Now, it is time for the fundamental model of all economics!

The supply and demand model allows us to determine how much of good will be sold and at what price it will be sold in the market under given conditions. It works well for most markets. Mathematically, we achieve this end by finding relations between price and quantity for both buyers and sellers. We expect that buyers will want to buy more when the price is lower, while sellers will want to sell more when the price is higher. We then find the equilibrium price and quantity, where the price is such that buyers want to buy exactly as much as sellers want to sell.

—-

For this post, let’s find a relationship between price and quantity for buyers. We assume that other factors that might affect how much of a good buyers would like to buy (quantity demanded) are held constant. Such factors include tastes, income, how much information buyers have about the good, and government policy.

Let us consider watermelons.

These numbers are all made up, by the way. This line is a demand curve, a depiction of how quantity demanded changes with price. We can see on the graph that 24 watermelons are purchased if the price is \$3, while 15 are sought if the price is \$4. If the price changes and there is a corresponding change in quantity demanded, we say that we’ve “moved along the demand curve.”

A tangent regarding notation: You may be used to seeing x on the horizontal axis and y are the vertical axis, where x determines y — this convention holds across math and science for the most part. For example, if we were looking at a function, we would ordinarily put the value that goes into the function on the horizontal and the value that comes out on the vertical. However, economics does things differently, and I have no idea why. It’s a silly convention, but unfortunately it is widespread. Quantity (or sometimes quantity per unit time) is on the horizontal, price is on the vertical, but price determines quantity, not the other way around.

The demand curve for all buyers is built from the demand curves of each individual buyer.

Here is what an individual demand curve might look like. Jane, our hypothetical consumer, is very keen on having at least a single watermelon and will buy one if the price for watermelons is between \$6 and \$4 . She’ll buy a second and third watermelon as well, provided that the price is low enough. Between \$4 and \$2, she buys two watermelons, and at \$2 or less, she buys three. Beyond the third, she doesn’t want any more (for any positive price, at least). By adding up many individual “stair step” curves that are all a little different from one another, you can imagine how a fairly smooth curve would be built, approximating the line above.

Implicit in the slope of that line I have chosen for my example is the assumption that as price falls, buyers demand more of a good. This assumption is important in economics, earning the title Law of Demand. According to this “law,” if other factors affecting demand are held constant, demand curves slope downward. This law isn’t quite ironclad; one could contrive an example of a good where its value to buyers increases with price.

Of course, economists also wonder what happens when other factors are varied. Such a variation results in a “shift of the demand curve” (as opposed to “movement along…”). If, say, the price of cantaloupes were to fall, then at any given price for watermelons, we would expect quantity demanded to be less than before (since canteloupe is a decent substitute for watermelon and some consumers will switch over to the now-cheaper cantaloupe). The same effect might result if consumers began to dislike watermelons, if the government put a tax on them, or if it was discovered that they are bad for your health.

Here, a \$1 reduction in the price of cantaloupe causes consumers to buy fewer watermelons at any given price for watermelons. In other words, the demand curve for watermelons shifts to the left. (Sometimes a shift in this direction is called a shift inwards, a shift downwards, or a decrease in demand.) After the shift, a price of \$3 elicits demand for 18 watermelons, while a price of \$4 corresponds to a mere 8.

In the next post, we’ll look at how price and other factors affect the quantity of a good that sellers are willing to sell and, finally, put it all together to determine price and quantity based solely on those other factors.

Edited: 12/15/07