Supply and demand

Supply and demand constitute the foundational model of price determination in microeconomics. The model explains how prices and quantities of goods and services are set within a perfectly competitive market, where numerous buyers and sellers interact without exerting individual influence on price. Under the assumption of ceteris paribus—all other factors held constant—the market price adjusts until the quantity supplied equals the quantity demanded, a point known as the market-clearing equilibrium. This model forms the theoretical basis of contemporary economic analysis, though modifications are required when firms or buyers possess market power.

The Supply Schedule

A supply schedule, represented graphically as a supply curve, expresses the relationship between the price of a good and the quantity producers are willing to supply. In a competitive market, supply decisions depend upon marginal cost, with firms expanding production as long as the additional cost of output remains below the market price. Increases in input prices, such as wages or raw materials, shift the supply curve leftward, reflecting reduced quantities supplied at every price. Conversely, lower production costs shift the curve to the right.
Supply functions may be specified mathematically. Common forms include:

• Linear supply functions, such as Q(P)=−3+6PQ(P) = -3 + 6PQ(P)=−3+6P, which illustrate a straight-line relationship.
• Constant-elasticity (isoelastic) functions, such as Q(P)=5P0.5Q(P) = 5P^{0.5}Q(P)=5P0.5, which reflect proportional responsiveness and can be expressed in logarithmic form.

The model assumes firms are price takers. When firms possess market power, as in monopoly, oligopoly or monopolistic competition, output decisions affect price and more advanced models are required. Economists also distinguish between individual and market supply curves, the latter obtained by horizontally summing individual curves.
Time also matters. In the short run, at least one input is fixed and the number of firms is constant. In the long run, firms may enter or exit the market, and all inputs become variable, making long-run supply more price-elastic.
Common determinants of supply include:

• input prices,
• technology and productivity,
• expectations about future prices,
• number of suppliers.

The Demand Schedule

A demand schedule, illustrated by a demand curve, shows the quantity of a good that consumers are willing and able to purchase at various prices. Holding other influences constant—income, preferences, and prices of substitutes and complements—consumption decisions follow the law of demand, with quantity demanded falling as price rises.
Demand may be represented in two typical mathematical forms:

• Linear demand functions, such as Q(P)=32−2PQ(P) = 32 – 2PQ(P)=32−2P, giving straight-line curves.
• Isoelastic demand functions, for example Q(P)=3P−2Q(P) = 3P^{-2}Q(P)=3P−2, which display constant elasticity and can also be rewritten in logarithmic terms.

Traditionally, demand curves are drawn with price on the vertical axis and quantity on the horizontal axis. However, modern conventions sometimes reverse these axes to reflect price as the independent variable. Demand is closely related to marginal utility, with purchases occurring up to the point where marginal utility equals price.
Although normally downward sloping, demand curves can slope upward in specific cases:

• Veblen goods, where higher prices increase desirability due to status signalling.
• Giffen goods, inferior staples for which a price rise reduces real income so sharply that consumers buy more of the cheaper staple and fewer alternatives.

As with supply, the demand curve assumes that buyers are price takers. In monopsony conditions, where a buyer has market power, purchasing decisions influence price and require a different analytical approach. Market demand curves result from horizontally summing individual demand curves.
Common determinants of demand include:

• income levels,
• tastes and preferences,
• prices of related goods,
• expectations about future prices and income,
• number of potential buyers,
• advertising.

Historical Development of the Curves

Demand curves were first graphed by Augustin Cournot in 1838 in his pioneering analysis of competition. Fleeming Jenkin introduced supply curves in 1870. Their modern form was popularised by Alfred Marshall in Principles of Economics (1890), who standardised the convention of plotting price on the vertical axis. When supply or demand depend on variables beyond price, either families of shifted curves or higher-dimensional surfaces are used.

Microeconomic Equilibrium

Market equilibrium occurs where the supply and demand curves intersect. At this price–quantity pair, the quantity producers wish to sell equals the quantity consumers wish to buy. The market thereby clears. The study of equilibrium and its stability is central to microeconomics.

Changes in Market Equilibrium

Adjustments in equilibrium arise when determinants of supply or demand shift:

• Supply shifts left when production costs rise, reducing equilibrium quantity and raising equilibrium price.
• Supply shifts right when production becomes cheaper or technology improves, increasing quantity and lowering price.
• Demand shifts right when incomes rise or preferences strengthen, raising both equilibrium price and quantity.
• Demand shifts left when consumer incomes fall or substitutes become more attractive, lowering both price and quantity.