Market demand, supply and equilibrium

MARKET

A group of buyers and sellers who trade a particular good or service create a market. The people who buy it determine the demand side of the market, while the ones who sell the commodity or service determine the supply side of the market. There are many types of market. The simplest one and the one we will use as example is a perfectly competitive market. In order to be defined as such a market must have two main characteristics:

• The goods that are traded are exactly the same. So no one can be said to sell better (or worse) products compared to the competition.

• No one in the market has a strong market power. This means that no one in the market can alone influence the market price. This means that both buyers and sellers have to take the price the market determines as given.

DEMAND

The amount of the good or service that a buyer is able and willing to acquire is defined as the quantity demanded. The law of demand tells us that, if we keep any other possible factor equal and change only the price of the commodity, if the price raises the quantity demanded decreases, while, if the price becomes lower, the quantity demanded rises. This relationship can be depicted mathematically by a table, called a demand schedule or graphically. The sum of the demands of all individuals in the market is called the market demand. The graph representing how the quantity demanded changes with price is called demand curve and it is often simplified to be a linear relationship (and therefore represented with a line). The price is set on the vertical axis and the quantity is on the horizontal one. Because of the law of demand the demand curve has to be downward sloping.

FACTORS THAT MIGHT AFFECT A DEMAND CURVE

We said that, because of the law of demand, as price changes we have a change in the quantity demanded and therefore we move along the demand curve. But the demand curve itself needs not to be fixed. There some cases in which the demand curve itself can move. As examples of factors that can affect the demand curve we could list:

• Income. If you suddenly start earning less money, you will be able to buy less of the commodity. If, when you earn less, you consume less of the good, the commodity itself is called a normal good. An inferior good is, instead, a commodity that is consumed more when your income becomes lower. This means that if your income raises you will consume more of the commodity if it is a normal good and, therefore, your demand curve will shift to the right while you will consume less of it if it is an inferior good and, therefore, your demand curve will shift to the left. An example of normal good could be pizza: if your income rises you will consume more of it. An example of an inferior good is public transportation: if your income raises you will buy your own car or call a taxi (have you ever seen a billionaire taking the bus with you?).

• Price of related goods. The price of other goods which are related in some way to the one we are considering can influence the demand of the latter. The relationship between two goods usually arises if the two goods can be considered complements (so both goods will be consumed together) or substitutes (so, if you consume one of the two, you will not consume the other). Complements are for example a tennis ball and a tennis racket (obviously you can not play tennis without one of these two). Substitutes are for example butter and margarine (you use either butter or margarine and I hope never both at the same time). If the price of a complement good rises the quantity of the good considered will be lower and so your demand will shift to the left. If the price of a substitute good rises the quantity demanded of the good considered will rise and so the demand curve will shift to the left.

• Tastes. If you do not like a good, you will demand less of it (obviously).

• Expectations. Also your expectations about the future can influence the quantities you consume in the present. If you expect to earn more in the future you could think of having a pizza with friends one more time. If this is the case the demand curve will shift to the right.

• Number of buyers. If the number of buyers rises there will obviously be more demand for that specific good. Consider a small ice-cream store during summer, if in the neighbourhood where it is located there are 2000 people, it could sell 500 ice-creams a day, but, if in the neighbourhood there are 10000 people, the owner of the shop can expect a demand of 2500 ice creams a day. An increase in the number of buyers shifts the demand curve to the right.

SUPPLY

Now let’s switch perspective and look at the other side of the market. The amount of the good or service that a seller is willing to offer to the market is called the quantity supplied. The law of supply tells us that, if we keep any other possible factor equal and change only the price of the commodity, if the price raises the quantity supplied rises as well, while, if the price becomes lower the quantity supplied decreases. This relationship can be depicted mathematically by a table, called a supply schedule or graphically. The sum of supplies of all suppliers is called the market supply. The graph representing how the quantity supplied changes with price is called supply curve and, like demand, is often simplified to be a liner relationship (and therefore represented with a line). The price is once again set on the vertical axis and the quantity on the horizontal one. Because of the law of supply the supply curve has to be upward sloping.

SHIFTS IN THE SUPPLY CURVE

We said that, because of the law of supply, as the price changes we have a change in the quantity supplied and therefore we move along the supply curve. But the supply curve itself needs not to be fixed. There are some cases in which the supply curve itself can move. As examples of factors that can affect the supply curve we could list:

• Input prices. Consider a small pizza store. If the price of flour decreases more pizzas can be cooked spending the same amount of money. This means that at the same price more pizzas will be supplied and therefore the supply curve shifts to the right.

• Technology. If our pizza store buys a more efficient oven, then more pizzas are cooked using the same amount of inputs (ex. Electricity). This means that overall more pizzas are supplied at the same price and, therefore, the supply curve shifts to the right.

• Expectations. If a company expects that in the future the price of the goods it is produ

cing will rise it is more convenient for it to keep some items without selling them now in order to sell them at the higher price in the future. (the pizza store example could not fit here because you should eat pizzas right after they are cooked).

• Numbers of sellers. If the number of sellers rises there will obviously be more offer for that specific good. Consider again our pizza stores. If each pizza store is willing to produce 10 pizzas at a certain price. If in a specific neighbourhood there are 5 pizza stores you will have in the market 5*10=50 pizzas cooked. If there are 10 pizza stores then the number of pizzas produced are 10*10=100. This means that when the number of sellers rises the supply curve shifts to the right.

EQUILIBRIUM

Because the demand curve is downward sloping and the supply curve is upward sloping they will intersect in some point in the graph. The point where demand and supply curves intersect is called the market equilibrium. The y-value of that point represents the equilibrium price, the price at which quantities supplied and quantities demanded are exactly the same. The equilibrium price is also called the market-clearing price because, at this price, both buyers and sellers are satisfied. The quantity supplied and demanded in the market at the equilibrium price is called the equilibrium quantity and it is represented by the x-value of the equilibrium point.

WHEN THERE IS NO EQUILIBRIUM

Only at the equilibrium price as said the quantity demanded and supplied are equal. At any other price the market is in disequilibrium and we have a different situation whether the price considered is higher or lower than the equilibrium price.

If the market price is higher than the equilibrium price, more sellers will be willing to offer their products while less buyers will be willing to acquire those products. Therefore the market supply is greater than the market demand. The situation just depicted is called a surplus and it is often described as a situation of excess supply. If this happens, the firms in the market will reduce their prices in order to sell their products. This reduction in price is an incentive for firms to produce less and for customers to demand more. The price will continue to drop until it reaches the equilibrium price resulting in the market equilibrium.

The opposite happens when the market price is below the equilibrium price. In this case more people will be willing to buy the commodity while less sellers will be willing to offer that commodity. This means that the market demand is greater than the market supply. The situation just depicted is called a shortage and it is often described as a situation of excess demand. If this happens firms will raise their prices because they have the opportunity to do that without reducing the quantities they sell (that is because there are many people willing to buy a limited amount of products). This raise in prices is an incentive for firms to produce and sell more but at the same time customers will demand less. The price will continue to increase until it reaches the equilibrium price resulting in the market equilibrium.

The law of supply and demand says that, when the market price is higher or lower than the equilibrium price, it will naturally increase or decrease in order to bring the quantities supplied and demanded for that good in balance and therefore reaching the market equilibrium.

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