Supply and demand

Because of their importance to the development of economic theory, an appreciation of the concepts of supply and demand is essential to the understanding of economic theory. This article seeks to explain their significance in non-technical terms and to provide a simple introduction to the law of supply and demand, with links to more detailed explanations.

Definitions of the terms used in the article that are shown in italics can be found on the Related Articles subpage, and a selection of the diagrams and mathematical equations that are conventionally used for teaching purposes can be found on the Tutorials subpage.

Origins and applications

The proposition that prices are determined by supply and demand is so familiar that it seems like a statement of the obvious. In fact, it was not generally known, even to eminent intellectuals such as Adam Smith, John Stuart Mill and David Ricardo, until the idea was popularised by Alfred Marshall towards the end of the nineteenth century . Since then it has become universally accepted that demand rises in response to a reduction in price, that supply rises in response to an increase in price, and that price somehow settles to a level where demand is equal to supply. That proposition has come to be been termed "the law of supply and demand" and is often thought to be as firmly established as the law of gravity. In fact it is what Marshall termed "a statement of a tendency", depending upon particular premises about human behaviour, and falling short of a complete explanation of the market mechanism. It has nevertheless survived in general use as a robust statement that reflects widespread experience. In economics, it has served as a tool that has been used in the construction of other theories, and it has generated a terminology that has been widely used in discussions among economists.

Demand

Price effects

The basic premise that economists adopt when discussing demand was stated by Marshall as the proposition that "the larger the amount of a thing that a person has, the less ... will be the price which he will pay for a little more of it" - a proposition that they referred to as the "law of diminishing marginal utility". That premise has detailed implications for the price/demand relationship that are discussed on the Tutorials subpage, but the only implication that is necessary to the operation of the law of supply and demand is that demand rises in response to a reduction in price and vice versa. Among exceptions to this generally-observed behaviour are goods that people prize just because they are expensive - sometimes referred to as Veblen goods in reference to the economist who coined the phrase "conspicuous consumption". An increase (or decrease) in the price charged for a product usually has two effects: - one is to cause consumers to switch their buying from (or to) it, to (or from) other products; and the other is to bring about a reduction (or increase) in consumers' incomes with the consequences described in the following paragraph. Those two consequences of a price change are termed the substitution effect and the income effect. (In this context "substitution" refers to a switch to or from any other product. The particular effects of substitutes that serve as functional alternatives are described in a later paragraph). From a supplier's viewpoint, however, the relevant characteristic of the relationship between price and demand is the percentage increase of demand for a product that would result from a small percentage reduction in its existing price - a quantity known as the price elasticity of demand for the product.

Income effects

The missing passage in the above quotation from Marshall's Principles of Economics was his "other things being equal" qualification; and income is one of the other things that have to be taken into account. The effect of a rise in a community's income must obviously be a proportionately equal increase in its total spending, assuming no change in the proportion that it saves. That implies a community-wide income elasticity of demand of exactly one - but, within that average, different values pertain to different categories of product. It is common experience for example, that people spend a diminishing proportion on food as their incomes rise (an observation that is sometimes referred to as Engel's Law). There are circumstances in which Engel's law can have significant consequences. In international trade, its effect is a continuing deterioration in the terms of trade of food-exporting countries with every rise in the prosperity of their customer countries; and in some developing countries the income effect referred to in the previous paragraph can produce an exception to the law of supply and demand that is similar to that of Veblen goods, but for a different reason. In markets predominated by people whose income is spent mainly on a basic good such as rice, the income effect of a reduction in its price can lead them to spend less upon it, thus reversing the normal effect of a price reduction. (Goods to which this exception applies are termed Giffen goods). Corresponding to Engel's law at the other end of the spectrum, the income elasticity of demand of luxury goods such as sports cars and jewelery is usually well above one.

Demand with substitutes and complements

The demand for a product is reduced if a new substitute becomes available - as happened to CDs when DVDs became available - and is increased if the price of an existing substitute is increased. The converse applies to complementary goods, so that the demand for microwave ovens is increased by the introduction of improved microwaveable meals, and the demand for cars is reduced if the price of petrol is increased. The sensitivity of the demand for a product to a change in the price of a substitute or a complement is referred to as the cross elasticity of demand between the products, and is positive for substitutes and negative for complementary goods. However, in estimating the net effect upon demand of any price change, allowance has also to be taken of its effect upon consumers' incomes.

Supply

Diminishing returns

The inferences of economic theory concerning the determination of supply relationships are less well established than those concerning demand, and they have been the subject of the controversy that is summarised on the tutorials subpage. The consensus view is that the premise that an increase in the price of a product results in an increase in its supply is justified by the law of diminishing returns.

Supply with substitutes and complements

Supply is also affected by the prices of substitutes and complements in the markets for the inputs used in production. Where nurses are used as substitutes for doctors, an increase in the pay of doctors would increase the demand for nurses, but where doctors and nurses perform complementary functions, it would reduce the demand for nurses. However, the concept of cross-elasticity has less currency in this context than in connection with demand.

Market interactions

The Auctioneer analogy

The original theory of supply and demand offered no explanation of the actual mechanism that achieves the postulated equality between demand and supply, but a possible explanation was put forward by Marshall's French contemporary, Léon Walras. Walras described a market in which an imaginary auctioneer invites offers to sell and offers to buy at an arbitrary starting price, and then announces a succession of price revisions that bring the amounts offered by buyers and sellers progressively closer together until equality is reached - and allows no transactions to take place until that price is established . Similar arrangements (termed "French auctions") are, in fact, used to set opening prices in some stock markets, but the Walrassian auction was intended - and is widely accepted - as an analogy to be applied to markets in general. It can be shown, however, that that analogy is strictly applicable only to markets consisting of rational participants, each of whom is fully informed about the product and its substitutes, each of whom acts independently in the exclusive pursuit of self-interest, and in which all transactions are costlessly enforceable. Those restrictions exclude the possibility of externalities, of the exercise of market power, of the existence of incomplete contracts , and of all forms of cooperation or of motivations based upon social interaction.

Equilibrium and disequilibrium

The term "equilibrium" is applied by economists to the situation in which supply is equal to demand - by analogy with the state of a physical body which is at rest because it is acted upon by forces that are in balance. It can also be seen as an optimum situation for each participant in a market given the reactions of the other participants - mirroring the games theory concept of a Nash equilibrium.

Marshall's analysis of supply and demand was concerned with equilibrium in the market for a single product, taking no account of interactions with other markets - an approach that is termed termed "partial equilibrium analysis". By contrast, the term "general equilibrium analysis" describes an approach that takes account of such interactions - acknowledging, for example the interactions that take place between the market for steel with the market for iron ore and the interactions of that market with the markets for ore-bearing land, mining machinery and so on. At the operational level, economists developing economic forecasting models have used limited forms of general equilibrium analysis, and at the theoretical level, other economists have explored the characteristic of a closed system of interacting competitive markets. The "Walras' law of markets" has established the possibility of simultaneous equilibrium of all of the markets in such a system and the Arrow-Debreu theorems have further developed the characteristics of completely general equilibrium.

In the absence of a Walrasian auctioneer, however, information failures may lead to disequilibrium as demands arise of which suppliers are unaware, and vice versa. Errors in forecasting traffic demand, could, for example, lead to an under-supply of transport services that - despite any pricing response - could persist for many years. Lack of price flexibility can also lead to disequilibrium, as in the Keynesian account of the causes of unemployment . It is in fact, the problem of unemployment that has been the main reason for the study of the economics of disequilibrium, and economists including Axel Leijonhufvud and Edmond Malinvaud have used the concept to provide alternative explanations of the mechanism of unemployment.

Empirical evidence

The theory that has been outlined depends entirely upon logical deduction from untested axioms, and it consequently has limited application to the real world unless it is supplemented by empirical evidence. Developments over the past 40 years in the field of experimental economics have, in fact, led to the creation of a substantial body of evidence concerning human behaviour in trading situations. Experiments conducted by Vernon Smith have demonstrated that equilibrium can be achieved in many situations without the necessity for perfect information or the conditions necessary for pure competition. The evidence indicates that market behaviour is strongly influenced by the rules of the institutions within which the trading takes place, and has provided practical guidance concerning the efficient design of such institutions.