Supply and demand
In a perfectly competitive market, the unit price for a particular good varies until it settles at the market-clearing price. This specific moment occurs when the quantity demanded equals the quantity supplied. Such an economic equilibrium is achieved for both price and quantity transacted. The concept forms the theoretical basis of modern economics. If a firm possesses market power, its decision on output influences the market price. This situation violates perfect competition. A more complicated model becomes necessary in these instances. An oligopoly or differentiated-product model serves as an example. Likewise, where a buyer holds market power, models such as monopsony prove more accurate.
A supply schedule appears graphically as a supply curve showing the relationship between price and quantity supplied by producers. Under perfect competition assumptions, supply determines marginal cost. Firms produce additional output as long as extra production costs remain less than the market price. A rise in raw material costs decreases supply, shifting the curve to the left. At each possible price, a smaller quantity gets supplied. Mathematically, a supply function gives quantity supplied as a function of price and other variables. Linear supply functions appear as slanted lines. Constant-elasticity supply functions appear as smooth curves. Economists distinguish between individual firm supply curves and market supply curves. The market supply curve shows total quantity supplied by all firms at each potential price. Short-run periods fix one or more inputs like physical capital. Long-run periods allow new firms to enter or existing firms to exit.
The 256th couplet of Tirukkural states that if people desire not meat for eating, there will be none offered for sale. This statement implies that without consumption, no supplier exists for that product. Fourteenth-century Syrian scholar Ibn Taymiyyah wrote about this mechanism centuries before Adam Smith. He noted that if desire increases while availability decreases, prices rise. Conversely, if availability increases and desire decreases, prices fall. English economics writers did not use the phrase supply and demand until after the end of the seventeenth century. John Locke mentioned the idea in his 1691 work Some Considerations on the Consequences of the Lowering of Interest. James Denham-Steuart first used the phrase in his 1767 book Inquiry into the Principles of Political Economy. Adam Smith applied it in his 1776 book The Wealth of Nations. Antoine Augustin Cournot developed a mathematical model in his 1838 Researches into the Mathematical Principles of Wealth. Fleeming Jenkin published the first drawing of curves in an 1870 essay. Alfred Marshall popularized the model in his 1890 textbook Principles of Economics.
When consumers increase quantity demanded at a given price, economists call this an increase in demand. Graphically, the curve shifts to the right. At each price point, a greater quantity is demanded than before. This shift raises equilibrium price from one level to a higher level. It also raises equilibrium quantity from an initial amount to a new higher amount. Changes come from shifting tastes, incomes, or market expectations. If demand decreases, the curve shifts leftward. Equilibrium price falls while equilibrium quantity also drops. Technological progress shifts the supply curve outward. Producers become willing to supply more wheat at every price if costs decrease. This causes equilibrium price to decrease and equilibrium quantity to increase. Movement along the supply curve occurs as consumers move to the new lower price. The movement of the supply curve responds to changes in non-price determinants like input prices or technology.
The aggregate demand-aggregate supply model explains how total output and aggregate price levels determine in equilibrium. Different theoretical considerations apply to macroeconomic counterparts compared to microeconomic uses. Demand and supply relate money supply and money demand to interest rates. They also relate labor supply and labor demand to wage rates. In both classical and Keynesian economics, the money market functions as a supply-and-demand system. Interest rates serve as the price within this framework. Central banks may fix value regardless of interest rate, making the money supply totally inelastic. Alternatively, central banks target fixed interest rates, creating a perfectly elastic money supply curve. The intersection determines the final interest rate. Human-hours worked per week in the United States illustrate labor supply against money demand.
Economists commonly apply the model to wages in the labor market. Suppliers are individuals trying to sell labor for the highest price. Demanders are businesses buying needed labor at the lowest price. Equilibrium price becomes the wage rate. However, economist Steve Fleetwood concluded evidence is inconclusive regarding empirical reality. Kaufman and Hotchkiss found nearly all studies show the labor supply curve negatively sloped or backward bending. The model explains physician shortages, nursing shortages, or teacher shortages. Some studies suggest laws apply to behavior of social animals in scarce resource environments. Noë and Hammerstein wrote about biological markets determining partner choice effects. These interactions occur in cooperation, mutualism, and mating scenarios. Metabolic systems accurately describe characteristics explained by feedback inhibition. Pathways respond to demand for intermediates while minimizing variation effects from supply changes.
Demand and supply relations can be statistically estimated from price, quantity, and other data. Simultaneous-equation methods allow solving for structural coefficients in econometrics. Data on exogenous variables become necessary to perform such estimation. Parameter identification remains a common issue in structural estimation. Reduced-form estimation regresses each endogenous variable on respective exogenous variables. Such methods derive algebraic counterparts of theoretical models. Critics like Piero Sraffa focused on inconsistency of partial equilibrium analysis. Paul Samuelson engaged with these critiques over many years. Modern Post-Keynesians criticize the model for failing to explain administered prices. Retail prices set by firms based on mark-ups are not responsive to demand changes up to capacity. Lee F.S. documented this post-Keynesian price theory in 1999.
Common questions
When did the phrase supply and demand first appear in economic literature?
English economics writers did not use the phrase supply and demand until after the end of the seventeenth century. James Denham-Steuart first used the phrase in his 1767 book Inquiry into the Principles of Political Economy.
Who developed the mathematical model for supply and demand in 1838?
Antoine Augustin Cournot developed a mathematical model in his 1838 Researches into the Mathematical Principles of Wealth. This work established the theoretical foundation for analyzing price determination through mathematical functions.
What happens to equilibrium price when raw material costs rise?
A rise in raw material costs decreases supply, shifting the curve to the left. At each possible price, a smaller quantity gets supplied which raises the equilibrium price.
How does the aggregate demand-aggregate supply model determine interest rates?
Demand and supply relate money supply and money demand to interest rates where central banks may fix value regardless of interest rate or target fixed interest rates. The intersection determines the final interest rate within this framework.
Why do some economists consider labor supply curves backward bending?
Kaufman and Hotchkiss found nearly all studies show the labor supply curve negatively sloped or backward bending. This phenomenon occurs because suppliers are individuals trying to sell labor for the highest price while businesses buy needed labor at the lowest price.