Back to Basics: Supply and Demand

• Author: Irena Asmundson
• Position: an Economist in the IMF's Strategy, Policy, and Review Department.

THREE little words. Often that is all it takes to make one’s heart beat faster. “Liberty, equality, fraternity” captured the French Revolution. “I love you” underpins many a successful relationship. “Life, liberty, happiness” are at the heart of the U.S. Declaration of Independence. For many economists, those three magic words are “supply, demand, price.”

In any market transaction between a seller and a buyer, the price of the good or service is determined by supply and demand in a market. Supply and demand are in turn determined by technology and the conditions under which people operate. At one extreme, the market could be populated by a large number of virtually identical sellers and buyers (for example, the market for ballpoint pens). At the other extreme, there might be only one seller and one buyer (as would be the case if I want to barter my table for your quilt).

Perfect competition

Economists have formulated models to explain various types of markets. The most fundamental is perfect competition, in which there are large numbers of identical suppliers and demanders of the same product, buyers and sellers can find one another at no cost, and no barriers prevent new suppliers from entering the market. In perfect competition, no one has the ability to affect prices. Both sides take the market price as a given, and the market-clearing price is the one at which there is neither excess supply nor excess demand. Suppliers will keep producing as long as they can sell the good for a price that exceeds their cost of making one more (the marginal cost of production). Buyers will go on purchasing as long as the satisfaction they derive from consuming is greater than the price they pay (the marginal utility of consumption). If prices rise, additional suppliers will be enticed to enter the market. Supply will increase until a market-clearing price is reached again. If prices fall, suppliers who are unable to cover their costs will drop out.

Economists generally lump together the quantities suppliers are willing to produce at each price into an equation called the supply curve. The higher the price, the more suppliers are likely to produce. Conversely, buyers tend to purchase more of a product the lower its price. The equation that spells out the quantities consumers are willing to buy at each price is called the demand curve.

Demand and supply curves can be charted on a graph, with prices on the vertical axis and quantities on the horizontal...