Supply and Demand

EP Research

The most widely utilized concept of Supply and Demand was conceived in 1890 by Alfred
Marshall in Principles of Economics. It built upon the concepts introduced by Adam Smith
and David Ricardo on price determination. Smith introduced the concept of price being
relative to cost of labor so price is constant regardless of quantity produced. Ricardo built
on this concept by adding diminishing returns which implied the price of a good will increase
with the quantity produced to compensate for the increased cost of production per unit.
Marshall’s rendition is often visualized with two curves (or lines) on a 1st quadrant on a
2-dimensional graph as depicted in Figure 1.

P rice
Supply

P∗ e

Demand

0 Quantity
Q∗

Figure 1: Basic Supply and Demand graph.

As with most graphs in economics, the x and y axis are labeled Quantity and Price
respectively, with the two curves being labeled Supply and Demand, respectively. In this
graph the supply curve is meant to signify the producers of goods which reflects the Ricardian
model where price increases positively with quantity. Conversely the demand curve is meant
to represent the consumers which implies that consumer are not willing to pay large sums
of money for a large quantity. The intersection of these two curve is called the equilibrium,

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where the price and quantity are most efficient. The reason it is referred to as the equilibrium
is should the price or quantity deviate, waste is introduced. Quantity is the main way
producers can influence the price, hence if the quantity is lower than the equilibrium quantity,
dead weight loss (DWL) which is lost Total Surplus (Total Surplus (TS) is equal to Consumer
Surplus (CS) plus Producers Surplus (PS))and a shortage of supply as seen with Figure 2. A
larger quantity than equilibrium will result in a surplus of whatever good is being produced.

P rice DWL
Supply CS
PS

P1 A
e
P2 B

Demand

0 Quantity
Q

Figure 2: Supply and Demand with Dead Weight Loss.

These two curves can respectively shift, either to the right or the left. The supply curve
shifts largely due to industrial changes, shocks to the factors of production, which are land,
labor, capital (which is economic jargon for equipment purchased for business operations,
such as computers, machinery, etc...) and entrepreneurship. Most commonly labor and
capital will shift the supply curve the most. Changes to minimum wage, surplus or shortage
in the labor force, artificial changes to cost of materials and/or surplus or shortages in
materials. On the flip side the demand curve changes due to consumer attitudes. The most
common shift occurs due to changes in the income of buyers which can be due to sudden local
changes in the minimum wage or aggregate wages of the population. Second most common
is shift in consumer trends, expectations or tastes which could be related to increases in
popularity for products or competing products such as substitutes.
As an example, assume a firm in the market for cars is experiencing a shortage in a
popular paint color, does the supply or demand curve shift? If so, which way?. In this
example there is no implication that production is stifled in any way. All we can assume
from the question is a popular paint color on a certain cars is no longer available. Production
is not affected. Consumer taste is what is affected in this scenario with the color no longer
being available as such consumer demand falls for people who want that sole color and are

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not willing to get another. This would not completely remove the market but it would
decrease a bit. As a result, the demand curve will shift to the left, this shift results in the
price decreasing slightly as well as the quantity. This is visualized in Figure 3.

P rice
S1

P∗ e1

P 1∗ e2

D1

D2
0 Quantity
Q1 ∗ Q∗

Figure 3: Shift in the Demand curve to the Left.

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In Practice
In the industry, the supply and demand curve is used to predict future trends in a hypo-
thetical scenario to gain an estimate. Yet the Supply and Demand curve does not always
the simplistic model used above. Perfect competition is a scenario in which there are infinite
sellers, hence one since firm is not capable of influencing the price. In this scenario only the
demand curve is capable of only shifting the quantity since all firms are price takers rather
than price maker as with a monopoly situation. This is visualized in Figure 4.

P rice

e S
P∗

0 Quantity
Q∗

Figure 4: Basic Supply and Demand graph under perfect competition.