What Is Supply and Demand?

Understanding Supply and Demand

First Published: ADawnJournal.com April 18, 2010

Two highly important concepts that drive economics around the world is the concept of supply and demand. Supply and demand is an economic model of price determination within an economic market. In supply and demand, it states that in a competitive market the price will function to equalize the amount of quantity demanded by the consumers, with the quantity available from producers. When supply and demand is equal, there is equilibrium between price and quantity.

The concept of supply and demand, and the power of it, has been understood for several centuries, all the way back to Muslim economists Ibn Taymiyyah, who lived during the 13th and 14th centuries, and wrote “If desire for goods increases, while its availability decreases, its price rises. On the other hand, if availability of the good increases and the desire for its decreases, the price comes down.”

The phrase of supply and demand was first used by James Denham-Steuart in a book published in 1767, and in the iconic economic book, The Wealth of Nations, by Adams Smith; supply and demand is mentioned as well. As things progressed into the 19th century, the idea set in that supply was not fixed but could change and the idea that the price was set by the most expensive price, which itself is the price of the margin. This was a big change from the previous concepts of supply. The famous supply and demand graph, which shows the curves of both, appeared for the first time in 1870 in an essay written by Fleeming Jenkin. This model of supply and demand was further popularized in 1890 in an essay in Alfred Marshall. In this graph, equilibrium is reached where the two points cross.

The Graphic Representation

The model of supply and demand is a partial equilibrium model, which shows the determination of the price of a good and the quantity of the good. On the graph, which most believe was created in its common form, by Alfred Marshall; you have the price on the vertical axis and the quantity of the product on the horizontal axis.

The supply curve represents the amount of a good that the producer is able to, or willing to, sell at a certain price. The demand curve represents the amount of a good that buyers are willing to purchase at a certain price. Usually, the demand curve is represented as a downward slope, so that when the price decreases, customers will begin to buy more of the good.

How It Works

So, how does supply and demand work? Well, when there is a greater demand for a product, and if the product is scarce, then the price of the product is going to go up as a result. In contrast, if the demand for a product is low and the product is abundant, then the price of the product is going to go down as a result. However, if the demand for the product is high, and the supply is high, then we should have reached equilibrium for the product.

Elasticity of Supply-Demand

Elasticity is a very important concept in supply and demand. Elasticity refers to how supply and demand works, and how the price is determined. Elasticity can be defined as the percentage change in one variable that is divided by the percentage change in other variables. So, elasticity is the relative change in supply and demand.

It is very useful to know exactly how much supply and demand will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. This helps economists answer several questions including will a tax on a good increase the price, and will it affect the quantity that customers want? Will an increase in the price offset the decrease in sales volume and will someone who holds a monopoly be able to increase the price of a product and not affect the revenue from sales?

The slope of a line corresponds elasticity and it is typically shown as a percentage, so that the units of measure do not matter, only the slope does.

To calculate the elasticity of supply and demand, you take the percentage change in quantity over the percentage change in price. So, if the price moves up by five cents, and the quantity of product sold to go up by two, the slope will be 2/0.05, which is 40 products per dollar. This means that the quantity of the product increased by two percent, the price by five percent and that makes the price elasticity of supply to be 2/5, which is .4, or 40 percent.

Changes in the unit of measurement, or the currency, do not change the elasticity of supply or demand either because it is measured in percentages.

When the demand or supply quantity changes a great deal when the price has only changed slightly, then this is called elastic. However, if the quantity of supply or demand changes a little bit, and the price changes a lot, then it is inelastic.

In macroeconomics, supply and demand has been used to explain the variables in a market economy, including price level and total output. Within macroeconomics, supply and demand is often used in relation to money supply to demand and interest rates as well.

Another important concept within supply and demand is the demand shortfall, which results when the demand of a product ends up being lower than was originally projected as the demand for the product. These shortfalls are typically caused by the over-estimation in planning of new products. For example, when Coke created New Coke, they anticipated a huge amount of demand, but this never materialized. Hence, there was a demand shortfall to what they had expected.

When there is a demand shortfall from demand overestimation, it is typically caused by strategic misrepresentation in which the strategy of a company was flawed, or optimism bias.