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The Graphical Representation of Supply and Demand
The Graphical Representation of Supply and Demand
The supply-demand model is a partial equilibrium model representing the determination of the price of a particular good and the quantity of that good which is traded. Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the good, the standard graphical representation, usually attributed to Alfred Marshall, has price on the vertical axis and quantity on the horizontal axis, the opposite of the standard convention for the representation of a mathematical function. Determinants of supply and demand other than the price of the good in question, such as consumers' income, input prices and so on, are not explicitly represented in the supplydemand diagram. Changes in the values of these variables are represented by shifts in the supply and demand curves. By contrast, responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.
Production costs The technology used in production The price of related goods Firm's expectations about future prices Number of suppliers
3. Prices of related goods and services 4. Buyer's expectations about future prices 5. Number of Buyers
[edit] Microeconomics
[edit] Equilibrium
Equilibrium is defined to the price-quantity pair where the quantity demanded is equal to the quantity supplied, represented by the intersection of the demand and supply curves. Market Equilibrium: A situation in a market when the price is such that the quantity that consumers wish to demand is correctly balanced by the quantity that firms wish to supply. Comparative static analysis: Examines the likely effect on the equilibrium of a change in the external conditions affecting the market.
labor is the wage rate.[4] A number of economists (for example Pierangelo Garegnani,[5] Robert L. Vienneau,[6] and Arrigo Opocher & Ian Steedman[7]), building on the work of Piero Sraffa, argue that that this model of the labor market, even given all its assumptions, is logically incoherent. Michael Anyadike-Danes and Wyne Godley [8] argue, based on simulation results, that little of the empirical work done with the textbook model constitutes a potentially falsifying test, and, consequently, empirical evidence hardly exists for that model. Graham White [9] argues, partially on the basis of Sraffianism, that the policy of increased labor market flexibility, including the reduction of minimum wages, does not have an "intellectually coherent" argument in economic theory. This criticism of the application of the model of supply and demand generalizes, particularly to all markets for factors of production. It also has implications for monetary theory[10] not drawn out here. In both classical and Keynesian economics, the money market is analyzed as a supplyand-demand system with interest rates being the price. The money supply may be a vertical supply curve, if the central bank of a country chooses to use monetary policy to fix its value regardless of the interest rate; in this case the money supply is totally inelastic. On the other hand,[11] the money supply curve is a horizontal line if the central bank is targeting a fixed interest rate and ignoring the value of the money supply; in this case the money supply curve is perfectly elastic. The demand for money intersects with the money supply to determine the interest rate.[12]
rates, and to relate labor supply and labor demand to wage rates.
[edit] History
The power of supply and demand was understood to some extent by several early Muslim economists, such as Ibn Taymiyyah who illustrates:[verification needed] "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 it decreases, the price comes down."[13] John Locke's 1691 work Some Considerations on the Consequences of the Lowering of Interest and the Raising of the Value of Money.[14] includes an early and clear description of supply and demand and their relationship. In this description demand is rent: The price of any commodity rises or falls by the proportion of the number of buyer and sellers and that which regulates the price... [of goods] is nothing else but their quantity in proportion to their rent. The phrase "supply and demand" was first used by James Denham-Steuart in his Inquiry into the Principles of Political Oeconomy, published in 1767. Adam Smith used the phrase in his 1776 book The Wealth of Nations, and David Ricardo titled one chapter of his 1817 work Principles of Political Economy and Taxation "On the Influence of Demand and Supply on Price".[15] In The Wealth of Nations, Smith generally assumed that the supply price was fixed but that its "merit" (value) would decrease as its "scarcity" increased, in effect what was later called the law of demand. Ricardo, in Principles of Political Economy and Taxation, more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand. Antoine Augustin Cournot first developed a mathematical model of supply and demand in his 1838 Researches into the Mathematical Principles of Wealth, including diagrams. During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanley Jevons, Carl Menger, and Lon Walras. The key idea was that the price was set by the most expensive price, that is, the price at the margin. This was a substantial change from Adam Smith's thoughts on determining the supply price. In his 1870 essay "On the Graphical Representation of Supply and Demand", Fleeming Jenkin in the course of "introduc[ing] the diagrammatic method into the English economic literature" published the first drawing of supply and demand curves therein, [16] including comparative statics from a shift of supply or demand and application to the labor market.[17] The model was further developed and popularized by Alfred Marshall in the 1890 textbook Principles of Economics.[15] A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price. A negative supply shock (sudden supply decrease) will raise prices and shift the
aggregate supply curve to the left. A negative supply shock can cause stagflation due to a combination of raising prices and falling output. A positive supply shock (an increase in supply) will lower the price of said good and shift the aggregate supply curve to the right. A positive supply shock could be an advance in technology (a technology shock) which makes production more efficient, thus increasing output. An example of a negative supply shock is the increase in oil prices during the 1973 energy crisis.
Specific elasticities
[edit] Elasticities of demand
Price elasticity of demand Main article: Price elasticity of demand Price elasticity of demand measures the percentage change in quantity demanded caused by a percent change in price. As such, it measures the extent of movement along the demand curve. This elasticity is almost always negative and is usually expressed in terms of absolute value (i.e. as positive numbers) since the negative can be assumed. In these terms, then, if the elasticity is greater than 1 demand is said to be elastic; between zero and one demand is inelastic and if it equals one, demand is unitelastic. Income elasticity of demand Main article: Income elasticity of demand Income elasticity of demand measures the percentage change in demand caused by a percent change in income. A change in income causes the demand curve to shift reflecting the change in demand. IED is a measurement of how far the curve shifts horizontally along the X-axis. Income elasticity can be used to classify goods as
normal or inferior. With a normal good demand varies in the same direction as income. With an inferior good demand and income move in opposite directions.[2] Cross price elasticity of demand Main article: Cross price elasticity of demand Cross price elasticity of demand measures the percentage change in demand for a particular good caused by a percent change in the price of another good. Goods can be complements, substitutes or unrelated. A change in the price of a related good causes the demand curve to shift reflecting a change in demand for the original good. Cross price elasticity is a measurement of how far, and in which direction, the curve shifts horizontally along the x-axis. A positive cross-price elasticity means that the goods are substitute goods. Cross elasticity of demand between firms Main article: Conjectural variation Cross elasticity of demand for firms, sometimes referred to as conjectural variation, is a measure of the interdependence between firms. It captures the extent to which one firm reacts to changes in strategic variables (price, quantity, location, advertising, etc.) made by other firms. Elasticity of intertemporal substitution Main article: Elasticity of intertemporal substitution Combined Effects It is possible to consider the combined effects of two or more determinant of demand. The steps are as follows: PED = (Q/P) x P/Q. Convert this to the predictive equation: Q/Q = PED(P/P) if you wish to find the combined effect of changes in two or more determinants of demand you simply add the separate effects: Q/Q = PED(P/P) + YED(Y/Y)[12] Remember you are still only considering the effect in demand of a change in two of the variables. All other variables must be held constant. Note also that graphically this problem would involve a shift of the curve and a movement along the shifted curve.
quantity supplied is fixed. Elasticities of scale Main article: Returns to scale Elasticity of scale or output elasticities measure the percentage change in output induced by a percent change in inputs.[4] A production function or process is said to exhibit constant returns to scale if a percentage change in inputs results in an equal percentage in outputs (an elasticity equal to 1). It exhibits increasing returns to scale if a percentage change in inputs results in greater percentage change in output (an elasticity greater than 1). The definition of decreasing returns to scale is analogous.[5]
[edit] Applications
The concept of elasticity has an extraordinarily wide range of applications in economics. In particular, an understanding of elasticity is fundamental in understanding the response of supply and demand in a market. Some common uses of elasticity include: Effect of changing price on firm revenue. See Markup rule. Analysis of incidence of the tax burden and other government policies. See Tax incidence. Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms investment decisions. See Income elasticity of demand. Effect of international trade and terms of trade effects. See MarshallLerner condition and SingerPrebisch thesis. Analysis of consumption and saving behavior. See Permanent income hypothesis. Analysis of advertising on consumer demand for particular goods. See Advertising elasticity of demand