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supply and demand, in economics, relationship between the quantity of a commodity that producers wish to sell at various prices and the quantity that consumers wish to buy. It is the main model of price determination used in economic theory. The price of a commodity is determined by the interaction of supply and demand in a market. The resulting price is referred to as the equilibrium price and represents an agreement between producers and consumers of the good. In equilibrium the quantity of a good supplied by producers equals the quantity demanded by consumers. increase in demandEncyclopædia Britannica, Inc. The quantity of a commodity demanded depends on the price of that commodity and potentially on many other factors, such as the prices of other commodities, the incomes and preferences of consumers, and seasonal effects. In basic economic analysis, all factors except the price of the commodity are often held constant; the analysis then involves examining the relationship between various price levels and the maximum quantity that would potentially be purchased by consumers at each of those prices. The price-quantity combinations may be plotted on a curve, known as a demand curve, with price represented on the vertical axis and quantity represented on the horizontal axis. A demand curve is almost always downward-sloping, reflecting the willingness of consumers to purchase more of the commodity at lower price levels. Any change in non-price factors would cause a shift in the demand curve, whereas changes in the price of the commodity can be traced along a fixed demand curve.
decrease in supplyEncyclopædia Britannica, Inc.
The quantity of a commodity that is supplied in the market depends not only on the price obtainable for the commodity but also on potentially many other factors, such as the prices of substitute products, the production technology, and the availability and cost of labour and other factors of production. In basic economic analysis, analyzing supply involves looking at the relationship between various prices and the quantity potentially offered by producers at each price, again holding constant all other factors that could influence the price. Those price-quantity combinations may be plotted on a curve, known as a supply curve, with price represented on the vertical axis and quantity represented on the horizontal axis. A supply curve is usually upward-sloping, reflecting the willingness of producers to sell more of the commodity they produce in a market with higher prices. Any change in non-price factors would cause a shift in the supply curve, whereas changes in the price of the commodity can be traced along a fixed supply curve.
The most basic laws in economics are the law of supply and the law of demand. Indeed, almost every economic event or phenomenon is the product of the interaction of these two laws. The law of supply states that the quantity of a good supplied (i.e., the amount owners or producers offer for sale) rises as the market price rises, and falls as the price falls. Conversely, the law of demand (see demand) says that the quantity of a good demanded falls as the price rises, and vice versa. (Economists do not really have a “law” of supply, though they talk and write as though they do.)
One function of markets is to find “equilibrium” prices that balance the supplies of and demands for goods and services. An equilibrium price (also known as a “market-clearing” price) is one at which each producer can sell all he wants to produce and each consumer can buy all he demands. Naturally, producers always would like to charge higher prices. But even if they have no competitors, they are limited by the law of demand: if producers insist on a higher price, consumers will buy fewer units. The law of supply puts a similar limit on consumers. They always would prefer to pay a lower price than the current one. But if they successfully insist on paying less (say, through price controls), suppliers will produce less and some demand will go unsatisfied.
Economists often talk of “demand curves” and “supply curves.” A demand curve traces the quantity of a good that consumers will buy at various prices. As the price rises, the number of units demanded declines. That is because everyone’s resources are finite; as the price of one good rises, consumers buy less of that and, sometimes, more of other goods that now are relatively cheaper. Similarly, a supply curve traces the quantity of a good that sellers will produce at various prices. As the price falls, so does the number of units supplied. Equilibrium is the point at which the demand and supply curves intersect—the single price at which the quantity demanded and the quantity supplied are the same.
Markets in which prices can move freely are always in equilibrium or moving toward it. For example, if the market for a good is already in equilibrium and producers raise prices, consumers will buy fewer units than they did in equilibrium, and fewer units than producers have available for sale. In that case producers have two choices. They can reduce price until supply and demand return to the old equilibrium, or they can cut production until the quantity supplied falls to the lower number of units demanded at the higher price. But they cannot keep the price high and sell as many units as they did before.
Why does the quantity supplied rise as the price rises and fall as the price falls? The reasons really are quite logical. First, consider the case of a company that makes a consumer product. Acting rationally, the company will buy the cheapest materials (not the lowest quality, but the lowest cost for any given level of quality). As production (supply) increases, the company has to buy progressively more expensive (i.e., less efficient) materials or labor, and its costs increase. It charges a higher price to offset its rising unit costs.
Are there any examples of supply curves for which a higher price does not lead to a higher quantity supplied? Economists believe that there is one main possible example, the so-called backward-bending supply curve of labor. Imagine a graph in which the wage rate is on the vertical axis and the quantity of labor supplied is on the horizontal axis. It makes sense that the higher the wage rate, the higher the quantity of labor supplied, because it makes sense that people will be willing to work more when they are paid more. But workers might reach a point at which a higher wage rate causes them to work less because the higher wage makes them wealthier and they use some of that wealth to “buy” more leisure—that is, to work less. Recent evidence suggests that even for labor, a higher wage leads to more hours worked.
Or consider the case of a good whose supply is fixed, such as apartments in a condominium. If prospective buyers suddenly begin offering higher prices for apartments, more owners will be willing to sell and the supply of “available” apartments will rise. But if buyers offer lower prices, some owners will take their apartments off the market and the number of available units will drop.
History has witnessed considerable controversy over the prices of goods whose supply is fixed in the short run. Critics of market prices have argued that rising prices for these types of goods serve no economic purpose because they cannot bring forth additional supply, and thus serve merely to enrich the owners of the goods at the expense of the rest of society. This has been the main argument for fixing prices, as the United States did with the price of domestic oil in the 1970s and as New York City has done with apartment rents since World War II (see rent control).
Economists call the portion of a price that does not influence the amount of a good in existence in the short run an “economic quasi-rent.” The vast majority of economists believe that economic rents do serve a useful purpose. Most important, they allocate goods to their highest-valued use. If price is not used to allocate goods among competing claimants, some other device becomes necessary, such as the rationing cards that the U.S. government used to allocate gasoline and other goods during World War II. Economists generally believe that fixing prices will actually reduce both the quantity and the quality of the good in question. In addition, economic rents serve as a signal to bring forth additional supplies in the future and as an incentive for other producers to devise substitutes for the good in question.
Alchian, Armen. “Costs and Outputs.” In Choice and Costs under Uncertainty. Vol. 2 of The Collected Works of Armen A. Alchian. Indianapolis: Liberty Fund, 2006. Pp. 161–179.
Robinson, Joan. “Rising Supply Price.” Economica 8 (1941): 1–8.
I will be on BBC Newsday tonight at 10:06 PST live. That's 6:06 a.m. tomorrow London time. Topic: Drop in stock prices.
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