Supply and Demand: A Model of a Competitive Market

Cotton sellers and cotton buyers constitute a market—a group of producers and consumers who exchange a good or service for payment. In this chapter, we’ll focus on a particular type of market known as a competitive market. Roughly, a competitive market is a market in which there are many buyers and sellers of the same good or service. More precisely, the key feature of a competitive market is that no individual’s actions have a noticeable effect on the price at which the good or service is sold. It’s important to understand, however, that this is not an accurate description of every market.

For example, it’s not an accurate description of the market for cola beverages. That’s because in the market for cola beverages, Coca-Cola and Pepsi account for such a large proportion of total sales that they are able to influence the price at which cola beverages are bought and sold. But it is an accurate description of the market for cotton. The global marketplace for cotton is so huge that even a jeans maker as large as Levi Strauss & Co. accounts for only a tiny fraction of transactions, making it unable to influence the price at which cotton is bought and sold.

It’s a little hard to explain why competitive markets are different from other markets until we’ve seen how a competitive market works. So let’s take a rain check—we’ll return to that issue at the end of this chapter. For now, let’s just say that it’s easier to model competitive markets than other markets. When taking an exam, it’s always a good strategy to begin by answering the easier questions. In this book, we’re going to do the same thing. So we will start with competitive markets.

When a market is competitive, its behavior is well described by the supply and demand model. Because many markets are competitive, the supply and demand model is a very useful one indeed.

There are five key elements in this model:

• The demand curve
• The supply curve
• The set of factors that cause the demand curve to shift and the set of factors that cause the supply curve to shift
• The market equilibrium, which includes the equilibrium price and equilibrium quantity
• The way the market equilibrium changes when the supply curve or demand curve shifts

To understand the supply and demand model, we will examine each of these elements.