Closed economy: Supply and demand

Demand and supply are possibly the two most fundamental concepts used in economics. The concept of market is usually defined as a number of buyers and sellers of a given good or service that are willing to negotiate in order to exchange those goods. We will first explain them separately and then jointly to show their interaction.

Demand:

Demand is the global market value that expresses the purchasing intentions of consumers. The demand curve shows the quantity of a specific product that individuals or society are willing to buy according to its price and their income. This curve shows an inverse relationship between price and quantity demanded giving it a downward slope. The reason why this happens is known as the law of demand: ceteris paribus, and considering ordinary goods, the higher the price the lower the quantity demanded, and vice versa.

We can start by analysing demand from a purely microeconomic point of view: a single individual, let’s say her name is Joan. Joan’s demand for, let’s say, books, is such as shown in the adjacent graph. If the price of a book is $35 or more, Joan won’t demand any (point a), given her preferences (basically, she would rather spend her money on something else). However, if the price of books goes down to $30, she will want to buy one (point b). If it decreases to $20, Joan will buy two books (point c), and so on. By joining all the points (a-h), we’ll get Joan’s demand curve. It’s worth mentioning that, for simplicity’s sake (though violating monotonicity), we consider that the demand curve ends at the axes.

From a macroeconomic point of view, the demand curve is just the aggregation of all demand curves from all buyers in a particular market. Let’s say the market for books has only two buyers: Joan and her classmate Edward. The horizontal sum of Joan and Edward’s demand curves will give us the market demand: 

Supply:

On the other side, supply is the set of offers made in the market for the sale of goods and services. The supply curve records the location of the points corresponding to the amount offered for a particular good or service at the different prices. This curve shows a direct relationship between price and quantity supplied, giving it an upward slope. The reason why this happens is known as the law of supply: ceteris paribus, and considering ordinary goods, the higher the price the higher the quantity supplied, and vice versa.

Let’s see how the supply curve can be built, starting with an individual’s offer, let’s say his name is Robert. Robert is willing to supply books for $10 or more, this is, Robert won’t supply any books for $5 (point a). However, if the price of books goes up to $10, he will be willing to sell one book (point b). If it increases to $15, Robert will sell two books (point c), and so on. By joining all the points (a-g), we’ll get Robert’s supply curve. Notice that the supply curve goes up and seems not to have limits, an assumption made for simplicity’s sake. Of course Robert will have troubles to supply more than a certain amount of books, but let’s keep it simple and not think about the upper end of the supply curve.

Again, the market’s supply curve is just the aggregation of all supply curves from all sellers in a particular market. Let’s say the market for books has only two sellers: Robert and the librarian next door, Gregory. The horizontal sum of Robert and Gregory’s supply curves will give us the market supply:

Equilibrium and market clearing:

The demand and supply curves define the market clearing, that is, where the demand of the products meets its supply. At this point we have what is known as, an equilibrium point, with its corresponding price and quantity of equilibrium.

It is possible for disequilibrium to occur when the amount demanded does not equal the amount supplied. There are a series of scenarios in which this can happen. In situations in which the quantity demanded is higher than the quantity supplied, the market is suffering from an excess demand. When the opposite occurs we will be talking about an excess supply. Prices will have to gradually adjust through different market mechanisms until the equilibrium price is met.

Movements vs. shifts:

When analysing demand and supply and their respective curves, it is important to distinguish between two aspects: movements along curves and shifts in curves.

A movement refers to a change in either the demand or supply curve, which occurs when a change in the quantity is caused by a change in price and vice versa. An increase in the price of a good or service would cause a movement along its demand curve, decreasing the amount demanded. In the case of supply curves, as we previously saw, an increase in price would also increase quantity. It’s important to understand that movement along the curves does never actually change the equilibrium point, as movements along the curves do not affect it. In the adjacent figure we can see a price increase (let’s say, because an increase of VAT), which causes a movement along the demand curve.

Sometimes the market suffers from changes due to a displacement (shift) of the demand and/or the supply curve. This shift in curves will always result in a new market equilibrium. When a shift occurs, the curve moves, meaning that for each price there will be a new different quantity being demanded or offered. This curve shifts can occur in two directions, upwards and downwards, or if preferred, rightwards and leftwards. Depending in what curve we are considering one is equal to another one.

Demand curves may shift for multiple reasons, for example, an increase in the consumers’ level of income would increase the aggregate demand of a normal good for each price, and hence shift the demand curve to the right (left figure). Other examples would include changes in the price of competitors (substitute goods), changes in complementary goods, tastes, expectations, number of buyers, seasonality, etc.  Supply curve shifts may be also motivated by a variety of different reasons, such as input prices: an increase on the price of paper would shift the supply curve to the left, since the same quantity would be sold at a higher price (right figure). Other variables that can shift the supply curve include technological progress, expectations, number of sellers, etc.