Principles of Economics/Supply and Demand

The Model

We can apply supply and demand to a graph in the form of curves. Note that in some cases, these curves may be shown as lines instead; this is okay, but not quite as accurate. In such a model, the x axis is the quantity produced and the y axis is the price.

The demand model is concave up because changes in price are more significant when the initial price is less, ie. when the percentage change in price is greater, and hence more able to stimulate a response from buyers. This is often shown with a constant positive slope when linear.

The supply model is concave up because additional units of production rapidly come to cost more. Initially, it drops, because of the fixed-cost-division effect (hence the reason for mass production in modern times). This is also the reason why luxury goods cost so much even though they are clearly not overproduced. The low-quantity-produced section of the supply curve is frequently omitted for simplicity. This curve is often shown with a constant negative slope when linear.

The equilibrium is found at where the supply and demand curves intersect. At this point, allocative efficiency has been reached because everyone who is willing to buy the good at the going price is able to do so, and none who are not willing are able to do so. The equilibrium is the one stable point.

Supply and demand

If you have been following this text chapter by chapter you will have seen where the green supply and blue demand curves came from. Their intersection is the position where the market will produce and trade goods: at the price P* and quantity Q*. Remember that the firm has two minimum production points: one for short run and one for long run. The green point to the right is the long run minimum and hence the most important. Should the demand curve fall so that the intersection lies below that point, the firm will experience losses and shut down if the demand curve does not return to the blue curve shown here.

Total revenue

A firm's total revenue - the accounting profit's income side - is the price of the goods it produces times the quantity sold. In perfect competition all goods produced are assumed to be traded. This is the green shaded area.

Firm's output surplus and loss

So far you have already been introduced to the firm's labor surplus and loss. The firm's output surplus and loss follows a similar line of reasoning. The green supply curve indicates the firm's marginal cost of production, while the horizontal gray line is the price level, so the area between them where the supply curve is lower is the firm's surplus because at that range it can sell units of its good for more than what it costs to produce them. This area is filled green. The area between them where the supply curve is higher is the firm's loss because at that range it can sell units of its good for more than what it costs to produce them. This area is filled red.

If this analysis is done using the long run supply (as it is here), the green and red areas should equal each other, indicating (as is often the case) a firm that has zero economic profit. If this analysis is done using the short run supply, the red area will be exactly fixed costs' area greater than the green area.

Most textbooks refer to a general producer surplus that is the green area minus the red area. In that case it is simply not considering expenses. This is often the case in simplified micro-econ textbooks in which the supply curve is a straight line (which is not the case in real life).

Consumer surplus

The consumer surplus, by comparison, is the area between the demand curve and the price level, as explained in an earlier chapter on demand. There is no consumer loss, because consumers would not buy at that point. Beyond the equilibrium point, there is no consumer surplus, producer surplus, or producer loss because those points are not reached in practice; however, in theory they could be reached, in which case one merely has to extrapolate.

Surplus and Shortage

If at any time a product's price is not what it should be at equilibrium, there will be a pressure to restore it.

If the price is too high, suppliers will be willing to produce more than what would be allocatively efficient, while demanders will buy less than they would at the (cheaper) equilibrium price, causing a surplus. The increased stocks in the warehouses cause suppliers to drive price down.

If the price is too low, suppliers will be willing to produce fewer than is optimal because their marginal costs are higher than their marginal profits beyond that point. Meanwhile, demanders will want to buy more than would be efficient because the price is too low to adequately reflect the value (utility) of the good. Many demanders will be unable to obtain the good, causing a shortage. Producers see this and produce more at higher prices, expecting to be able to rise the price due to the excess demand and so still manage to break even.