The market forces of demand and supply

In each market, there are two main groups of actors: Buyers wanting to acquire particular goods and services, as opposed to sellers aiming at the sale of their products.

These two aggregated groups of people are termed the demand and the supply side of the market.

85 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 26.

86 N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 66.

a) The demand side of the market

Demand is defined as “the amount of the good that buyers are willing and able to purchase”⁸⁷. The individual demand function of a customer (xi) therefore depends on three variables:

▪ The price of the good (pj),

▪ the prices of other goods (pk), and

▪ the individual income of the customer (mi).⁸⁸ This relationship can be written more formally as

xi (pj, pk, mi).

Market demand for the product j (X^j) is derived from individual consumer choice by adding up the individual quantities of the number of consumers in the market n:

X^j(p_j, p_k, m₁, …, m_n) = ∑x_i(p_j, p_k, m_i)

n i=1

.⁸⁹

All other things equal⁹⁰, the entire quantity demanded in the market is determined by the price of the good. For normal goods, the quantity demanded is negatively correlated with the price charged, other things equal.⁹¹ In other words: People buy more units of a normal good if the price is lower. This correlation is best represented graphically in the demand curve D(p):

87 Ibid, 67.

88 Other influences on demand, like the individual and social tastes, are left out in this analysis. For a detailed discussion of these special influences see Paul A. Samuelson and William D. Nordhaus, Economics (Singapore:

McGraw-Hill, 2005), 48.

89 For the formal derivation see Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Com-pany, 2006), 266.

90 Ceteris paribus assumption, in this example, the price of other goods pk and the income mi are held con-stant.

91 So-called law of demand. See N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 67.

Figure 1: Downward-sloping demand curve and the price elasticity of demand

The demand curve is downward sloping⁹², for reasons of simplification, a linear progression has been assumed in the figure above. The exact slope of the curve depends on the price elasticity of demand. This parameter measures the change in quantity demanded of a good when its price changes.⁹³ Economists discern elastic demand, where the quantity demanded changes substantially with price increases and inelastic demand, if only slight changes in quantity are observed in reaction to price increases.⁹⁴ In the graphical repre-sentation, perfectly inelastic demand results in a straight vertical line, whereas perfectly elastic demand yields a horizontal line that parallels the quantity axis.⁹⁵ The interpretation of the price elasticity of demand is straightforward: In case of inelastic demand, customers buy the same quantity of the good irrespective of the price. By contrast, in case of elastic demand, customers stop buying the product already in the event of slight price increases.

The determinants of the price elasticity are manifold, however, some general influences can be spotted: The availability of close substitutes favors elastic demand, as well as a longer time horizon does. In contrast, necessities usually go along with inelastic demand.

Eventually, the price elasticity depends on the boundaries of the market: Narrowly defined markets have more elastic demand than broadly defined ones.⁹⁶

Apart from changes in price, the quantity demanded in a market can be influenced by external factors, such as the income available to buyers, changes in the prices of related goods, changes in trends, tastes, and expectations within the population or the number of

92 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 47.

93 Ibid, 66.

94 See N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 90. Fur-thermore, some textbooks also discuss unit-elastic demand if the percentage change in quantity equals the percentage change in price. See. For example Paul A. Samuelson and William D. Nordhaus, Economics (Singa-pore: McGraw-Hill, 2005), 67.

95 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 68.

96 For details of the determinants of price elasticity see N. Gregory Mankiw, Principles of Economics (Mason:

South-Western Cengage Learning, 2008), 90-91.

Price (p)

Quantity (x)

Unit-elastic demand Elastic demand Inelastic demand D(p)

buyers in the market.⁹⁷ These influences lead to shifts of the demand curve to the left (characterizing a decrease in demand) or to the right (increase in demand).

b) The supply side of the market

Inversely to the demand side of the market, the group of suppliers forms the supply side. The quantity supplied is defined as the amount of a commodity that producers are willing to produce and sell, ceteris paribus.⁹⁸ The quantity supplied depends on the market price of the commodity concerned and is positively related to it.⁹⁹ Hence, a higher market price for a good causes the supply to increase. Equally as for the demand side, the market supply can be derived from the addition of the individual supply curves of all producers in the market.¹⁰⁰

The slope of the supply curve depends on the price elasticity of supply. This measure states how much the quantity supplied of a given commodity changes in response to a change of the price of that good.¹⁰¹ Similar to the price elasticity of demand, there are two cases: Elastic and inelastic supply. If the quantity supplied changes heavily with a change in price, supply is said to be elastic. If, on the contrary, the quantity offered in the market does only slightly respond to changes in price, supply is inelastic.¹⁰² The graphical repre-sentation of the supply curve and the extreme cases of perfectly elastic and perfectly inelastic supply summarizes these relationships clearly.¹⁰³

97 Ibid, 70-71.

98 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 51.

99 So-called law of supply. See N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 73.

100 Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Company, 2006), 289.

101 N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 99.

102 Ibid, 99.

103 See for similar illustrations: Hal R. Varian, Intermediate Microeconomics (New York: W.W. Norton & Com-pany, 2006), 291. Also: N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learn-ing, 2008), 101.

Figure 2: Upward-sloping supply curve and the price elasticity of supply

In the economic interpretation, the price elasticity of supply indicates the ability of pro-ducers to change the amount of the commodity they produce flexibly. Goods that are naturally or technologically limited in supply are relatively inelastic compared to manufac-tured goods with theoretically unlimited production.¹⁰⁴ Furthermore, the time horizon con-sidered influences the elasticity of supply: In the short run, firms are relatively inflexible in changing their production capacity. Over a longer time period, however, they can adapt their production facilities and technique to the situation on the market, which results in an increasing elasticity of supply.¹⁰⁵

Eventually, external factors other than the price of the good influence the quantity supplied and shift the supply curve to the right (increase in supply) or to the left (decrease in supply).¹⁰⁶ The most important of the influences to lead to an increase in supply are falling market prices for inputs and advances in production technology. On the contrary, a de-crease in supply can be due to negative expectations of sellers for the future or a falling number of suppliers in the market.¹⁰⁷

Now that both sides of the market have been introduced, the next subsection will present the concept of equilibrium in competitive markets.

104 N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 99.

105 Paul A. Samuelson and William D. Nordhaus, Economics (Singapore: McGraw-Hill, 2005), 73.

106 Ibid, 53.

107 N. Gregory Mankiw, Principles of Economics (Mason: South-Western Cengage Learning, 2008), 75-76.

Price (p)

Quantity (x)

Unit-elastic supply Elastic supply Inelastic supply S(p)