Chapter 2: The Basics of Supply and Demand
Chapter 2: The Basics of Supply and Demand
Introduction to Supply and Demand
This chapter explores fundamental concepts of supply and demand, how markets function to reach equilibrium, the impact of market changes, various elasticities, and the effects of government price controls.
Utility of Supply and Demand Analysis
Supply and demand analysis is crucial for understanding and predicting market prices and production, as well as for evaluating the economic impact of government interventions like price controls, taxes, and subsidies.
The Supply Curve
The supply curve illustrates the positive relationship between the price of a good and the quantity producers are willing to sell (Q_S = a + bP where b > 0), sloping upward. Production costs (labor, capital, raw materials) are key determinants. A change in quantity supplied is a movement along the curve due to price, while a change in supply is a shift of the entire curve due to other factors.
The Demand Curve
The demand curve shows the inverse relationship between the price of a good and the quantity consumers are willing to buy (Q_D = a + bP where b < 0), sloping downward. Income, tastes, and prices of related goods (substitutes/complements) influence demand. A change in quantity demanded is a movement along the curve due to price, while a change in demand is a shift of the entire curve due to other factors.
The Market Mechanism
In a free market, the market mechanism adjusts price until quantity demanded equals quantity supplied (Q_D = Q_S), reaching equilibrium (market clearing). A surplus occurs when price is above equilibrium (Q_S > Q_D), driving prices down. A shortage occurs when price is below equilibrium (Q_D > Q_S), pushing prices up. Competitive markets are essential for this efficient adjustment.
Changes in Market Equilibrium
Shifts in supply and/or demand curves cause new equilibrium prices and quantities. For instance, falling raw material prices shift supply right, increasing quantity and decreasing price. Simultaneously, an increase in wages (cost of production) shifts supply left, increasing price and decreasing quantity. When both supply and demand shift, the effect on price can be ambiguous, though quantity changes are often clearer.
Elasticities of Supply and Demand
Elasticity measures the percentage change in one variable in response to a one percent change in another.
Price Elasticity of Demand (E_P^D)
Measures the sensitivity of quantity demanded to price changes (E_P^D = \frac{\%\Delta Q}{\%\Delta P}). It's typically negative. Demand is elastic if |E_P^D| > 1 (highly responsive), inelastic if |E_P^D| < 1 (less responsive), and unit elastic if |E_P^D| = 1. The primary determinant is the availability of substitutes. Along a linear demand curve, elasticity varies, being more elastic at higher prices and less at lower prices.
Other Demand Elasticities
Income Elasticity of Demand (E_I) measures how quantity demanded changes with income.
Price Elasticity of Supply (E_P^S)
Measures the sensitivity of quantity supplied to price changes (E_P^S = \frac{\%\Delta Q_S}{\%\Delta P}).
Short-Run Versus Long-Run Elasticity
Elasticity varies based on the time consumers and producers have to react to price changes. Generally, both demand and supply are more elastic in the long run than in the short run because consumers have more time to adjust habits and find substitutes, and firms can adjust production capacity. An exception is durable goods, where short-run demand can be more elastic as consumers delay purchases.
Effects of Price Controls
Government price controls fix prices above or below equilibrium. A price ceiling (maximum price) set below the equilibrium price creates a shortage (Q_D > Q_S), leading to consequences such as queues and rationing. Historically, natural gas price controls in the U.S. led to significant shortages.