Supply and Demand (econ essay)
How is the price of things determined? When we go to the store, the prices are all written out on the things we buy. The temptation is to assume that the store decides how much things should cost, and technically that is true to some degree. But if that were the whole truth, why wouldn't they raise prices indefinitely? If the price is too high, customers will buy less of it, reducing the supplier's profit. Prices are determined by the interaction of both supply and demand. Without considering both of them, prices can not be determined.
The supply and demand graph combines the ideas of opportunity cost, trade, production, elasticity and decision making on the margin.
The vertical axis is the price of the good. It represents what the buyer has to give up in order to buy the good. Normally it is written as money, but that represents other goods that the money could have bought. The price also represents the resources the suppliers get to produce the good. The higher the price, the more resources the suppliers get per unit of the good sold. The horizontal axis is the quantity of goods sold in the entire market. The quantity supplied equals the quantity demanded when the market is in equilibrium.
The demand curve represents the people who want to buy the good and the prices they are willing to pay for it. If a person wants more than one unit, they may be represented by multiple points. Each point represents the next best alternative the buyer has to buying that good (the opportunity cost of purchasing the good). The demand curve slopes down in most situations. It represents a sorted list of the people who want to buy the good, from highest willingness to pay to lowest willingness to pay. In general, the higher the price, the fewer units people will want to buy of it, which is known as the Law of Demand . For the most part, any person willing to buy a good when the price is high will not change their mind if the price goes down. There are two exceptions to the downward slope: Veblen goods, and Giffen goods, which we'll get to later. Those who value the good the most are represented by the left part of the demand curve, and those who value the good the least are the right part of the demand curve. I don't think that downward sloping demand has much empirical support, even for goods which might be Veblen or Giffen. I think that whole idea comes from the faulty assumption that price is the independent variable and quantity is the dependent variable. I agree with Alfred Marshall that quantity is independent.
The Supply Curve represents how much suppliers will charge for each quantity of goods demanded. Below the supply curve, they have a better alternate use to their productive capacity to producing the good. It might be that there are things that are more valuable that they can make, or perhaps they will stop production entirely if the price is too low. Above the supply curve, producing the good is the best alternative the suppliers have. The total quantity of resources flowing to the producers is P*Y, where P is the equilibrium price and Y is the equilibrium output. Supply curves usually slope upward, but can slope down because of economies of scale . Economies of scale mean that as the producers get more resources, they are able to use more efficient methods of production, such as large scale automated assembly lines. If changing the quantity does not change the per unit opportunity cost, the supply curve will be flat. If additional production is more costly than earlier amounts of production, the supply curve will slope up. This is actually the most common scenario, because of the Low Hanging Fruit Principal. The first factors of production used are those with lower opportunity costs, since producers have to give up the least "other stuff" to produce using them. In other words, the most efficient factors of production are used first, and less efficient factors of production are used later. If society wanted to make wine, the first wine produced would be on land that was in the best wine growing region. As more and more wine was produced, the additional land used wouldn't have as good weather, soil, etc for growing wine grapes.
The second major concept that the supply and demand curve illustrates is that people make decisions on the margin. Prices are determined not by the total value of a good, but by the value of the last unit added to the market. Consider the "Diamond Water Paradox." Water is necessary for human life. Without it we would all die. However, it is very cheap in most places. Diamonds are useful for some industrial applications, but are not critical for survival. Mostly people use them for decoration, however, they are extremely expensive. Why is water cheaper than diamonds? Price is determined by the interaction of the buyer and seller of the marginal unit - the least valued unit by the consumers and the highest opportunity cost unit to supply. Since water is so abundant, the least valued unit of water used in the economy has low value. Likewise, water is cheap to supply to the market. Without thinking about how both supply and demand interact, you cannot explain market prices accurately.
The supply and demand graph combines the ideas of opportunity cost, trade, production, elasticity and decision making on the margin.
The vertical axis is the price of the good. It represents what the buyer has to give up in order to buy the good. Normally it is written as money, but that represents other goods that the money could have bought. The price also represents the resources the suppliers get to produce the good. The higher the price, the more resources the suppliers get per unit of the good sold. The horizontal axis is the quantity of goods sold in the entire market. The quantity supplied equals the quantity demanded when the market is in equilibrium.
The demand curve represents the people who want to buy the good and the prices they are willing to pay for it. If a person wants more than one unit, they may be represented by multiple points. Each point represents the next best alternative the buyer has to buying that good (the opportunity cost of purchasing the good). The demand curve slopes down in most situations. It represents a sorted list of the people who want to buy the good, from highest willingness to pay to lowest willingness to pay. In general, the higher the price, the fewer units people will want to buy of it, which is known as the Law of Demand . For the most part, any person willing to buy a good when the price is high will not change their mind if the price goes down. There are two exceptions to the downward slope: Veblen goods, and Giffen goods, which we'll get to later. Those who value the good the most are represented by the left part of the demand curve, and those who value the good the least are the right part of the demand curve. I don't think that downward sloping demand has much empirical support, even for goods which might be Veblen or Giffen. I think that whole idea comes from the faulty assumption that price is the independent variable and quantity is the dependent variable. I agree with Alfred Marshall that quantity is independent.
The Supply Curve represents how much suppliers will charge for each quantity of goods demanded. Below the supply curve, they have a better alternate use to their productive capacity to producing the good. It might be that there are things that are more valuable that they can make, or perhaps they will stop production entirely if the price is too low. Above the supply curve, producing the good is the best alternative the suppliers have. The total quantity of resources flowing to the producers is P*Y, where P is the equilibrium price and Y is the equilibrium output. Supply curves usually slope upward, but can slope down because of economies of scale . Economies of scale mean that as the producers get more resources, they are able to use more efficient methods of production, such as large scale automated assembly lines. If changing the quantity does not change the per unit opportunity cost, the supply curve will be flat. If additional production is more costly than earlier amounts of production, the supply curve will slope up. This is actually the most common scenario, because of the Low Hanging Fruit Principal. The first factors of production used are those with lower opportunity costs, since producers have to give up the least "other stuff" to produce using them. In other words, the most efficient factors of production are used first, and less efficient factors of production are used later. If society wanted to make wine, the first wine produced would be on land that was in the best wine growing region. As more and more wine was produced, the additional land used wouldn't have as good weather, soil, etc for growing wine grapes.
The second major concept that the supply and demand curve illustrates is that people make decisions on the margin. Prices are determined not by the total value of a good, but by the value of the last unit added to the market. Consider the "Diamond Water Paradox." Water is necessary for human life. Without it we would all die. However, it is very cheap in most places. Diamonds are useful for some industrial applications, but are not critical for survival. Mostly people use them for decoration, however, they are extremely expensive. Why is water cheaper than diamonds? Price is determined by the interaction of the buyer and seller of the marginal unit - the least valued unit by the consumers and the highest opportunity cost unit to supply. Since water is so abundant, the least valued unit of water used in the economy has low value. Likewise, water is cheap to supply to the market. Without thinking about how both supply and demand interact, you cannot explain market prices accurately.