The model of supply and demand. Market equilibrium.

Demand is the relationship between the price of a good and the quantity of the good that consumers are willing and able to buy.

Quantity demanded is the total amount of a good that buyers would choose to purchase under given conditions. The given conditions include:

· price of the good

· income and wealth

· prices of substitutes and complements

· population

· preferences

We refer to all of these things except the price of the good as determinants of demand.

The Law of Demand states that when the price of a good rises, and everything else remains the same, the quantity of the good demanded will fall.

A demand curve is a graphical representation of the relationship between price and quantity demanded (ceteris paribus). It is a curve or line, each point of which is a (P, Qd) pair. Each point shows the amount of the good buyers would choose to buy at that price. A change in demand or shift in demand occurs when one of the determinants of demand changes.

Supply is the relationship between the price of a good and the quantity of the good that firms are willing and able to produce and sell.

Quantity supplied is the total amount of a good that sellers would choose to produce and sell under given conditions. The given conditions include:

· price of the good

· prices of inputs (labor, capital, etc.)

· technology

· number of firms in the industry

We refer to all of these, except for the price of the good, as determinants of supply.

The Law of Supply states that when the price of a good rises, and everything else remains the same, the quantity of the good supplied will also rise. Again, the “everything else remains the same” or “ceteris paribus” assumption is important. It means that the determinants of supply --prices of inputs, technology progress, and number of firms --are not changing along a given supply curve.

A supply curve is a graphical representation of the relationship between price and quantity supplied (ceteris paribus). It is a curve or line, each point of which is a (P, Qs) pair. Each point shows the amount of the good firms would choose to produce and sell at that price. Changes in supply or shifts in supply occur when one of the determinants of supply changes.

Market Equilibrium. Putting demand and supply together, we can find an equilibrium where the supply and demand curve cross. The equilibrium consists of an equilibrium price P* and an equilibrium quantity Q*. The equilibrium price is a price that satisfies the market-clearing condition, which is that quantity demanded must equal quantity supplied.

Graphically, this occurs where the supply and demand curves cross.

Changes in Market Equilibrium. Consider first a rightward shift in Demand. This could be caused by many things: anincrease in income, higher price of a substitute good, lower price of a complement good, etc. Such a shift will tend to have two effects: raising equilibrium price, and raisingequilibrium quantity. This is shown in the figure below. The numbers have beenremoved to simplify the picture.A leftward shift of demand would reverse the effects, resulting in a fall in both price andquantity. The general result is that demand shifts cause equilibrium price and equilibriumquantity to move in the same direction.

Now consider a rightward shift of supply (caused by lower input prices, better technology, or entry of new firms). This will tend to have two effects: raising equilibrium quantity, and lowering equilibrium price. This is shown in the figure below, again with the numbers removed for simplicity.