In this lesson students will:
- understand the assumptions required in order to impose a linear supply and demand model for an economy
- explain the main premises of linear supply and demand curves from both the perspective of the consumer and the producer
- determine an equilibrium solution, given a supply and demand curve
- explain how sudden increases or decreases to price might affect the consumer or producer
- explain how a non-price fluctuation to the economy might affect the equilibrium point of a given market
Introduction to Microeconomics
The results of this chapter’s discussion follow from a few initial assumptions about how producers and consumers act within our market system. In reality, these assumptions may or may not be valid, in which case the model that you will use may vary. For now, we introduce the basic linear model for supply and demand; and this model assumes the following:
- (Assumption of Large Numbers) The actions of a single producer or consumer have little impact on the economy as a whole.
- (Assumption of Perfect Information) Everyone involved in the economy has relevant information. All actions are based on this knowledge.
- (Assumption of Product Homogeneity) All products from all producers are identical.
- (Assumption of Mobility) Resources can be easily moved from one location to another at any time.
- (Assumption of Independence) Decisions made by individuals are independent of the decisions made by others.
With these assumptions in place, we introduce the linear supply and demand model.
Supply and Demand Curves
Think about an item that you really like. What might be your reaction if the price of that item went up? What might be your reaction if the price of that item went down? For most consumers, as the price of a desired item increases, their willingness to purchase that item decreases. However, if they see a price decrease, they might be more willing to purchase the desired item. For example, if the price of a Pumpkin Spice Latte at Starbucks went on sale, I might be more inclined to buy it; however, if the price of the latte increased suddenly, I might be tempted to go elsewhere for my daily caffeine fix. This makes up the premise for the linear demand curve of an item.
To understand the linear supply curve, we have to think in the mindset of a producer of the desired item. If a particular item has a high selling price, we might be more inclined to produce more of this item; however, if the same item saw a drastic decrease in the selling price, we might be less inclined to produce more of that item. In other words, think from the perspective of revenue – the less revenue per item we are able to bring in as a producer leads to a lower production level of that particular good.
Notice that the linear supply and demand curves are opposite to each other; that is there is a constant tug-of-war between the consumers and producers. Consumers generally want to purchase more goods at a lower price point, yet producers only want to increase production as prices increase for a particular good. Overlapping our supply and demand curves shows us that the lines will intersect at a single point. This point is called the equilibrium point of the market. At this point the number of items produced and consumed is equal. This is also the point at which the selling and purchase prices of an item is the same. We typically label the equilibrium point as , where is a number that represents the equilibrium quantity and is a number that represents the equilibrium price.
In chapters BM1.7 and BM1.8 we saw how to use algebra to graph two lines and find their intersection point. The video below will use the strategies from those lessons to determine the equilibrium point of given economy that can be modelled using the methods from above.
Excess, Shortage & Shocks
The equilibrium solution is a stable solution in our given economy. That is, no matter the starting price or production level of the good, eventually over time the production level will settle down to and the price per item will settle down to . This doesn’t mean that a producer may not try to alter the price or production level of a particular item. In fact, there are many interactions that may occur in a given market:
- The producer may suddenly increase or decrease the price of a good causing the market to move away from the equilibrium price for a period of time.
- An error in inventory tracking might cause the market to move away from the equilibrium quantity for a period of time.
- A single non-price fluctuation may cause a shift in the supply or demand curves.
- Multiple non-price fluctuations may occur over a period of time.
Whatever might happen in the market, it is important to review the change from both the perspective of the consumer as well as the producer. There are two common scenarios when either the price or quantity suddenly change. A shortage of goods occurs when the quantity of items purchased by the consumers is higher than the quantity of items produced by the producer. In the opposite scenario, when the production level is higher than the consumption level, market excess occurs – there is an overabundance of goods. Whenever non-price fluctuations cause the supply or demand curve to shift, this is called a shock to the market.
The two videos below will walk you through examples of a shortage/excess, as well as a market experiencing a shock. In the first scenario we will analyze from both the perspectives of the consumer and producer. In the second, we will pay more attention to how the equilibrium point changes.