Supply and demand

Because of their importance to the development of economic theory, an appreciation of the significance of the concepts of supply and demand is essential to the understanding of much of the subject-matter of economics. This article seeks to explain their significance in non-technical terms, as well as introducing the lay reader to some of the associated terminology used by economists and providing a simple introduction to the concepts for students of economics.

Definitions of the terms used in the article that are shown in italics can be found on the Related Articles subpage, and a selection of the diagrams and mathematical equations that are conventionally used for teaching purposes can be found on the Tutorials subpage

Overview: origins and applications

The proposition that prices are determined by supply and demand is so familiar that it seems like a statement of the obvious. In fact, it was not generally known, even to eminent intellectuals such as Adam Smith, John Stuart Mill and David Ricardo, until the idea was popularised by Alfred Marshal towards the end of the nineteenth century . Since then it has become universally accepted that demand rises in response to a reduction in price, that supply rises in response to an increase in price, and that price somehow settles to a level where demand is equal to supply. That proposition has come to be been termed "the law of supply and demand" and is often thought to be as firmly established as the law of gravity. In fact it is what Marshall termed "a statement of a tendency", depending upon particular premises about human behaviour, and falling short of a complete explanation of the market mechanism. It has nevertheless survived in general use as a robust statement that reflects widespread experience. In economics, it has served as a tool that has been used in the construction of other theories and has generated a terminology that has been widely used in discussions among economists.

The determinants of demand

Price

The basic premise concerning demand was stated by Marshall as the proposition that "the larger the amount of a thing that a person has, the less ... will be the price which he will pay for a little more of it" - a proposition that is referred to by economists as the "law of diminishing marginal utility". That premise has implications for the price/demand relationship that are discussed on the Tutorials subpage, but the only implication that is necessary to the operation of the law of supply and demand is that demand rises in response to a reduction in price and vice versa. (Among exceptions to this generally-observed behaviour are goods that people prize just because they are expensive - sometimes referred to as Veblen goods in reference to the economist who coined the phrase "conspicuous consumption".) In principle, an increase (or decrease) in the price charged for a product has two effects upon the demand for it: one is to cause consumers to switch their buying from (or to) it to (or from) other products; and the other is to bring about a reduction (or increase) in consumers' incomes with the consequences described in the following paragraph. Those two consequences of a price change are termed the substitution effect and the income effect. From a supplier's viewpoint, the important characteristic of the relationship between price and demand is the percentage increase of demand for a product that would result from a small percentage reduction in its existing price - a quantity known as the price elasticity of demand for the product, and unlike many of the concepts in the theories of supply and demand, that is an empirically measurable quantity.

Income

The missing passage in the above quotation from Marshall's Principles of Economics was his "other things being equal" qualification, and the most important of the other things that have to be taken into account. The effect of general rise in incomes must obviously be a proportionately equal increase in total spending (unless there were to be an increase in the proportion saved), implying a community-wide income elasticity of demand of 1, but within that weighted-average figure there a great variations among the various categories of product. It is common experience, for example, that people spend a diminishing proportion on food as their incomes rise, implying a negative income elasticity of demand (an observation that is sometimes referred to as "Engel's Law") and a correspondingly greater proportion on other products. Reports of nineteenth-century observations concerning the behaviour of people in extreme poverty even suggest that, not only proportional, but total demand for some commodities (known as Giffen goods) could fall in response to a price reduction.