Economists use models to analyze markets. Models employ simplifying assumptions to reduce the incredible complexity of the real world so that general insights can be learned. The supply and demand model is one of the most used analytical frameworks in economics. This model makes several assumptions about the market that is being analyzed, including that all goods bought and sold in the market are identical, they are all sold for the same price, and there are many producers and consumers in the market. [Section 2.1]
Demand describes the willingness of consumers to purchase a product. There are many factors that affect demand, including price, income, quality, tastes, and availability of substitutes. Economists commonly use the concept of a demand curve, which essentially divides these factors into two groups: price and everything else. A demand curve relates consumers’ quantity demanded to the price of the good while holding every other factor affecting demand constant. A change in a good’s price results in a movement along a given demand curve. If nonprice factors change, the quantity demanded at every price changes and the whole demand curve shifts. [Section 2.2]
Supply describes the willingness of producers to make and sell a product. Factors that affect supply include price, available production technologies, input prices, and producers’ outside options. Supply curves isolate the relationship between quantity supplied and price, holding all other supply factors constant. A change in a good’s price results in a movement along a given supply curve. If nonprice factors change, the quantity supplied at every price changes and the whole supply curve shifts. [Section 2.3]
Combining demand and supply curves lets us determine the market equilibrium price, which is where quantity demanded equals quantity supplied. This equilibrium can be determined because demand and supply curves isolate the relationships between quantities and the one factor that affects both demand and supply: price. At the equilibrium, every consumer who wants to buy at the going price can, and every producer who wants to sell at the current market price can as well. [Section 2.4]
Changes in the factors (other than price) that affect demand or supply will change the market equilibrium price and quantity. Changes that increase demand and shift out the demand curve will raise equilibrium price and quantity in the absence of supply shifts; when the changes decrease demand and shift the demand curve in, price and quantity will fall. Changes that increase supply and shift out the supply curve, assuming no change in the demand curve, will increase equilibrium quantity and reduce price. Changes that decrease supply and shift in the supply curve decrease quantity and raise price. [Section 2.4]
If both supply and demand shift, either the effect on equilibrium price or the effect on equilibrium quantity will be ambiguous. If supply and demand move in the same direction, equilibrium quantity will follow, but the impact on price is unknown. On the other hand, if supply and demand move in opposite directions, equilibrium price will move in the same direction as demand (increase when demand rises, fall when demand decreases), but we cannot say with certainty what the effect on equilibrium quantity will be. [Section 2.4]
Economists typically express the sensitivity of demand and supply to various factors, but especially price, in terms of elasticities. An elasticity is the ratio of the percentage changes in two variables. The price elasticity of demand is the percentage change in quantity demanded for a 1% change in price, and the price elasticity of supply is the percentage change in quantity supplied for a 1% price change. [Section 2.5]
Other common demand elasticities measure the responsiveness of quantity demanded to changes in income and the prices of other goods. The income elasticity of demand is positive for normal goods and negative for inferior goods. The cross-