In microeconomic theory, the theory of supply and demand explains how the price and quantity of goods sold in markets are determined.

In general where goods are traded in a market, prices of goods tend to rise when the quantity demanded exceeds the quantity supplied at that price, leading to a shortage, and conversely that prices tend to fall when quantity supplied exceeds the quantity demanded. This causes the market to approach an equilibrium point at which quantity supplied is equal to the quantity demanded. Price is thus seen as a function of supply curves and demand curves.

The theory of supply and demand is important in the functioning of a market economy in that it explains the mechanism by which most resource allocation decisions are made.

The theory of supply and demand is usually developed assuming that markets are perfectly competitive. This means that there are many small buyers and sellers, each of which is unable to influence the price of the good on its own.

Supply and demand

1. A theory of price

What is it? The theory of supply and demand is a theory of price and output in competitive markets.

Adam Smith had argued that each good or service has a "natural price." If the price (of beer, for example), were above the natural price, then more resources would be attracted into the trade (brewing, in the example), and the price would return to its "natural" level. Conversely if the price began below its "natural" level.

The modern theory of supply and demand differs from Smith's theory in some important ways. Economists have made some progress in the last 200 years, and great economists such as John Stuart Mill and Alfred Marshall (and many others) have played their part in the growth of the modern theory of supply and demand. Nevertheless, the theory of supply and demand is the modern expression of Smith's great insight about "the natural price."

To make a long story short, before about the 1850's most economists accepted the Labor Theory of Value as the theory of the "natural price." But there were some cases it did not apply to: international trade, for example. John Stuart Mill suggested a "supply and demand" solution for prices in international trade. Other economists extended it to apply to prices in general.

Unlike the "natural price," a long-run theory only, the theory of supply and demand applies in the short run as well as the long.

2. Analysis of Markets

Our approach to market theory will be first analytic and then synthetic. To "analyze" something is to take it apart into its components. Common sense tells us that competitive markets work through an interaction of "supply and demand." Alfred Marshall compared the supply and demand sides to the two blades of scissors -- one won't cut by itself. You have to have both.

Accordingly, we will first "analyze" competitive markets, by discussing demand and supply separately. Then we will try to put them back together (synthesize them) in order to understand the working of competitive markets.

Thus, in the next few pages, we will look at

· demand

· supply

· equilibrium of demand and supply

3. Simple Supply and Demand curves

This can be illustrated with the following graph:

The demand curve is the amount that will be bought at a given price. The supply curve is the quantity that producers are willing to make at a given price. As you can see, more will be purchased when the price is lower (the quantity goes up). On the other hand, as the price goes up, producers are willing to produce more goods. Where these cross is the equilibrium. This will create a price of P and a quantity of Q since that is where the two lines cross.

In the figure straight lines are drawn instead of the more general curves. See also Price elasticity of demand.

4. Demand curve shifts

When more people want something the demand curve will shift right. 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 supplied will decrease - a contraction in supply.

5. Supply curve shifts

When the suppliers costs change the supply curve will shift. For example, if someone invents a better way of growing wheat, then the amount of wheat that can be grown for a given price will increase. This creates a shift from a original supply curve S0 to a new lower supply curve S1 - a decrease 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 - an extension in demand. Notice that the price and the quantity move in opposite directions in a supply curve shift.

Conversely, if the supply increases, the opposite happens. If the supply curve starts at S1, and then shifts to S0, the price will increase and the quantity will decrease as there is a contraction in demand.

6. Effects of being away from the Equilibrium Point

If the price is set too high, such as at P1, then the quantity produced will be Qs. The quantity demanded will be Qd. Since the quantity demanded is less than the quantity supplied there will be a oversupply problem. If the price is too low, then too little will be produced to meet demand at that price. This will cause a undersupply problem. Businesses responses to both these problems restores the quantity and the price to the equilibrium. In the case of oversupply, the businesses will soon have too much execess inventory, so they will lower prices to reduce this.

7. Vertical Supply Curve

It is sometimes the case that the supply curve is vertical. 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 one more acre of land, the extra can not be created. Also, even if no one wanted all the land, it still would exist. These conditions create a vertical supply curve. In the short run near vertical supply curves are even 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 below graph illustrates a vertical supply curve. When the demand 1 is in effect, the price will 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 effect price.

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