Supply and Demand

by Silas Barta Jan 24 2016 updated Jan 28 2016

How are prices typically formed in market systems?

In economics, the concept of supply and demand is used to provide explanations of many phenomena, especially related to pricing in market economies. It refers to the model of how there exists a sort of price schedule among providers and seekers of an economic good, such that they will offer to buy/sell varying amounts depending on the price. The observed price is a point where these schedules intersect, and is known as the market-clearing price/quantity. The schedule for providers is known as the supply curve, and the one for seekers is known as the demand curve.

Generally speaking, as a good can be sold for a higher price, providers are willing to offer more for sale, and vice versa for offering to buy. (In other words, supply curve slope upwards and demand downwards.) However, there are well-documented phenomena that can cause exceptions to this general pattern.

Illustration of supply/demand interplay

Consider an example: a Farmer John might consider it worth his time to grow 40 bushels of wheat at his farm if the price is \$3/bushel. (Any more wheat at that price would not be worth it, since John values the free time more than the extra money it would get him.) But if they price were \$4/bushel, the extra money would make it worth his time to do the extra work to set up more land and plant more wheat, perhaps 20 bushels. And a \$5/bushel price lead him to produce 10 extra bushels.

For Farmer John, this "supply curve" is (for dollars/bushels provided): 3/40, 4/60, 5/70.

For two other farmers, the corresponding figures might be (for dollars/bushels)

3/20, 4/30, 5/35
3/80, 4/120, 5/150

All together, the market is (counterfactually) offering, in the aggregate, a schedule of:

Supply curve (dollar price/bushels offered): 3/140, 4/210, 5/255

A similar dynamic applies on the demand side, for people who can make use of wheat. At high prices, it may only be worthwhile to use the wheat for beer production. At a lower price, it might be used for beer and bread. And at a further lower price it may also be viable to use as animal feed. Across multiple (potential) wheat users, this demand curve might aggregate to something like:

Demand curve (dollar price/bushels purchased): 3/260, 4/210, 5/150

In this example, the supply/demand model implies that wheat will trade at \$4/bushel, and 210 bushels will be traded, as that is where the two curves intersect.

Price movements

Only one price/quantity will be observed at a time; changes in price/quantity result from movement of (one or both of) the curves such that their intersection point is different. Causes in this example might be:

"Reasoning from a price change"

[move to different article]