a product that producers are willing to sell at given prices. For example, the potato growers may be willing to sell 1 million lbs of potatoes if the price is $0.75 per lb and substantially more if the market price is $0.90 per lb. The main determinants of supply will be the market price of the good and the cost of producing it. In fact, supply curves are constructed from the firm's long-run cost schedule. Supply curves are traditionally represented as upward-sloping because of the law of [[diminishing returns|diminishing marginal returns]]. This need not be the case, however, as described below.
 
==Special cases of a supply curve==
 
As described above, the general form of a supply curve is upward sloping. There are cases, however, when supply curves do not slope upwards. A well known example is for the supply curve for labor: [[backward bending supply curve of labour]]. As a person's wage increases, they are willing to supply a greater number of hours working, but when the wage reaches an extremely high amount (say a wage of $1,000,000 per hour), the amount of labor supplied actually decreases. Another example of a nontraditional supply curve is generally the supply curve for [[Public utility|utility]] production companies. Because a large portion of their total costs are in the form of fixed costs, the marginal cost (supply curve) for these firms is often depicted as a constant.


==Demand==
==Demand==


'''Demand''' is economic want backed up by purchasing power. i.e., it is the plan, or relationship, expressing different amounts of a product buyers are willing and able to buy at possible prices, assuming all other non-price factors remain the same.  For example, a consumer may be willing to purchase 2 lb of potatoes if the price is $0.75 per lb. However, the same consumer may be willing to purchase only 1 lb if the price is $1.00 per lb. A demand schedule can be constructed that shows the quantity demanded at each given price. It can be represented on a graph as a line or curve by plotting the quantity demanded at each price. It can also be described mathematically by a demand equation. The main determinants of the quantity one is willing to purchase will typically be the price of the good, one's level of income, personal tastes, the price of [[substitute good]]s, and the price of [[complementary good]]s.
===Price effects===
 
The basic premise that economists adopt when discussing demand was stated by Marshall as the proposition that "the larger the amount of a thing that a person has, the less ... will be the price which he will pay for a little more of it" - a proposition that they referred to as the [[law of diminishing marginal utility|law of diminishing ''marginal utility'']]. That premise has detailed implications for the price/demand relationship that are discussed on the Tutorials subpage, but the only implication that is necessary to the operation of  the law of supply and demand is that demand rises in response to a reduction in price and vice versa.   
The shape of the [[Aggregation of individual demand to total, or market, demand|aggregated demand curve]] can be convex or concave, possibly depending on income distribution.
 
The '''capacity to buy''' is sometimes used to characterise demand as being merely an alternate form of supply.
 
==Special cases of a demand curve==
As described above, the general form of a demand curve is that it is downward sloping. The demand curve for most, if not all, goods conforms to this principle. There may be rare examples of goods that have upward sloping demand curves. A good whose demand curve has an upward slope is known as a [[Giffen good]].
 
The existence of Giffen goods can not be explained by [[conspicuous consumption]], since an increase in stature associated with buying an expensive product means that more than just price is variable.  In fact the actual existence of a Giffen good is debatable.  Examples of conspicuous consumption are clearly subjective, but might include the [[Bugatti Veyron 16.4|Bugatti Veyron]]. The social phenomenon often referred to as '[[Bling]]' can also be thought of in this way.
 
==Simple supply and demand curves==
 
Mainstream economic theory centers on creating a series of supply and demand relationships, describing them as [[equation]]s, 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.
 
[[Image:simple_supply_and_demand.png|thumbnail|320px|right|Graph of simple supply and demand curves]]
 
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 at which these curves intersect is the '''[[Economic equilibrium|equilibrium point]]'''. At a price of <tt>P</tt> producers will be willing to supply <tt>Q</tt> units per period of time and buyers will demand the same quantity. <tt>P</tt> in this example, is the equilibrating price that equates supply with demand.
 
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 [[Supply and demand#Elasticity|elasticity]].)
 
It should be noted that on supply and demand curves both are drawn as a [[function (mathematics)|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.
 
==Demand curve shifts==
[[image:demand_shift_out.png|right]]
When more people want something, the quantity demanded at all prices will tend to increase.  This can be referred to as an ''increase in demand''.  The increase in demand could also come from changing tastes, where the same consumers desire more of the same good than they previously did.  Increased demand can be represented on the graph as the curve being shifted right, because at each price point, a greater quantity is demanded.  An example of this would be more people suddenly wanting more coffee. This will cause the demand curve to shift from the initial curve <tt>D0</tt> to the new curve <tt>D1</tt>.  This raises the equilibrium price from <tt>P0</tt> to the higher <tt>P1</tt>.  This raises the equilibrium quantity from <tt>Q0</tt> to the higher <tt>Q1</tt>.  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 <tt>D1</tt> and then ''decreases'' to <tt>D0</tt>, the price will decrease and the quantity supplied will decrease&mdash;a ''contraction'' in supply. Notice that this is purely an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the demand is different.
<br style="clear:both" />
 
==Supply curve shifts==
[[image:supply_curve_shift.png|left]]
When the suppliers' costs change the supply curve will shift.  For
example, assume that someone invents a better way of growing [[wheat]] so that the amount of wheat that can be grown for a given cost will increase.
Producers will be willing to supply more wheat at every price and this shifts the supply curve <tt>S0</tt> to the right, to <tt>S1</tt>&mdash;an ''increase in supply''.  This causes the equilibrium price to
decrease from <tt>P0</tt> to <tt>P1</tt>.  The equilibrium quantity increases
from <tt>Q0</tt> to <tt>Q1</tt> as the quantity demanded increases at the new lower prices.  Notice that in the case of a supply curve shift, the price and the quantity move in opposite directions.
Conversely, if the quantity supplied ''decreases'', the opposite happens.  If the supply curve starts at <tt>S1</tt> and then shifts to <tt>S0</tt>, the equilibrium price will increase and the quantity will decrease. Notice that this is purely an effect of supply changing.  The quantity demanded at each price is the same as before the supply shift (at both <tt>Q0</tt> and <tt>Q1</tt>). The reason that the equilibrium quantity and price are different is the ''supply'' is different.
 
There are only 4 possible movements to a demand/supply curve diagram. The demand curve can move to the left and right, and the supply curve can also move only to the left or right. If they do not move at all then they will stay in the middle where they already are.
 
'''See also:''' [[Induced demand]]
<br style="clear:both" />
 
==Market "clearance"==
 
The market "clears" at the point where all the supply and demand at a given price are balanced. That is, the amount of a commodity available at a given price equals the amount that buyers are willing to purchase at that price. It is assumed that there is a process that will result in the market reaching this point, but exactly what the process is in a real situation is an ongoing subject of research. Markets which do not clear will react in some way, either by a change in price, or in the amount produced, or in the amount demanded. Graphically the situation can be represented by two curves: one showing the price-quantity combinations buyers will pay for, or the [[demand curve]]; and one showing the combinations sellers will sell for, or the [[supply curve]]. The market clears where the two are in equilibrium, that is, where the curves intersect. In a [[general equilibrium]] model, all markets in all goods clear simultaneously and the "price" can be described entirely in terms of tradeoffs with other goods. For a century most economists believed in [[Say's Law]], which states that markets, as a whole, would always clear and thus be in balance.
 
For [[Neoclassical|traditional economics]], the market clearing price contains no maximization basis. As a result, any disequilibrium (excess demand or excess supply) is just a matter of graphical exercises. Some economists regarded that a demand curve could be represented by a diminishing marginal use value curve (the schedule of a consumer's maximum willing to pay with different quantity endowments). By this framework, people will buy when the market price is low enough, and they will sell when the price is high enough. In market clearing condition, the market price implies that the marginal use value of all participants are equalized. In other words, mutual gain of exchange is exhausted. Here come the basis of maximization for the concept of market equilibrium.
 
==Elasticity==
{{main|Elasticity (economics)}}
 
An important concept in understanding supply and demand theory is '''elasticity'''. In this context, it refers to how supply and demand change in response to various stimuli.  One way of defining elasticity is the percentage change in one variable divided by the percentage change in another variable (known as ''arch elasticity'' because it calculates the elasticity over a range of values, in contrast with ''point elasticity'' that uses differential calculus to determine the elasticity at a specific point).  Thus it is a measure of ''relative'' changes.
 
Often, it is useful to know how the quantity supplied or demanded will change when the price changes.  This is known as the '''[[price elasticity of demand]]''' and the '''[[price elasticity of supply]]'''.  If a [[monopoly|monopolist]] decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely  decrease in sales volume? If a government imposes a [[tax]] on a good, thereby increasing the effective price, how will this affect the quantity demanded?
 
If you do not wish to calculate elasticity, a simpler technique is to look at the slope of the curve.  Unfortunately, this has units of measurement of quantity over monetary unit (for example, [[liter]]s per [[euro]], or [[battleship]]s per million [[yen]]), which is not a convenient measure to use for most purposes.  So, for example, if you wanted to compare the effect of a price change of [[gasoline]] in [[Europe]] versus the [[United States]], there is a complicated conversion between [[gallon]]s per [[dollar]] and liters per euro.  This is one of the reasons why economists often use relative changes in percentages, or elasticity.  Another reason is that elasticity is more than just the slope of the function: It is the slope of a function in a coordinate space, that is, a line with a constant slope will have different elasticity at various points.
 
Let's do an example calculation. We have said that one way of calculating elasticity is the percentage change in quantity over the percentage change in price.  So, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar.  Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2/5 or 0.4. 
 
Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity.  If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic.  An example of perfectly inelastic supply, or zero elasticity, is represented as a [[Supply and demand#vertical supply curve|vertical supply curve]]. (See that section below)
 
Elasticity in relation to variables other than price can also be considered.  One of the most common to consider is [[income]].  How would the demand for a good change if income increased or decreased?  This is known as the '''[[income elasticity of demand]]'''.  For example, how much would the demand for a luxury [[automobile|car]] increase if average income increased by 10%?  If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve, because at all price levels, a greater quantity of luxury cars would be demanded.
 
Another elasticity that is sometimes considered is the '''[[cross elasticity of demand]]''', which measures the responsiveness of the quantity demanded of a good to a change in the price of another good.  This is often considered when looking at the relative changes in demand when studying '''[[complement good|complement]]''' and '''[[substitute good]]s'''.  Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also.  Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.
 
Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be &minus;20%/10% or, &minus;2.
 
==Vertical supply curve==
 
It is sometimes the case that the supply curve is vertical: that is the quantity supplied is fixed, no matter what the market price.  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 a piece of land, the extra cannot be created.  Also, even if no one wanted all the land, it still would exist.  If land is considered in this way, then it warrants a vertical supply curve, giving it zero elasticity (i.e., no matter how large the change in price, the quantity supplied will not change).  On the other hand, the supply of useful land can be increased in response to demand -- by irrigation. And land that otherwise would be below sea level can be kept dry by a system of dikes, which might also be regarded as a response to demand. So even in this case, the vertical line is a bit of a simplification.
 
In the short run near vertical supply curves are 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 graph below illustrates a vertical supply curve.  When the
<tt>demand 1</tt> is in effect, the price will be <tt>p1</tt>.  When
<tt>demand 2</tt> is occurring, the price will be <tt>p2</tt>.  Notice
that at both values the quantity is <tt>Q</tt>.  Since the supply is fixed, any shifts in demand will only affect price. 
 
[[image:vertical_supply.png|Diagram of vertical supply curve]]
 
==Other [[market forms]]==
 
In a situation in which there are many buyers but a single '''[[monopoly]]''' supplier that can adjust the supply or price of a good at will, the monopolist will adjust the price so that his profit is maximized given the amount that is demanded at that price. This price will be higher than in a competitive market.  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&mdash;changes in supply can affect demand and vice versa.  '''[[Game theory]]''' can be used to analyze 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, horizontal or upward sloping. While it is possible for industry supply curves to be downward sloping, supply curves for individual firms are never downward sloping.
 
Standard microeconomic assumptions cannot 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 goods|giffen good]]'''). Non-economists sometimes think that certain goods would have such a curve.  For example, some people will buy a luxury car because it is expensive.  In this case the good demanded is actually [[prestige (sociology)|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 (see '''[[Veblen good]]''').  Even with downward-sloping demand curves, it is possible that an increase in income may lead to a decrease in demand for a particular good, probably due to the existence of more attractive alternatives which become affordable: a good with this property is known as an '''[[fernando rules]]'''.
 
==An example: Supply and demand in a 6-person economy==
 
Supply and demand can be thought of in terms of individual people interacting at a market. Suppose the following six people participate in this simplified economy:
 
* Alice is willing to pay $10 for a sack of potatoes.
* Bob is willing to pay $20 for a sack of potatoes.
* Cathy is willing to pay $30 for a sack of potatoes.
* Dan is willing to sell a sack of potatoes for $5.
* Emily is willing to sell a sack of potatoes for $15.
* Fred is willing to sell a sack of potatoes for $25.
 
There are many possible trades that would be mutually agreeable to both people, but not all of them will happen.  For example, Cathy and Fred would be interested in trading with each other 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.  However, at the market Cathy will discover that there are other sellers willing to sell at well below $25, so she will not trade with Fred at all. In an efficient market, each seller will get as high a price as possible, and each buyer will get as low a price as possible. 
 
Imagine that Cathy and Fred are bartering over the price.  Fred offers $25 for a sack of potatoes.  Before Cathy can agree, Emily offers a sack of potatoes for $24.  Fred is not willing to sell at $24, so he drops out.  At this point, Dan offers to sell for $12.  Emily won't sell for that amount so it looks like the deal might go through.  At this point Bob steps in and offers $14.  Now we have two people willing to pay $14 for a sack of potatoes (Cathy and Bob), but only one person (Dan) willing to sell for $14.  Cathy notices this and doesn't want to lose a good deal, so she offers Dan $16 for his potatoes.  Now Emily also offers to sell for $16, so there are two buyers and two sellers at that price (note that they could have settled on any price between $15 and $20), and the bartering can stop.  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 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 other words, a stable equilibrium has been reached. 
[[Image:discrete_supply_and_demand.png|right|Graph  of discrete example]]
A supply and demand graph could also be drawn from this.  The demand would be:
 
* 1 person is willing to pay $30 (Cathy).
* 2 people are willing to pay $20 (Cathy and Bob).
* 3 people are willing to pay $10 (Cathy, Bob, and Alice).
 
The supply would be:
 
* 1 person is willing to sell for $5 (Dan).
* 2 people are willing to sell for $15 (Dan and Emily).
* 3 people are willing to sell for $25 (Dan, Emily, and Fred).
 
Supply and demand match when the quantity traded is two sacks and the price is between $15 and $20.  Whether Dan sells to Cathy, and Emily to Bob, or the other way round, and what precisely is the price agreed cannot be determined.  This is the only limitation of this simple model.  When considering the full assumptions of perfect competition the price would be fully determined, since there would be enough participants to determine the price.  For example, if the "last trade" was between someone willing to sell at $15.50 and someone willing to pay $15.51, then the price could be determined to the penny.  As more participants enter, the more likely there will be a close bracketing of the equilibrium price.
 
It is important to note that this example violates the assumption of perfect competition in that there are a limited number of market participants.  However, this simplification shows how the equilibrium price and quantity can be determined in an easily understood situation. The results are similar when unlimited market participants and the other assumptions of perfect competition are considered.
 
==History of supply and demand==
 
Attempts to determine how supply and demand interact began with [[Adam Smith]]'s ''[[The Wealth of Nations]]'', first published in 1776.  In this book, he mostly assumed that the supply price was fixed but that the demand would increase or decrease as the price decreased or increased. [[David Ricardo]] in 1817 published the book ''[[Principles of Political Economy and Taxation]]'', in which the first idea of an economic model was proposed.  In this, he more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand. 
 
During the late 19th century the marginalist school of thought emerged.  This field mainly was started by [[William Stanley Jevons|Stanley Jevons]], [[Carl Menger]], and [[Léon Walras]].  The key idea was that the price was set by the most expensive price, that is, the price at the margin.  This was a substantial change from Adam Smith's thoughts on determining the supply price.   


Finally, most of the basics of the modern school theory of supply and demand were finalized by [[Alfred Marshall]] and [[Léon Walras]], when they combined the ideas about supply and the ideas about demand and began looking at the equilibrium point where the two curves crossed.  They also began looking at the effect of markets on each other. Since the late 19th century, the theory of supply and demand has mainly been unchanged.  Most of the work has been in examining the exceptions to the model (like oligarchy, transaction costs, non-rationality).
Among exceptions to this generally-observed behaviour are goods that people prize just because they are expensive - sometimes referred to as [[Veblen good]]s in reference to the economist [[Thorstein Veblen]] who coined the phrase "[[conspicuous consumption]]".  


==Criticism of Marshall's theory of supply and demand==
An increase (or decrease) in the price charged for a product usually has two effects: - one is to cause consumers to switch their buying from (or to) it, to (or from) other products; and  the other is to bring about a reduction (or increase) in consumers' incomes with the consequences described in the following paragraph. Those two consequences of a price change are termed the [[substitution effect]] and the [[income effect]]. (In this context "substitution" refers to a switch to or from any other product. The particular effects of substitutes that serve as functional alternatives are described in a later paragraph).  From a supplier's viewpoint, however,  the relevant characteristic of the relationship between price and demand is the percentage increase of demand for a product that would result from a small percentage reduction in its existing price - a quantity known as the ''price elasticity of demand'' for the product.


Marshall's theory of supply and demand runs counter to the ideas of economists from Adam Smith and David Ricardo through the creation of the marginalist school of thought.  Although Marshall's theories are dominant in elite universities today, not everyone has taken the fork in the road that he and the marginalists proposed.  One theory counter to Marshall is that price is already known in a commodity before it reaches the market, negating his idea that some abstract market is conveying price information.  The only thing the market communicates is whether or not an object is exchangeable or not (in which case it would change from an object to a commodity).  This would mean that the producer creates the goods without already having customers&nbsp;&mdash; blindly producing, hoping that someone will buy them ("buy" meaning exchange money for the commodities). Modern producers often have market studies prepared well in advance of production decisions; however, misallocation of factors of production can still occur.
===Income effects===
The missing passage in the above quotation from Marshall's Principles of Economics was his "other things being equal" qualification; and income is one of the other things that have to be taken into account. The effect of a rise in a community's income must  obviously be a proportionately equal increase in its total spending, assuming no change in the proportion  that it saves. That implies a community-wide ''income elasticity of demand '' of exactly one - but, within  that average, different values pertain to different categories of product.  It is common experience for example, that people spend a diminishing proportion on food as their incomes rise (an observation that is sometimes referred to as [[Engel's Law]]). There are circumstances in which Engel's law can have significant consequences. In international trade, its effect is a continuing deterioration in the [[terms of trade]] of food-exporting countries with every rise in the prosperity of their customer countries; and in some developing countries the ''income effect'' referred to in the previous paragraph can produce an exception to the law of supply and demand that is similar to that of ''Veblen goods'', but for a different reason.  In markets predominated by people whose income is spent mainly on a basic good such as rice, the ''income effect'' of a reduction in its price can lead them to spend less upon it, thus reversing the normal effect of a price reduction. (Goods to which this exception  applies are termed [[Giffen good]]s). Corresponding to Engel's law at the other end of the spectrum, the ''income elasticity of demand'' of luxury goods such as sports cars and jewelery is usually well above one.


[[Keynesians|Keynesian economics]] also runs counter to one aspect of the [[Neoclassical]] theory of supply and demand the [[Say's Law]]<small>In short: supply creates its own demand</small>.  In [[Keynesian|Keynesian theory]], prices can become "sticky" or resistant to change, especially in the case of price decreases. This leads to a market failure. Modern supporters of [[Keynes]], such as [[Paul Krugman]], have noted this in recent history, such as when the [[Boston, Massachusetts|Boston]] housing market dried up in the early 1990s, with neither buyers nor sellers willing to exchange at the price equilibrium.
=== Demand with substitutes and complements===
The demand for a product is reduced if a new substitute becomes available - as happened to CDs when DVDs became available - and is increased if the price of an existing substitute is increased. The converse applies to complementary goods, so that the demand for microwave ovens  is increased  by the introduction of improved microwaveable meals,  and the demand for cars  is reduced  if the price of petrol is increased. The sensitivity of the demand for a product to a change in the price of a substitute or a complement is referred to as the [[cross elasticity of demand]] between the products, and is positive for substitutes and negative for complementary goods. However, in estimating the net effect upon demand of any  price change, allowance has also to be taken of its effect upon consumers' incomes.


[[N. Gregory Mankiw|Gregory Mankiw]]'s work on the irrationality of actors in the markets also undermines Marshall's simplistic view of the forces involved in supply and demand.
==Supply==
===The [[production function]]===
The price necessary to generate a particular supply of a product is taken to be that which is "just sufficient to induce capitalists to invest their capital, and workers of all grades to invest their personal capital" <ref>[http://www.econlib.org/library/Marshall/marP.html Alfred Marshall: ''Principles of Economics'', p497,  ]</ref>. For the price to increase with  increasing supply implies a [[production function]] for which every increase of output requires an increasing quantity of inputs -  conforming, that is to say, to the "law of diminishing returns". In the alternative case of constant returns, price is determined solely by the cost of production <ref>[http://www.econlib.org/library/Marshall/See Alfred Marshall ''Principles of Economics'' Book V Chapter III, Macmillan 1964]</ref>.


==Empirical estimation==
==Market interactions==
===The Auctioneer analogy===
The original theory of supply and demand  offered no explanation of the actual mechanism that achieves the postulated equality between demand and supply,  but a possible explanation was put forward by Marshall's French contemporary, Léon Walras.  Walras described a market in which an imaginary auctioneer  invites offers to sell and offers to buy at an arbitrary starting price, and then announces a succession of  price revisions that  bring the amounts offered by buyers and sellers progressively closer together  until equality is reached - and allows no transactions to take place until that price is established <ref> Léon Walras ''Elements of Pure Economics'' (translated by William Jaffe from the 1874 original) Routledge 2007</ref>. Similar arrangements (termed "[[French auction]]s") are, in fact,  used to set opening prices in some stock markets, but the Walrassian auction was intended - and is widely accepted - as an analogy to be applied to markets in general. It can be shown, however, that analogy is strictly applicable only to markets consisting of rational participants, each of whom is fully informed about the product and its substitutes,  each of whom acts independently in the exclusive pursuit of self-interest, and in which all transactions are costlessly enforceable. Those restrictions exclude the possibility of [[Externality|externalities]], of the exercise of [[market power]], of the existence of [[incomplete contracts]] and of their consequent costs.
<ref>[http://www.questia.com/read/105454747?title=The%20Economics%20of%20Contracts%3A%20%20Theories%20and%20Applications. For an account of the implications of incomplete  contracts, see Eric Brousseau and Jean-Michel Glachant  (eds):    ''The Economics of Contracts: Theories and Applications''.  Chapter 4,  Cambridge University Press, 2002] </ref>, and of all forms of cooperation or of motivations based upon social interaction.
<ref>[http://www.santafe.edu/~bowles/2000QJE.pdf For a survey of the implications of the assumptions underlying the Walrassian auctioneer model see  Samuel Bowles and Hubert Gintis: "Walrasian Economics in Retrospect", ''Quarterly Journal of Economics'' November  2000]</ref>


The demand and supply relations in a market can be statistically estimated from price and quantity [[data]] using the ''[[System of linear equations|simultaneous system]] estimation'' ("structural estimation") method in [[econometrics]]. An alternative to "structural estimation" is [[Reduced form]] estimation. ''[[Identification (parameter)|Parameter identification problem]]'' is a common issue in "structural estimation." Typically, data on [[exogenous]] variables (that is, variables other than price and quantity, both of which are [[Endogeneity (economics)|endogenous]] variables) are needed to perform such an estimation.
===Equilibrium and disequilibrium ===
The term "[[equilibrium (economics)|equilibrium]]" is applied by economists to the situation in which supply is equal to demand - by analogy with the state of a physical body which is at rest because it is acted upon by forces that are in balance. It can also be seen as an optimum situation for each participant in a market given the reactions of the other participants - mirroring the games theory concept of a [[Nash equilibrium]].


==Application in Macroeconomics==
Marshall's analysis of supply and demand was concerned with equilibrium in the market for a single product, taking no account of interactions with other markets - an approach that is termed termed "partial equilibrium analysis". By contrast, the term "general equilibrium analysis" describes an approach that takes account of such interactions - acknowledging, for example the interactions that take place between the market for steel with the market for iron ore and the interactions of that market with  the markets for ore-bearing land, mining machinery and so on. At the operational level, economists developing [[economic forecasting model]]s have used limited forms of general equilibrium analysis, and at the theoretical level, other economists have explored the characteristic of a closed system of interacting competitive markets. The "''Walras' law'' of markets" has established the possibility of simultaneous equilibrium of all of the markets in such a system and the Arrow-Debreu theorems <ref>Kenneth  Arrow and Gerard  Debreu: "The Existence of an Equilibrium for a Competitive Economy", ''Econometrica'', vol. XXII 1954 </ref> <ref> Kenneth Arrow: "An Extension of the Basic Theorem of Classical Welfare Economics", '' Proceedings of the Second Berkeley Seminar on Mathematical Statistics and Probability'' University of California Press 1951</ref> have further developed the characteristics of completely general equilibrium.


The application of supply and demand concepts in [[macroeconomics]] is somewhat complicated by the fact that supply and demand analytical concepts are often predicated on the notion of a stable [[unit of account]] via which prices can be observed. In Macroeconomics this assumption can not be taken for granted as currencies themselves are subject to dynamic supply and demand forces that influence quantities and prices of the currencies themselves.
In the absence of a Walrasian auctioneer, however, information failures may lead to disequilibrium as demands arise of which suppliers are unaware, and vice versa. Errors in forecasting traffic demand, could, for example, lead to an under-supply of transport services that - despite any pricing response - could persist for many years. Lack of price flexibility can also lead to disequilibrium, as  in the Keynesian account of the causes of unemployment <ref> See the article on [[macroeconomics]]</ref>. It is in fact, the problem of unemployment that has been the main reason for the study of the economics of disequilibrium, and economists including Axel Leijonhufvud and Edmond Malinvaud
<ref>[http://www.nbs.sk/BIATEC/BIA08_03/28_31.PDF, Edmond Malinvaud in ''Profiles of World Economists'' Národná Banka Slovenska 2008]</ref> have used the concept to provide alternative explanations of the mechanism of unemployment.


==See also==
==Empirical evidence==
<div style="-moz-column-count:2; column-count:2;">
The theory that has been outlined depends entirely upon logical deduction from untested axioms, and it consequently  has limited application to the real world unless it is supplemented by empirical  evidence. Developments over the past 40 years in the field of [[experimental economics]] have, in fact, led to the creation of  a substantial body of evidence concerning human behaviour in trading situations. Experiments conducted by [[Vernon Smith]] have demonstrated that  equilibrium can be achieved in many situations without the necessity for [[perfect information]] or the conditions necessary for [[pure competition]]<ref> [http://www.econlib.org/library/Downloads/y2007/Smithexperimental.mp3  Vernon Smith (oral interview) :  ''Markets and Experimental Economics'',  on Econtalk .com,  Library of Economics and Liberty,  May 21 2007. ]</ref><ref>[http://www.econlib.org/Library/Columns/CourseyVSmith.html Don Coursey: ''Vernon Smith, Economic Experiments and the Visible Hand'',  Library of Economics and Liberty, October 2002]</ref>. The evidence indicates that market behaviour is strongly influenced  by the rules of the institutions within which the trading takes place, and has provided practical guidance concerning the efficient design of such institutions.
* [[Aggregate demand]]
* [[Artificial demand]]
* [[Classical economy]]
* [[Consumer surplus]]
* [[Consumer theory]]
* [[Deadweight loss]]
* [[Economic surplus]]
* [[Effect of taxes and subsidies on price]]
* [[Elasticity (economics)|Elasticity]]
* [[Externality]]
* ''[[Foundations of Economic Analysis]]'' by [[Paul Samuelson|Paul A. Samuelson]]
* [[History of economic thought]]
* [[John Maynard Keynes]]
* [[Labor shortage]]
* [[Microeconomics]]
* [[Neoclassical Schools (1871-today)]]
* [[Keynesians]]
* [[Producer's surplus]]
* [[Profit]]
* [[Rationing]]
* [[Real prices and ideal prices]]
* [[Say's Law]]
* [[Supply shock]]
* ''[[The Wealth of Nations|An Inquiry into the Nature and Causes of the Wealth of Nations]]'' by Adam Smith
</div>


== External link and references ==
*[http://www.greekshares.com/supdem.php Economics and Supply and Demand]
*[http://gutenberg.net/1/0/6/1/10612/10612-h/10612-h.htm Supply and Demand] book by [[Hubert Douglas Henderson|Hubert D. Henderson]] at Project Gutenberg.
*Price Theory and Applications by Steven E. Landsburg ISBN 0-538-88206-9
*''An Inquiry into the Nature and Causes of the Wealth of Nations'', Adam Smith, 1776 [http://www.gutenberg.net/etext/3300]
*''By what is the price of a commodity determined?'', a brief statement of Karl Marx's rival account [http://www.marxists.org/archive/marx/works/1847/wage-labour/ch03.htm]
{{microeconomics-footer}}
==References==
==References==
<div class="references-small" style="-moz-column-count:2; column-count:2;">
{{reflist}}
<references /></div>


[[Category:Consumer theory]]
[[Category:Suggestion Bot Tag]]
[[Category:Economics Workgroup]]

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This editable, developed Main Article is subject to a disclaimer.

Because of their importance to the development of economic theory, an appreciation of the concepts of supply and demand is essential to the understanding of economic theory. This article seeks to explain their significance in non-technical terms and to provide a simple introduction to the law of supply and demand, with links to more detailed explanations.

Definitions of the terms used in the article that are shown in italics can be found on the Related Articles subpage, and a selection of the diagrams and mathematical equations that are conventionally used for teaching purposes can be found on the Tutorials subpage.

Origins and applications

The proposition that prices are determined by supply and demand is so familiar that it seems like a statement of the obvious. In fact, it was not generally accepted, even by eminent intellectuals such as Adam Smith, John Stuart Mill and David Ricardo, until the idea was popularised by Alfred Marshall towards the end of the nineteenth century.[1] [2] Since then there has been general acceptance of the proposition that demand rises in response to a reduction in price, that supply rises in response to an increase in price, and that price somehow settles to a level where demand is equal to supply. That proposition has come to be been termed "the law of supply and demand" and is often thought to be as firmly established as the law of gravity. In fact it is what Marshall termed "a statement of a tendency", depending upon particular premises about human behaviour, and some economists have questioned its logical consistency [3]. It has nevertheless survived in general use as a robust statement that reflects widespread experience. In economics, it has served as a tool that has been used in the construction of other theories, and it has generated a terminology that has been widely used in discussions among economists.

Demand

Price effects

The basic premise that economists adopt when discussing demand was stated by Marshall as the proposition that "the larger the amount of a thing that a person has, the less ... will be the price which he will pay for a little more of it" - a proposition that they referred to as the law of diminishing marginal utility. That premise has detailed implications for the price/demand relationship that are discussed on the Tutorials subpage, but the only implication that is necessary to the operation of the law of supply and demand is that demand rises in response to a reduction in price and vice versa.

Among exceptions to this generally-observed behaviour are goods that people prize just because they are expensive - sometimes referred to as Veblen goods in reference to the economist Thorstein Veblen who coined the phrase "conspicuous consumption".

An increase (or decrease) in the price charged for a product usually has two effects: - one is to cause consumers to switch their buying from (or to) it, to (or from) other products; and the other is to bring about a reduction (or increase) in consumers' incomes with the consequences described in the following paragraph. Those two consequences of a price change are termed the substitution effect and the income effect. (In this context "substitution" refers to a switch to or from any other product. The particular effects of substitutes that serve as functional alternatives are described in a later paragraph). From a supplier's viewpoint, however, the relevant characteristic of the relationship between price and demand is the percentage increase of demand for a product that would result from a small percentage reduction in its existing price - a quantity known as the price elasticity of demand for the product.

Income effects

The missing passage in the above quotation from Marshall's Principles of Economics was his "other things being equal" qualification; and income is one of the other things that have to be taken into account. The effect of a rise in a community's income must obviously be a proportionately equal increase in its total spending, assuming no change in the proportion that it saves. That implies a community-wide income elasticity of demand of exactly one - but, within that average, different values pertain to different categories of product. It is common experience for example, that people spend a diminishing proportion on food as their incomes rise (an observation that is sometimes referred to as Engel's Law). There are circumstances in which Engel's law can have significant consequences. In international trade, its effect is a continuing deterioration in the terms of trade of food-exporting countries with every rise in the prosperity of their customer countries; and in some developing countries the income effect referred to in the previous paragraph can produce an exception to the law of supply and demand that is similar to that of Veblen goods, but for a different reason. In markets predominated by people whose income is spent mainly on a basic good such as rice, the income effect of a reduction in its price can lead them to spend less upon it, thus reversing the normal effect of a price reduction. (Goods to which this exception applies are termed Giffen goods). Corresponding to Engel's law at the other end of the spectrum, the income elasticity of demand of luxury goods such as sports cars and jewelery is usually well above one.

Demand with substitutes and complements

The demand for a product is reduced if a new substitute becomes available - as happened to CDs when DVDs became available - and is increased if the price of an existing substitute is increased. The converse applies to complementary goods, so that the demand for microwave ovens is increased by the introduction of improved microwaveable meals, and the demand for cars is reduced if the price of petrol is increased. The sensitivity of the demand for a product to a change in the price of a substitute or a complement is referred to as the cross elasticity of demand between the products, and is positive for substitutes and negative for complementary goods. However, in estimating the net effect upon demand of any price change, allowance has also to be taken of its effect upon consumers' incomes.

Supply

The production function

The price necessary to generate a particular supply of a product is taken to be that which is "just sufficient to induce capitalists to invest their capital, and workers of all grades to invest their personal capital" [4]. For the price to increase with increasing supply implies a production function for which every increase of output requires an increasing quantity of inputs - conforming, that is to say, to the "law of diminishing returns". In the alternative case of constant returns, price is determined solely by the cost of production [5].

Market interactions

The Auctioneer analogy

The original theory of supply and demand offered no explanation of the actual mechanism that achieves the postulated equality between demand and supply, but a possible explanation was put forward by Marshall's French contemporary, Léon Walras. Walras described a market in which an imaginary auctioneer invites offers to sell and offers to buy at an arbitrary starting price, and then announces a succession of price revisions that bring the amounts offered by buyers and sellers progressively closer together until equality is reached - and allows no transactions to take place until that price is established [6]. Similar arrangements (termed "French auctions") are, in fact, used to set opening prices in some stock markets, but the Walrassian auction was intended - and is widely accepted - as an analogy to be applied to markets in general. It can be shown, however, that analogy is strictly applicable only to markets consisting of rational participants, each of whom is fully informed about the product and its substitutes, each of whom acts independently in the exclusive pursuit of self-interest, and in which all transactions are costlessly enforceable. Those restrictions exclude the possibility of externalities, of the exercise of market power, of the existence of incomplete contracts and of their consequent costs. [7], and of all forms of cooperation or of motivations based upon social interaction. [8]

Equilibrium and disequilibrium

The term "equilibrium" is applied by economists to the situation in which supply is equal to demand - by analogy with the state of a physical body which is at rest because it is acted upon by forces that are in balance. It can also be seen as an optimum situation for each participant in a market given the reactions of the other participants - mirroring the games theory concept of a Nash equilibrium.

Marshall's analysis of supply and demand was concerned with equilibrium in the market for a single product, taking no account of interactions with other markets - an approach that is termed termed "partial equilibrium analysis". By contrast, the term "general equilibrium analysis" describes an approach that takes account of such interactions - acknowledging, for example the interactions that take place between the market for steel with the market for iron ore and the interactions of that market with the markets for ore-bearing land, mining machinery and so on. At the operational level, economists developing economic forecasting models have used limited forms of general equilibrium analysis, and at the theoretical level, other economists have explored the characteristic of a closed system of interacting competitive markets. The "Walras' law of markets" has established the possibility of simultaneous equilibrium of all of the markets in such a system and the Arrow-Debreu theorems [9] [10] have further developed the characteristics of completely general equilibrium.

In the absence of a Walrasian auctioneer, however, information failures may lead to disequilibrium as demands arise of which suppliers are unaware, and vice versa. Errors in forecasting traffic demand, could, for example, lead to an under-supply of transport services that - despite any pricing response - could persist for many years. Lack of price flexibility can also lead to disequilibrium, as in the Keynesian account of the causes of unemployment [11]. It is in fact, the problem of unemployment that has been the main reason for the study of the economics of disequilibrium, and economists including Axel Leijonhufvud and Edmond Malinvaud [12] have used the concept to provide alternative explanations of the mechanism of unemployment.

Empirical evidence

The theory that has been outlined depends entirely upon logical deduction from untested axioms, and it consequently has limited application to the real world unless it is supplemented by empirical evidence. Developments over the past 40 years in the field of experimental economics have, in fact, led to the creation of a substantial body of evidence concerning human behaviour in trading situations. Experiments conducted by Vernon Smith have demonstrated that equilibrium can be achieved in many situations without the necessity for perfect information or the conditions necessary for pure competition[13][14]. The evidence indicates that market behaviour is strongly influenced by the rules of the institutions within which the trading takes place, and has provided practical guidance concerning the efficient design of such institutions.

References

  1. ↑ Alfred Marshall Principles of Economics Book V Macmillan 1964
  2. ↑ For previous beliefs, see the article on history of economic thought
  3. ↑ For an account of some accusations of inconsistency, see the tutorials subpage of this article
  4. ↑ Alfred Marshall: Principles of Economics, p497,
  5. ↑ Alfred Marshall Principles of Economics Book V Chapter III, Macmillan 1964
  6. ↑ Léon Walras Elements of Pure Economics (translated by William Jaffe from the 1874 original) Routledge 2007
  7. ↑ For an account of the implications of incomplete contracts, see Eric Brousseau and Jean-Michel Glachant (eds): The Economics of Contracts: Theories and Applications. Chapter 4, Cambridge University Press, 2002
  8. ↑ For a survey of the implications of the assumptions underlying the Walrassian auctioneer model see Samuel Bowles and Hubert Gintis: "Walrasian Economics in Retrospect", Quarterly Journal of Economics November 2000
  9. ↑ Kenneth Arrow and Gerard Debreu: "The Existence of an Equilibrium for a Competitive Economy", Econometrica, vol. XXII 1954
  10. ↑ Kenneth Arrow: "An Extension of the Basic Theorem of Classical Welfare Economics", Proceedings of the Second Berkeley Seminar on Mathematical Statistics and Probability University of California Press 1951
  11. ↑ See the article on macroeconomics
  12. ↑ Edmond Malinvaud in Profiles of World Economists Národná Banka Slovenska 2008
  13. ↑ Vernon Smith (oral interview) : Markets and Experimental Economics, on Econtalk .com, Library of Economics and Liberty, May 21 2007.
  14. ↑ Don Coursey: Vernon Smith, Economic Experiments and the Visible Hand, Library of Economics and Liberty, October 2002
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