The first step in a demand-and-supply analysis of the market for a product is to determine the demand for the product.
A product's demand curve shows how much of the product consumers and firms want to buy at each possible price, holding fixed all other factors that affect demand.
The demand function for a product is a formula of the form Quantity Demanded = D(Price, Other Factors). It gives the total demand for the product at every possible combination of its price and other factors.
A change in a product's price leads to a movement along its demand curve. A change in other factors leads to a shift in the entire demand curve.
Supply
The second step in a demand-and-supply analysis of the market for a product is to determine the supply of the product.
A product's supply curve shows how many units sellers of the product want to sell at each possible price, holding fixed all other factors that affect supply.
The supply function for a product is a formula of the form Quantity Supplied = S(Price, Other Factors). It gives the total supply of the product at every possible combination of its price and other factors.
A change in a product's price leads to a movement along its supply curve. A change in other factors leads to a shift in the entire supply curve.
Market equilibrium
Once we know the demand and supply in a market, the next step is to determine the equilibrium price—the price at which the demand and supply curves intersect, so that the amounts supplied and demanded are equal. That price can be found graphically or algebraically.
Market prices tend to adjust to equate the amounts demanded and supplied. If there is excess demand then some buyers will have an incentive to raise the price they offer in order to acquire their desired quantity. If there is excess supply, then some sellers will have an incentive to lower the price in order to sell their desired quantity. These processes tend to restore the balance between supply and demand.
To determine how a change in market conditions, such as a change in the price of an input or a shift in consumer preferences, will change the price and the amount bought and sold, we solve for the market equilibrium before and after the change.
Changes that increase demand (shifting the demand curve to the right) raise the price and the amount bought and sold; changes that decrease demand lower them. In contrast, changes that increase supply (shifting the supply curve to the right) raise the amount bought and sold but lower the price; changes that decrease supply have the opposite effect.
If both the demand curve and supply curve shift and each would individually increase the price, the overall effect is to increase the price. If the two effects work in opposite directions, the overall effect is ambiguous. The same principle applies to changes in the amount bought and sold.
When demand or supply increases, shifting the demand or supply curves, the size of the change in price and the amount bought and sold depends on how much the curve shifts and on the steepness of the nonshifting curve. The steeper the nonshifting curve, the greater the change in the equilibrium price and the smaller the change in the amount bought and sold.
Elasticities of supply and demand
The elasticity of one variable, Y, with respect to another, X, measures how responsive Y is to a change in X. It equals the percentage change in Y divided by the percentage change in X, or equivalently, the percentage change in Y for each 1 percent increase in X.
The (price) elasticity of demand at a given price P, denoted Ed, measures the percentage change in the amount demanded for each 1 percent increase in its price, for small price changes. The elasticity of demand is typically a negative number.
The elasticity of demand is calculated using the formula Ed= (P/Q)/(ΔP/ΔQ). For a linear demand curve of the form Qd= A - BP, (ΔP/ΔQ) equals -(1/B), the slope of the demand curve. For a nonlinear demand curve, it equals the slope of the demand curve at the partcular price P (which equals the slope of the line that is tangent to the curve at that point).
Demand is inelastic at price P when the elasticity of demand is closer to zero than -1 (Ed >-1). It is elastic at price P when the elasticity of demand at that price is further from zero than -1 (Ed<-1). It is perfectly inelastic when the price elasticity of demand is zero, and perfectly elastic when the price elasticity of demand equals negative infinity.
When demand is elastic, a small price increase causes total expenditure to fall. When demand is inelastic, a small price increase causes total expenditure to rise. Total expenditure is largest at a price at which the elasticity of demand equals -1.
The price elasticity of supply at a given price P, denoted Es, measures the percentage change in supply for each 1 percent increase in price.
Supply is inelastic when the price elasticity of supply is closer to zero than 1 (Es< 1). It is elastic when the price elasticity of supply is further from zero than 1 (Es>1) . Supply is perfectly inelastic when the elasticity of supply is zero, and perfectly elastic when the elasticity of supply is infinite.
For small shifts in the demand curve, the less elastic the supply curve at the equilibrium price, the larger the price change and the smaller the change in the amount bought and sold. For small shifts in the supply curve, the less elastic the demand curve at the initial equilibrium price, the larger the price change and the smaller the change in the amount bought and sold.
Economists also study elasticities of a product's demand or supply with respect to other factors, such as income (for demand), the prices of other products (for demand and supply), and input prices (for supply).
