Economic Basics: Supply And Demand

TUTORIAL Supply And Demand, Definitions.

In the context of supply and demand discussions, demand refers to the quantity of a good that is desired
by buyers. An important distinction to make is the difference between demand and
the quantitiy demanded. The quantity demanded refers to the specific amount of that product that
buyers are willing to buy at a given price. This relationship between price and the quantity of product
demanded at that price is defined as the demand relationship.
Supply is defined as the total quantity of a product or service that the marketplace can offer.
The quantity supplied is the amount of a product/service that suppliers are willing to supply at a given
price. This relationship between price and the ammount of a good/service supplied is known as
the supply relationship.
When thinking about demand and supply together, the supply relationship and demand relationship
basically mirror eachother at equilibrium. At equilibrium, the quantity supplied and quantity demanded
intersects and are equal.
In the diagram below, supply is illustrated by the upward sloping blue line and demand is illustrated by
the downward sloping green line. At a price of P* and a quantity of Q*, the quantity demanded and
the supply demanded intersect at the Equilibirum Price. At equilibrium price, suppliers are selling all
the goods that they have produced and consumers are getting all the goods that they are demanding.
This is the optimal economic condition, where both consumers and producers of goods and services are
satisfied.
The Law Of Demand
Very simply, the law of demand states that if all other factors
remain constant, if a good's price is higher, fewer people will
demand it. As the price of that good goes down, the quantity of
that good that the market will demand will increase. In the
diagram below, you see this relationship. At price P1, the quanity
of that good demanded is Q1. If the price of this good were to be
decreased to P2, the quantity of that good demanded would
increase to Q2. The same is true for P3 and Q3. When prices
move up or down (assuming all else is constant), the quantity
demanded will move up or down the demand curve and define the
new quantity demanded.
The Law Of Supply
After understanding the law of demand, the law of supply is simple, it's
effectively the inverse of the law of demand. The law of supply states that
as the price rises for a given product/service, suppliers are willing to supply
more. Selling more goods/services at a higher price means more revenue.
In the diagram below, you can see that as the price shifts from P1 to P2,
the quantity supplied of that good shifts from Q1 to Q2. The movement in
price (up or down) causes movement along the supply curve and the
quantity demanded will change accordingly.
Econ 101: The Basics of Supply and
Demand
When I teach principles of economics, I start the class by asking two questions:

1. Do you believe people buy more at lower prices and less at higher
prices?
2. Do you believe that sellers want to sell more at higher prices and less
at lower prices?
After I get almost universal agreement--and I do because I tell them their grade
hinges on agreeing with me--I tell them: Then you believe that markets work.
So let's take a quick look the basics and then use it to explain why the current
high gas prices are your fault.
Believing that people buy less at higher prices and that sellers want to sell more
at higher prices means that you believe that price and quantity demanded are
inversely related and that price and quantity supplied are directly related. If we
put this onto a standard graph with prices on the vertical axis and quantity on the
horizontal axis then believing those two statements means we can draw an
downward sloping demand curve and an upward sloping supply curve. Bear with
me...the good stuff's coming.

OK, so we now know that demand and supply can be

drawn as an X on an L shaped graph. Just like the picture on the right. After the
buyers and sellers bargain with each other until everyone is happy the market
price and quantity stabilize. This is called the equilibrium--the point (Q0, P0) on
the graph--and it means that those willing and able to buy the good are the ones
who get it, and those willing and able to sell the good are the ones who sell. Just
so you know I'm not using sleight of hand, remember, all of this hinges on you
agreeing that people buy more at low prices and sellers want to sell more at high
prices, that's all.
Now that the market is stable, we can start to figure out why prices and quantities
change. There are only 4 things that can change a price: Demand increases,
Demand decreases, Supply increases or Supply decreases. If you understand
these 4 cases, you can identify the cause of almost any price or quantity change
in any market--that's a pretty powerful statement, but supply and demand is a
pretty powerful tool.
Increases and decreases in supply and demand are represented by shifts to the
left (decreases) or right (increases) of the demand or supply curve. After the
demand or supply changes, buyers and sellers renegotiate the deals they had
previously made and the price and quantity are adjusted according to these
deals. When everyone is happy again, we can compare the new price and
quantity to the old and see what happened. Again, all of this depends only on
you agreeing that people buy more at low prices and sellers want to sell more at
high prices.

The picture on the right lays out all four of the possible
market changes. You'll notice that each of the inset pictures has one of the four
possible market changes. You'll also notice that each market change causes a
uniquely identifiable change in the price, quantity combination:
1. Demand Increase: price increases, quantity increases.
2. Demand Decrease: price decreases, quantity decreases.
3. Supply Increase: price decreases, quantity increases.
4. Supply Decrease: price increases, quantity decreases.
So if you observe a price and quantity changing, you know have a powerful tool
for understanding the underlying cause.
Take the case of high gas prices. From Reuters:
Millions of Americans will drive their cars to visit family and friends over the
Thanksgiving holiday even though gasoline is above $3.00 per gallon, travel and
leisure group AAA said Thursday.
About 38.7 million Americans, 1.5 percent more than last year, will travel 50
miles or more from home this holiday, AAA estimated, based on a national Web
survey of 2,200 adults.
The price per mile of travel is increasing (gas prices are increasing) and miles
traveled are increasing relative to last year. The only thing consistent with higher
prices and higher quantity is an increase in demand. If high gas prices were
supply driven we would see consumption decreasing, not increasing.
And all you have to believe is people buy less at higher prices and that seller
want to sell more at higher prices.