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Supply and demand

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          Supply and Demand is also the name of an album by Amos Lee

   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 D1 to D2 along with the
   consequent increase in price and quantity required to reach a new
   market-clearing equilibrium point on the supply curve Supply Curve A
   curve or a schedule showing the total quantity of a good that sellers
   want to sell at each price.(S).
   Enlarge
   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[1] to D[2] along with the
   consequent increase in price and quantity required to reach a new
   market-clearing equilibrium point on the supply curve Supply Curve A
   curve or a schedule showing the total quantity of a good that sellers
   want to sell at each price.(S).

   In microeconomic theory, the partial equilibrium supply and demand
   economic model originally developed by Antoine Augustin Cournot
   (published in a book in 1838) and thirty years later broadly publicized
   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.

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. The supply curve for a given firm is derived
   directly from its marginal cost curve where the price is greater than
   or equal to the minimum cost on the average variable cost curve. Supply
   curves are traditionally represented as upward-sloping because of the
   law of 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
   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 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 goods, and the price of complementary
   goods.

   The shape of the 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 cannot 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. The social phenomenon often referred to as ' Bling' can
   also be thought of in this way. And it consumes demand and supply
   without error

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.
   Graph of simple supply and demand curves
   Enlarge
   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 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.

   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.)

   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.

Demand curve shifts

   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 D0 to the new curve D1. This raises the equilibrium price
   from P0 to the higher P1. This raises the equilibrium quantity from Q0
   to the higher Q1. 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 D1 and then decreases to D0, the price will decrease
   and the quantity demanded will decrease—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.

Supply curve shifts

   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 S0 to the right, to S1—an increase in
   supply. This causes the equilibrium price to decrease from P0 to P1.
   The equilibrium quantity increases from Q0 to Q1 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 S1 and then shifts to S0, 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 Q0 and Q1). 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

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 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

   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 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, liters per
   euro, or battleships 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 gallons 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 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 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 and substitute goods. 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 −20%/10% or, −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 demand 1
   is in effect, the price will be p1. When demand 2 is occurring, the
   price will be p2. Notice that at both values the quantity is Q. Since
   the supply is fixed, any shifts in demand will only affect price.

   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—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 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, 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 inferior good.

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.
   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 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).

Criticism of Marshall's theory of supply and demand

   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 universities today, other economists have disagreed with
   it. 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 — 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.

   Keynesian economics also runs counter to the theory of supply and
   demand. In 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 housing market
   dried up in the early 1990s, with neither buyers nor sellers willing to
   exchange at the price equilibrium.

   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.

Empirical estimation

   The demand and supply relations in a market can be statistically
   estimated from price and quantity data using the simultaneous system
   estimation ("structural estimation") method in econometrics. An
   alternative to "structural estimation" is Reduced form estimation.
   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 endogenous variables)
   are needed to perform such an estimation.

Application in Macroeconomics

   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
   cannot be taken for granted as currencies themselves are subject to
   dynamic supply and demand forces that influence quantities and prices
   of the currencies themselves.

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