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Demand and Supply

Demand and Supply

I. GeneralKenneth E. Boulding

BIBLIOGRAPHY

II. Econometric StudiesKarl A. Fox

BIBLIOGRAPHY

I GENERAL

The idea that prices are dependent in some way on demand and supply is very old. Long before the development of theoretical economics, it was understood that a large supply would cause a fall in price and a large demand would cause a rise in price. A good deal of economic theory revolves around the clarification and quantification of this simple idea.

Adam Smith distinguished carefully between demand and desire and defined effective demand essentially as the quantity that would be purchased at a given price. He had a clear conception of what today we would call “equilibrium,” or “normal/’ price, which he called “natural price”—the price at which just enough would be forthcoming from the suppliers onto the market to equal the effective demand at that price. If the price in the market were above the natural price for a given commodity, there would be unusual incentives to produce this commodity and bring it to market, and the quantity offered for sale would increase.

If the amount coming onto the market were larger than the effective demand, that is, the amount taken off the market, the price would fall. Similarly, if the price in the market were below the natural price, there would be a diminished incentive to produce the commodity and bring it to market; hence the amount coming onto the market would decline, and if this were less than the effective demand, the price would rise. Much of the development of the theory of demand and supply since Adam Smith can be regarded as a clarification and elaboration of the fundamental principles that he enunciated.

Functions and curves

The next major development in the theory of demand and supply was the development of the concept of demand and supply functions and curves, associated mainly with the name of Alfred Marshall, although a Scottish economist, Fleeming Jenkin, is usually credited with the first formulation of these concepts. In its simplest form the demand function is a function relating the quantity demanded to the price of the commodity. The supply function similarly relates the quantity supplied to the price. When only these two variables are involved, the functions can be expressed as demand and supply curves in a two-dimensional diagram, as in Figure 1. The quantity of the commodity demanded or supplied is measured along the horizontal axis and the price is measured along the vertical axis. DD’ is the demand curve; SS’ is the supply curve. Figure 1

shows the most typical forms of these curves. In the case of demand, there is some price OD at which nothing will be bought at all. At a zero price, a finite quantity OD’ will be bought; this represents the point of satiation. The supply curve is drawn so that there is some price OS below which nothing will be offered and above which, as the price rises, a larger quantity will be supplied.

For many purposes it is convenient to describe the demand and supply curves in terms of parameters, that is, a set of numbers that is sufficient to identify each point on them. The simplest assumption is that of linearity, that is, that the demand and supply curves are straight lines. In this case the equations may be written:

(1)qd= d + edpd,
(2)qs= s + esps,

where qa is the quantity demanded, q3 is the quantity supplied, pd is the price at which each quantity is demanded, and p3 is the price at which each quantity is supplied. Each curve or function can then be described by only two parameters. In the case of demand, d measures what might be called the height or extent of demand and is equal to OD in Figure 1; ed may be called the absolute elasticity of demand, which in Figure 1 is negative. It measures the absolute change in the quantity demanded, which would result from a unit change in the price. In Figure 1 the slope or the gradient of the curve DD′ at any point is the “inelasticity,” l/ed. Similarly the parameter s, equal to OS in Figure 1, is a measure of the height or extent of the supply, and the parameter 1/es is the absolute elasticity of supply, which measures the change in the quantity supplied for each unit change in the price. Again, l/es represents the slope of the curve SS′.

Elasticity

The term elasticity was introduced into economic analysis by Alfred Marshall, the analogy being the elasticity of a spring. In an elastic spring, a given increase in the weight exerted produces a large increase in the length of the spring; similarly, if either demand or supply is elastic, a given increase in the price produces a large increase in the quantity demanded or supplied. Another name that might be given to this concept is responsiveness, the quantity demanded or supplied being thought of as responding more or less eagerly to a change in the price. Marshall himself did not use the absolute elasticity concept but a concept of relative elasticity, defined as the proportionate change in quantity divided by the proportionate change in the price, or:

(3)ε = dq/q dp

He apparently did this because it is a dimensionless parameter, that is, a number that is independent of the units in which the quantity or the price are measured. A demand or supply curve of constant relative elasticity would be a straight line on double-logarithmic paper. There is no reason to suppose in fact, however, that these functions are more likely to be logarithmic than linear in absolute terms, and for many purposes the absolute concepts are preferable. A logarithmically linear demand curve with constant relative elasticity, for instance, would not intersect either axis in Figure 1, implying that the price would have to be infinite before cutting off purchases altogether and that at a zero price an infinite quantity would be taken. This clearly is absurd. In practice, more than two parameters are often needed to describe demand and supply functions, but there are only a few problems in which the departure from linearity seems to have much economic significance. However, it is reasonable to suppose that there are eventual limitations on increasing the quantity supplied that cannot be overcome by a rise in price, so that the supply curve will become less elastic at high prices, as in Figure 1. It is possible also that a similar condition applies to demand. The simplest equation that can be used to express this condition is a quadratic form. [SeeElasticity.]

Equilibrium. The equilibrium position of the system of Figure 1 is assumed to be the point P, where the demand and supply curves intersect and where PN is the equilibrium price and ON is the equilibrium quantity. Any equilibrium, however, must be seen as a special case of a dynamic system, and in this case there are at least two different dynamic systems that have this point of equilibrium. The first, associated particularly with Adam Smith and Alfred Marshall, is that in which the difference between the demand price and the supply price, leading to changes in quantity supplied, is the principal motivating factor of the dynamic system. The demand price of a given quantity is that price at which the quantity can be sold in the market; thus a point on the demand curve such as D1, indicates that the quantity OQ1 can be sold at the price Q1P1 . The supply price is the price that will call forth a particular quantity. Thus, if S1 is a point on the supply curve, Q1S1 is the price that could call forth an amount OQ1. If then the quantity coming to market is OQ1, when the demand price is in excess of the supply price by an amount D1S1, this means that the actual price received by the sellers, Q1D1, is greater than the price that would motivate them to produce the quantity involved, Q1S1. They are therefore receiving excessive returns, and the assumption is that this will motivate them to expand the quantity offered for sale, as indicated by the arrow Al. Similarly, if the quantity coming on the market is OQ2, which is larger than the equilibrium quantity ON, the demand price, which is the actual price received, will be below the supply price; the suppliers will receive less than is necessary to persuade them to put this quantity on the market, and the amount coming to market will decline. In the circumstances of Figure 1 it is clear that P is a stable equilibrium, for if the quantity is below ON it will increase; if it is above ON it will diminish.

Another approach to the problem of the equilibrium of demand and supply, associated typically with the names of Léon Walras and J. R. Hicks, interprets the demand curve as showing the quantity that will be bought at each price and the supply curve as indicating the quantity that will be sold at each price, with equilibrium achieved through price change. That is, at a price of P1, the quantity that would be bought is P1D1, the quantity offered for sale is P1S3, and there is a “surplus,” or excess supply, equal to D1S3. This is the amount that is being offered for sale but that can find no buyers. Under these circumstances it is supposed that some sellers will offer the commodity for sale at a lower price; and if the market is competitive, the prices in all transactions will fall correspondingly. If, therefore, there is a surplus, the price will fall in the direction of the arrow A2. Similarly, if the price is below the equilibrium price, equal say to P2, the quantity that the buyers wish to purchase, P2D2, is greater than the amount offered for sale, P2S1, and there is an excess demand equal to S1D2. Under these circumstances there are unsatisfied buyers who wish to buy at the price but who cannot find sellers; they will offer to buy at a higher price, causing the price to rise, as indicated by the arrow A3. Here again the point P is an equilibrium price, for if the actual price is above NP it will fall; if it is below NP it will rise.

These different dynamic systems do not affect the position of stable equilibrium itself as long as the demand and supply curves have elasticities of opposite signs. However, if the two curves slope in the same direction, as in Figure 2, we are in serious trouble. Here we show a demand curve DD′ and a negatively elastic supply curve SS′ intersecting in three places, P1, P2, and P3. In terms of the Smith-Marshall dynamics, P1 and P3 are stable positions of equilibrium; P2 is unstable. At quantities smaller than implied by P1, the demand price exceeds the supply price and hence the quantity will expand toward P1. Between P1 and P2 the supply price exceeds the demand price and the quantity will contract toward P1 again. Between P2 and P3 the demand price exceeds the supply price and the quantity will expand toward P3. Thus any divergence around P2 is extended in the initiated direction. At quantities larger than implied by P2, the supply price exceeds the demand price and the quantity will contract toward P3 .

If, on the other hand, we look at the equilibrium from the Walras–Hicks point of view, we see that now P2 is the stable position of equilibrium and P1 and P3 are unstable. At prices above P1, there is excess demand and the price will rise still further. Between P1 and P2 there is excess supply, and the price will fall toward P2 . Between P2 and P3 there is again excess demand, and the price will rise toward P2 . Below P3 there is excess supply and the price will fall away from P3 .

The full resolution of this problem requires an investigation of the dynamics of the price system that we cannot pursue here. In the real world, these dynamic factors, of course, operate simultaneously. Shortages create pressure for prices to rise, surpluses for prices to fall. Excess demand-prices create pressure for production to increase, excess supply-prices for production to diminish. Circumstances can be postulated in which there are no stable equilibrium sets of prices and quantities. These circumstances are fortunately somewhat unlikely. There have been occasions, such as in the depression of the 1930s or in hyperinflations, in which the relative price system seemed to suffer a real breakdown. These occasions, however, have always been associated with profound disturbances in the absolute level of money prices and incomes; there are no clear examples of the inability of a

relative price system to move toward an equilibrium in the absence of monetary breakdown.

The demand and supply functions have different meanings, depending on the period of time to which they refer and the nature of the system that they are intended to describe. They may be used either to describe the forces underlying the determination of a price in a market on a particular day, in which case they are usually called “market demand and supply curves,” or they may be used to describe the forces determining a “normal” price, toward which the market price may tend.

Market curves. In the theory of market price, it is supposed that there is no production or consumption and the stocks of money and other exchangeables in the hands of the marketers remain constant during the “market day.” The market demand and supply functions are then psychologically based, describing the state of mind of the people in the market. The market demand curve shows how much would be offered to purchase at each price; the market supply curve shows how much would be offered for sale at each price. In the course of the day in the market as a whole, the equilibrium market price is that at which the market is “cleared,” that is, at which the quantity offered for sale is equal to the quantity offered to purchase. Here it is the shortage–surplus dynamic that clearly dominates the scene. The use of market demand and supply curves to describe the equilibrium of the market may be criticized on the grounds that in this case the two curves are not independent. For instance, a psychological change in the market that makes people more eager to buy will also make them less eager to sell. In other words, the same change will move the market demand curve to the right and the market supply curve to the left. If these moves are similar in extent, the price will rise without any change in the quantities exchanged. If on the other hand there is a decrease in the “divergence” in the market, that is, the degree to which the market is separated into buyers and sellers, people will be both more eager to buy and more eager to sell at each price. The market demand curve and the market supply curve will both move to the right, and the quantity of transactions will increase; the price will not change. Even though we recognize that market demand and supply curves are not independent, they still can be a very useful method, among others, of exposition and analysis of changes in the market.

Normal curves. Normal demand and supply curves refer not to the equilibrium of the market but to the equilibrium of production and consump tion. For each price, the normal demand curve shows what will be the amount consumed in the period under consideration. The normal supply curve likewise shows for each price what would be the quantity produced. At the point of intersection of the two curves, production is equal to consumption and also demand price is equal to supply price, that is, the production of the commodity is normally profitable. The position and shape of the curves will depend on the period of time that is considered. Generally speaking, the shorter the period of time under consideration, the more inelastic will be the demand and supply curves. In very short periods, a change in price will have little effect on the quantity produced, although it may have some effect on the quantity consumed. As we move to longer and longer periods, both production and consumption are more likely to make more adjustments, and the demand and supply curves will become more elastic.

Derivation of functions

A good deal of price theory is devoted to the derivation of demand and supply functions from the underlying functions that determine them. Supply functions are derived from the structure of cost functions, which in turn are derived from production functions. Demand functions are derived from preference functions. In the case of market demand and supply, both demand and supply curves are derived from the preferences of people in the market. Thus in Figure 3 we show the situation of a single marketer, let us say in the wheat market. In the upper part of the figure, we measure his stock of wheat along OW and his stock of money along OM. The point A represents his initial position, with a stock of wheat equal to ON and a stock of money equal to NA. The dashed lines are his indifference curves, each one showing a set of combinations of stocks of wheat and money to which he is indifferent. They may be thought of as the contours of a utility, or preference, “mountain” above the plane of the paper. In a perfect market, his exchange opportunity is represented by a straight line through A, the slope of which is equal to the price. Thus if the price of wheat is equal to OM1,/OW1, his exchange opportunity is represented by the line M1,W1, through A. He will look for the point on this exchange opportunity line that has the highest utility, which is the point at which it touches his highest attainable indifference curve, in this case at B1 . At this price, therefore, he will move from A to B1, meaning that he will buy an amount of wheat equal to NN1 for an amount of money equal to AC1. At a higher price the exchange opportunity line would be M2,W2, and he would move to B2, selling an amount of wheat equal to NN2 for an amount of money equal to C2B2. At a priceOM0/OW0, the exchange opportunity line is M0W0 and the marketer will neither buy nor sell. The locus of points such as B1 and B2 lies on the heavy curve through A, B1, B2. For each price, then, we can identify the quantity that the marketer will either buy or sell. This is shown in the lower part of Figure 3, in which price is measured on the vertical axis and quantity on the horizontal axis, reflecting the situation in the upper part. At a price equal to na, equal to OM0/OW0, the marketer will neither buy nor sell anything but will remain in his initial position. At a price equal to n2b2, equal to

OM1OW1, he will buy an amount equal to nn2, At a price equal to n1b1, equal to OM2OW2, he will sell an amount equal to nn1. The curve b2ab2, is then his market demand–supply curve, the section ab2 being his market demand curve and section abl being his market supply curve. If we summed these for all the marketers, we would get the total market demand and supply curves.

The problem of constructing normal demand and supply curves from the determining functions is more difficult. A simple model of normal supply can be derived if we suppose that we can identify the amount that will be produced at each level of average cost. Thus in the milk industry we might suppose that no milk is produced at an average cost below, say, 15 cents per gallon, that 10,000 gallons is produced at an average cost of 15 cents, 50,000 gallons at an average cost of 16 cents, 100,000 gallons at an average cost of 17 cents, and so on up the scale. If now the price is below 15 cents, no milk will be produced at all. At 15 cents, 10,000 gallons will be produced, at 16 cents, 60,000 gallons, at 17 cents, 160,000 gallons, and so again we go up the scale, cumulating the amounts that will be produced at all costs below the price in question. The supply curve is then seen to be the cumulative frequency distribution of those average costs that Marshall called “particular expenses.” The situation is complicated by the fact that different firms produce different quantities at different average costs. Essentially, however, a point on the supply curve indicates the quantity that can be produced at costs equal to or below the price indicated. These cost functions in turn are determined by the production functions, which show how much of the commodity can be produced with given amounts of input. The total cost of producing a given quantity is equal to the sum of the values of the inputs needed to produce it, and the value of each input is equal to its quantity multiplied by its price. Demand is related in a complex way to the preferences and incomes of consumers and the prices of substitute or complementary commodities.

Use of functions

Demand and supply functions are useful mainly in problems involving comparative statics [seeStatics and dynamics in economics], that is, in the comparison of one position of equilibrium of the price system with another such position after change in the parameters that determine the equilibrium of the system.

Parametric change. Thus, suppose we have a “rise in demand,” meaning by this a movement of the whole demand curve to the right, indicating that people are willing to buy more at each price

than they were before. The effect of this rise depends on the elasticity of supply, as shown in Figure 4. Here we suppose that DD’ is the original demand curve and D1D1 the dashed line, is the new demand curve after the rise in demand. P0 is the original equilibrium price. If the supply curve is perfectly inelastic, such as P0Sa, there will be a rise in price to Pa but no change in the quantity. If the supply curve is perfectly elastic, such as P0SC, there will be an increase in the quantity from P0 to Pc but no change in the price. In the intermediate situation, such as a supply curve P0Sb, the new equilibrium will be Pb, where there is some increase in the quantity and some increase in the price. The more elastic the supply curve, the greater the increase in the quantity, the smaller the increase in the price. If the supply curve is negatively elastic, such as P0Sd, there will be a decline in the price as a result of the increase in demand. Similarly we can show that the effect of an increase in supply, that is, a movement of the supply curve to the right, indicating that people will offer or produce larger quantities at a given price, depends on the elasticity of demand. The more elastic the demand, the greater the change in quantity and the less the change in price. These propositions, simple as they are, are of great importance in many branches of economics. They throw light, for instance, on the question as to why an increase in the money supply produces price and wage increases under some circumstances and produces increases in output and employment under other circumstances.

Tax and tariff incidence. Another important application of demand and supply curves is in the theory of the incidence of taxes and tariffs. The effect of a tax is shown in Figure 5. Suppose that DD′ and SS′ are the demand and supply curves, with an initial equilibrium at the point P. Suppose

now that a tax is imposed equal to TdTs. In equilibrium the demand price must now exceed the supply price by this amount, since a tax is, in effect, an addition to the cost of production. The output of the commodity will therefore decline from ON to ONS, at which point the required condition is fulfilled. The more elastic the demand and supply curves, the greater the reduction in output. The more elastic the demand, the less the increase in the demand price; the more elastic the supply, the less the decline in the supply price. That is, the relative incidence of the tax as between demanders and suppliers depends on the relative elasticity of the two demand and supply functions. The yield of the tax is equal to the tax per unit of commodity, TdTs, multiplied by the total output, ONS, that is, the shaded rectangle in the figure. This will clearly exhibit a maximum value at some point, so that if the tax is higher than at this point, a reduction in tax will actually increase the yield. The incidence of tariffs may be examined in like manner and be shown to depend on the elasticities of demand and supply curves in various countries.

The general rule that emerges is that in any such situation the most adjustable variable adjusts. When supplies and demands are inelastic, this indicates that price is more adjustable than quantity, hence the major impact is made upon price. If demands and supplies are elastic, the major impact is made upon quantity.

Dynamic solutions. Demand and supply curves can also be interpreted in such a way as to lead to certain dynamic solutions. The so-called cobweb theorem is a famous example. This is shown in Figure 6. Here DD′, the demand curve, shows the price that a particular quantity, say the harvest of a crop, will fetch. The supply curve, SS′, shows how much will be produced, let us say in the following year, in response to that price. Suppose then that we have a crop with the harvest equal to OA. The price is AB. As a result of this price, the harvest the following year is equal to RC, which makes the price that year equal to TE. In response to this, the harvest the following year is UF, and so we go on, following the path GHI, etc. If the demand curve is more elastic than the supply curve, the cycle will converge on the point of equilibrium, as in the figure. If the supply curve is more absolutely elastic than the demand curve, the cycle will explode. If the two elasticities are equal, the cycle will continue indefinitely with constant amplitude. There is some evidence of this phenomenon in agriculture, for instance in the so-called hog cycle and also in such crops as potatoes. These demand and supply curves are not stable over long periods, however, and we must be careful to avoid predictions from dynamic systems that are as simple as this, for the reality is always much more complex.

The demand and supply functions can easily be extended to include more variables, and for some purposes it is very important to do so. The demand and supply functions, for instance, may be written as functions of two or more commodities instead of one. We could, for instance, expand equations (1) and (2) into a two-commodity system as shown in equations (4) through (7),

The notation is the same as for equations (1) and (2) except that the subscript a refers to commodity A and the subscript b refers to commodity B. The parameters f are the (absolute) cross-elasticities. For instance, fad shows by how much the quantity of A demanded changes per unit change in the price of B. Several types of relationships are possible. If the commodities are independent in demand or supply, the f parameters will be zero. If the fd parameter is positive, it means that an increase in the price of B will raise the purchases of A, which means the two commodities are competitive in demand. If the d parameter is negative, a rise in the price of B, which presumably diminishes the purchases of B, also diminishes the purchases of A, suggesting that the commodities are complementary, such as knives and forks. Similarly in the case of supply, if the parameter fas is positive, it means that an increase in the price of B raises the quantity of A supplied. This suggests that the commodities are complementary in production, such as beef and hides or wool and mutton. If f1,. s is negative, a rise in the price of B diminishes the quantity of A supplied, indicating that the commodities compete in production because, for instance, they use the same scarce resources. If we now add to equations (4) through (7) the two conditions of equilibrium, representing the equality of quantities demanded and supplied for both commodities, as in equations (8) and (9), we have a complete equilibrium system, with six equations and six unknowns, the four quantities and the two prices.

The equations of course do not have to be restricted to the linear form.

We can easily extend this system to the general equilibrium of n commodities. In doing this, however, we have to be careful because there are certain constraints on the parameters of such a system

imposed by the fact of scarcity. For instance, an increase in demand (or supply) for one commodity must almost always be counterbalanced by a decline in demand (or supply) for another. These constraints, however, are very complex, and it is virtually impossible to put them into simple mathematical form. It is possible, for instance, for the demand for all commodities to increase if the velocity of circulation of money increases. Similarly, it is possible for the supply of all commodities to increase if there is technological change and economic development.

The prices of factors of production, such as wages and rents, can be treated like any other prices in demand and supply analysis. They present, however, some interesting peculiarities. In the case of the supply of a factor such as labor, we have the possibility of what is called a backward-sloping supply curve. Thus, in Figure 7 we plot the wage on the vertical axis and the amount of labor offered on the horizontal axis. There is likely to be some wage, OA, that is so low that no labor will be offered at all, because at this wage the labor cannot subsist, or because there are better opportunities elsewhere. At the wage that will just induce labor to come into this occupation, there may be quite a large amount of labor offered, AB, because the laborer has to work long hours in order to make enough to live on. At higher wages, however, the amount of labor offered may be less, following the course BC, for if the laborer has a conventional standard of living and requires only a certain income to live on, the higher the wage the less he has to work in order to earn this fixed amount. It is also possible, however, that at a certain point, such as C, the laborer realizes that he can earn much more than subsistence if he works harder, and the elasticity of supply again becomes positive, from C to D. A similar phenomenon may sometimes be observed in the case of land, when a rise in rents causes the landowner to employ a larger area in parks and gardens for his own private pleasure because he can get an adequate income from a smaller amount of land rented out. Under these circumstances there may be quite serious breakdowns in the equilibrium of demand and supply, resulting, for instance, in inflation or in perpetual labor shortages in cases where custom prevent? wages from rising. Some of the peculiarities of traditional societies may perhaps be explained in these terms.

Demand and supply have emerged over the years as very useful tools of fairly rough analysis. They serve to break down the forces operating on prices and outputs into those that operate mainly on the side of the sellers and those that operate mainly on the side of the buyers. They should not be expected to answer all the problems of price theory. They remain, however, indispensable tools.

Kenneth E. Boulding

[See also the biographies ofMarshall; Smith, Adam; Walras.]

BIBLIOGRAPHY

Boulding, Kenneth E. (1941) 1965 Economic Analysis. 4th ed. New York: Macmillan.

Henderson, H. D. (1922) 1958 Supply and Demand. Univ. of Chicago Press.

Hicks, Johne R. (1939) 1946 Value, and Capital: An Inquiry Into Some Fundamental Principles of Economic Theory. 2d ed. Oxford: Clarendon.

Jenkin, Fleeming (1870) 1931 The Graphic Representation of the Laws of Supply and Demand, and Their Application to Labour. Volume 2, pages 76–106 in Fleeming Jenkin, Papers: Literary, Scientific, etc. London School of Economics and Political Science. MARSHALL, ALFRED (1890) 1961 Principles of Economics. 9th ed. New York and London: Macmillan. → A variorum edition. The eighth edition is preferable for normal use.

Smith, Adam (1776) 1952 An Inquiry Into the Nature and Causes of the Wealth of Nations. Chicago: Encyclopedia Britannica. → See especially Book I, Chapter 7. A two-volume paperback edition was published in 1963 by Irwin.

Walras, Leon (1874–1877) 1954 Elements of Pure Economics: Or, the Theory of Social Wealth. Translated by William Jarré. Homewood, III.: Irwin; London: Allen & Unwin. → First published in French.

II ECONOMETRIC STUDIES

Econometric studies of demand and supply are directed toward obtaining quantitative estimates of market demand and supply functions from empirical data. The principal data used have been time series of prices, quantities, incomes, and related variables; the traditional estimating technique has been regression analysis; and the interpretation of the resulting equations has been guided by the theory of consumer demand and the theory of the firm.

Concepts of demand and supply have occupied a prominent place in the development of economic theory. The pure theory of consumer demand reached a high level of refinement in the hands of Pareto, who portrayed the individual consumer as attempting to maximize a utility function that included the quantities of every good and service purchased by him. The quantities purchased were themselves functions of prices and of the consumer’s income. The resulting demand functions of individual consumers were in principle measurable and could evidently be aggregated to yield market demand functions. Marshall and others specified the conditions of profit maximization for an individual firm and showed that the marginal cost curves of individual firms producing the same product could be aggregated to form an industry supply curve. Demand and supply functions for all commodities and services were included (conceptually) in the theory of general economic equilibrium formulated by Walras and Pareto.

Economic theory specified the signs of the coefficients relating prices and quantities in market demand and supply functions, but it could not specify the magnitudes of these coefficients for particular commodities. Yet major policy problems, for example, the effects of tariffs, bounties, and excise taxes, required quantitative knowledge. The policy interests of government agencies and the commercial interests of business firms began in the 1800s to generate time series data of an aggregative sort, including wholesale prices of staple commodities and quantities of imports, exports, production, and consumption of such commodities in various countries. The task confronting pioneers in the econometric analysis of demand and supply was to use market data of this kind as a basis for determining the required functions. When the task was first seriously taken up, after 1900, it was found to involve complex problems of statistical estimation and logical interpretation.

A sophisticated econometric analysis of the demand and supply relationships for particular commodities requires an analyst with many skills. He must be thoroughly grounded in economic theory. He must be well versed in the theory of statistical estimation (including the estimation of sets of simultaneous relationships) and in techniques for coping with the problems of autocorrelated disturbances and multicollinearity, which are frequently encountered in economic time series. He must acquaint himself very thoroughly with the conditions under which particular commodities are produced, marketed, and consumed, insofar as these conditions affect the decision processes of the relevant firms and consumers. He must take pains to determine the extent to which each of his economic time series corresponds to the variable called for by economic theory.

A person who has made the necessary investment in economic and statistical theory will ordinarily be tempted to slight the detailed study of data, institutions, and technology pertaining to a particular commodity. On the other hand, a person who because of predilection has made a major investment in learning the technological and insti tutional characteristics of an industry usually lacks sophistication in economic or statistical theory. This dilemma may sometimes be resolved by cooperation between the econometrician and the commodity or industry specialist.

The literature of demand analysis published prior to the late 1950s is much richer in volume and interest than that of supply analysis. The first and major part of this article will be devoted to studies of demand.

Studies of demand prior to 1939

The story of statistical demand analysis from its beginnings through 1938 can be told in terms of developments in economic theory, in statistical theory and techniques, and in published economic data.

Economic theory

The economic theory requisite for demand analysis was available at an early date. In 1838 Cournot stated the theory of demand in a form that lent itself to numerical application, and he suggested that it would be easy to learn, for all commodities for which statistics had been collected, whether current prices were above or below the value that would maximize the total value of the quantity sold during a given period. Marshall elaborated the concept of a market demand curve in a partial equilibrium context. Walras’ general equilibrium theory, published in 1874, expressed the quantity demanded of any commodity as a function not only of its own price but of all other prices. In various articles and books from 1893 to 1911, Pareto extended Walras’ theory and stated it with greater rigor.

Statistical theory and technique

Gauss’s method of least squares was published early in the nineteenth century, but for several decades it was used primarily by physical scientists in dealing with errors of measurement. The first demand analysts were encouraged to adopt statistical methods as a result of the work of Galton, Pearson, and their fellow biometricians, very late in the century. The theory of correlation was elaborated during the 1890s by Pearson, Yule, and others; and several years elapsed before anyone tried to apply it to price-quantity relationships.

The early work on correlation emphasized bivariate or multivariate normal populations for which the simple, partial, and multiple correlation coefficients had structural significance [seeMultivariate analysis, article on CORRELATION (1)]. This correlation emphasis, carried forward through various textbooks, was to prove quite misleading to the less sophisticated practitioners of statistical demand analysis during the 1920s and 1930s.

By the 1920s R. A. Fisher and others concerned with the design of experiments and the analysis of variance had arrived at a clear-cut distinction between the correlation model, emphasized by Galton and Pearson, and the regression model, in which values of the independent variables were predetermined by the investigator [seeLinear hypotheses, article onregression]. Ezekiel (1930), whose book was widely used by demand analysts in the United States, captured the new regression emphasis of Fisher but continued to use some of the older, correlation terminology.

In the 1930s the theory of statistical inference was further developed by J. Neyman and others. Frisch (1934) greatly illuminated the implications of multicollinearity (high intercorrelation) of the independent variables in regression analyses based on economic time series. The problem of autocorrelation in the residuals from time series regressions was largely ignored in empirical demand studies prior to the 1940s.

The problem of identifying a statistically estimated price–quantity relationship as a demand curve rather than a supply curve appears to have been recognized first by Lenoir, in 1913, and then, in 1914, by the critics of Moore’s upward-sloping “demand curve” for pig iron [seeStatistical identifiability]. It was very clearly stated by Working (1927), and its ready solution, in what would now be called recursive models, was noted by Ezekiel (1928). Statistical methods for dealing with the general simultaneous equation case were not available prior to 1943, although Wright (1934, pp. 196–201), in a paper relatively neglected by economists, successfully estimated what would now be called a just-identified model, by a method logically equivalent to that of reduced forms [seeSimultaneous equation estimation].

Economic data

The availability of data has been the most severely limiting factor in the estimation of demand functions, from Cournot’s time to the present. The data resources of most countries have been greatly enriched since the 1930s, in connection with the development of national income accounts, index numbers of prices, production and consumption, input–output tables, and, in some cases, econometric models of their national economies. The price and quantity data available for empirical studies of demand prior to 1939 were much more limited in scope. Data on agricultural staples have been particularly accessible in the United States, and these commodities were used almost exclusively by Moore, Schultz, and others in their empirical work. Knowledge of data limitations fostered a pragmatic attitude on the part of some agricultural economists, whose applied work was highly useful for policy and forecasting purposes. Ignorance or disregard of data limitations often vitiated the empirical work of academic economists, who were mainly interested in “testing” theories or techniques.

Empirical studies

At various times Cournot, Jevons, Marshall, and Pareto had all paid lip service to the idea of empirical studies of demand (Schultz 1938, pp. 657–658). Even earlier some businessmen and men of affairs (as well as economists) had no doubt formed judgments about price–quantity relationships of particular interest to them. Stigler (1954) reports some examples. These instances of casual empiricism had no cumulative effect. Benini (1907) computed a least squares multiple regression of coffee consumption on the price of coffee and the price of sugar—the first application to demand analysis of what came to be the dominant statistical technique.

Lenoir’s book (1913) in some respects remained unsurpassed until the 1930s. Starting from Pareto’s theory of consumer demand, Lenoir made an explicit transition to market demand curves. He made a similar derivation, based on Pareto, of market supply curves. A diagram showing three roughly parallel (nonlinear) demand functions intersecting two roughly parallel (nonlinear) supply curves was used to adumbrate, at least, what is now known as the identification problem. Lenoir then calculated multiple regression equations, involving as many as three independent variables, for a number of commodities, including coffee, wheat, and coal. His descriptions of the time series and the markets involved appear to reflect care and sound judgment. The book as a whole was a most promising integration of economic theory, statistical technique, and sophisticated attention to the data; but it was apparently unnoticed in the United States. It is not mentioned in later work by Moore. Schultz devotes part of one sentence to “Dr. Marcel Lenoir’s important book” (1938, p. 64) but gives no description or appraisal of Lenoir’s work.

Moore’s work. Schultz wrote, “The statistical study of demand is a new field in economics and may be said to be the creation of only one man— Professor Henry L. Moore” (1938, p. 63). Although recognizing that Moore had predecessors, Schultz commented that “none of these predecessors of Moore attracted much attention, none covered so wide a field, and none succeeded so well in wringing fresh knowledge from the accumulated masses of data” (p. 64).

Moore’s books Economic Cycles: Their Law and Cause (1914) and Forecasting the Yield and the Price of Cotton (1917) furnished the inspiration for much of the statistical demand analysis that was carried on in the United States during the 1920s. Unlike most American economists of his generation, Moore was thoroughly familiar with the works of Cournot, Walras, and Pareto. He was personally acquainted with Walras and corresponded with him. In 1909 and 1913 he took courses in mathematical statistics, including correlation, with Karl Pearson (Stigler 1962, p. 2).

Despite his admiration for the general equilibrium theory of Walras, Moore was pleased to find that in practice he could obtain fairly good fits to his data (prices and production of farm crops) by using equations in two or three variables. His statistical procedures were simple, in keeping with the rather crude data that were available to him. He expressed his time series variables in terms of percentage changes from one year to the next or in terms of link relatives (the given year’s value expressed as a ratio to the value in the preceding year) or as ratios to trend. The adjusted series on prices and production were then related by the method of least squares, using straight lines, second-degree parabolas, and in some cases third-degree parabolas. Moore derived statistical demand curves for corn, hay, oats, and potatoes in 1914 and a demand function for cotton in 1917. In subsequent articles, Moore introduced the concept of the flexibility of price (namely, the reciprocal of the elasticity of demand), estimated the response of cotton acreage to cotton prices in the preceding year, and described a moving equilibrium of demand and supply for potatoes in which the demand curve expressed current price as a function of current production and the supply curve expressed current production as a function of the preceding year’s price. We have here the wellknown cobweb model, the simplest member of a class of recursive models, which assume great importance in discussions of statistical techniques after 1943.

Moore’s methods of data adjustment were chosen on a common-sense basis. Two of them, link relatives and per cent changes from year to year, were essentially first-difference transformations. Many years later it was shown that first-difference transformations not only reduced intercorrelation of the explanatory variables but also frequently eliminated significant autocorrelation in the residuals. Moore’s third method, using ratios of actual observations to trends, largely eliminated the distorting effects of intercorrelated time trends, as did the quasi first-difference transformations. The constant term in a regression equation based on first differences of prices and quantities may be interpreted as a linear time trend in the level of the price–quantity relationship. [See the biography ofMoore, Henry L.]

Other studies. The simplicity of Moore’s statistical methods and his apparently successful applications of them to data for agricultural commodities excited great interest among agricultural economists in the United States. Some of them wished to provide farmers with dependable predictions of prices for the coming year, so that the farmers could adjust their production plans and increase their expected incomes. Some needed demand and supply functions to estimate the probable effects of alternative price support, supply control, tariff, or subsidy policies. Some of these men achieved a high level of sophistication in empirical demand analysis, notably Ezekiel, Waugh, H. Working, and E. J. Working, and a number of excellent studies were published by them between 1922 and 1929 (see the bibliography in Schultz 1938, pp. 779–803). Their work was distinguished by knowledge of data, technology, and institutions and by competent and in some cases highly creative use of economic and statistical theory. There were, also, some less competent “price analysts,” whose work was empirical in the extreme and tended to discredit the whole field of statistical demand analysis. With the onset of the economic depression of the 1930s, several of those who had done significant demand studies were drawn into the action programs of the Department of Agriculture and other government agencies. Their unpublished analyses continued to be influential in the appraisal of programs and contemplated policies.

European econometricians did important work in the 1920s and the 1930s. Frisch in Norway estimated the marginal utility of money from a statistical analysis of the demand for sugar in Paris (1926). Hanau in Germany estimated the demand curve and the supply curve for hogs (1927). Leontief in Germany published a statistical analysis of demand and supply functions for several commodities, using a highly imaginative but statistically unreliable technique (1929). Tinbergen in the Netherlands published an important paper on supply curves, including a statistical measurement of the supply elasticity of potato meal (1929). Marschak in Germany made econometric studies of family budgets and argued that on certain assumptions these data would also yield estimates of demand elasticities with respect to price (1931). Roy in France published a collection of his econometric studies (1935), including measurements of demand elasticities for goods and services whose prices change only infrequently—such as gas, postage stamps, trolley fares, and tobacco (a government monopoly in France). Some of these men had high creative potential in theory and methodology and are now well known for their important contributions to fields of econometrics other than demand analysis. Of those listed in this paragraph, Frisch had by far the greatest impact on econometric studies of demand, both before and after 1939.

Schultz’s work. Henry Schultz was a student of H. L. Moore. Inspired by Moore, he studied the works of Cournot, Walras, and Pareto and during 1919 attended lectures on statistics by A. L. Bowley and Karl Pearson.

Schultz’s monumental work The Theory and Measurement of Demand (1938) is the definitive statement on econometric analysis of demand prior to World War ii. Schultz was the “complete demand analyst” of his generation, and his 24-page bibliography is still the best point of departure for a survey of the pre-1938 literature.

Schultz’s life work is essentially summed up in his 1938 book (817 pages). Chapters 1, 18, and 19 together provide an excellent statement of the theory of consumer demand, incorporating the extensions of Pareto’s basic formulation developed by J. R. Hicks, R. G. D. Allen, and E. Slutsky. Chapters 2 and 3 deal with the logic and theoretical validity of various proposed methods for deriving demand curves from time series and from family budget data. The empirical section (chapters 5–17) presents statistical demand analyses for ten major crops, along with summary comparisons and interpretations of the results for the various commodities, time periods, and functional forms investigated. Further empirical studies are presented in the chapters on related demands (chapters 18 and 19), and the 50-page appendix on elements of curve fitting and correlation provides an excellent guide to least squares regression methods. It would be difficult to name any econometric work of large scope in the 1930s that achieved a better integration of economic theory and statistics with painstaking and realistic attention to institutions, markets, and data. [See the biography ofSchultz.]

Summary of accomplishments to 1939

Success in empirical demand analysis was not held up by the need for further development in economic theory. Multiple regression analysis was the standard estimating technique from 1914 on, although a number of interesting experiments (weighted regression; regression analysis by short-cut graphic methods; confluence, or bunch-map, analysis) were tried.

The leading demand analysts of the 1920s and 1930s were more sophisticated about the identification problem than is often supposed. Most of the commodities with which Moore, Schultz, and the agricultural economists were concerned followed the cobweb, or recursive, model. As a result of biologically necessary time lags, the identification of a relation between the current production and the current price of a farm commodity, as a demand function, was straightforward; a relation between last year’s price and this year’s acreage or production could be readily identified as a supply function. E. J. Working made a clear statement of the identification problem, but Ezekiel pointed out that “‘correlated shifts in demand and supply’ schedules, which Working feared might completely invalidate many price-analysis studies, are not so likely to cause trouble as he thought” (1928, p. 224). Only the “instantaneous” adjustment of supply to price within a given time unit could give rise to such trouble, and such adjustments (for farm products) were generally small, relative to those in subsequent time periods.

A few attempts were made in the 1930s to derive demand functions for consumer goods. In 1914 Moore found a positively sloping relationship between the price and production of pig iron and made the mistake of trying to rationalize it as a different kind of demand curve. Although it could be argued that the demand for iron, steel, and other producers’ durable goods is ultimately derived from consumer demand, the empirical connection is tenuous and the subject is best treated in contexts other than that of demand analysis.

Studies of demand since 1939

Since 1939 there have been important developments in methods of estimation, in data networks, and in the objectives of demand studies.

Methods of estimation

Tests for autocorrelation in the residuals from time series regressions were published in the early 1940s and became a standard feature of demand studies. Haavelmo’s brilliant generalization of the identification problem (1943) created in the minds of theoretically oriented economists grave doubts concerning the validity of any demand function estimated by conventional least squares methods. Interestingly enough, the economists who were or had been most deeply involved in empirical demand analysis, including Wold, Stone, Fox, Waugh, and Ezekiel, were not impressed with the implications of Haavelmo’s methods for their own work. Wold made the most creative response, and his articles on recursive models and causal chains did much to place the traditional single-equation methods and the proposed simultaneous equation methods in a common perspective (1953 and articles noted therein). Fox (1958) used arrow diagrams, which can be readily interpreted as causal ordering diagrams, to express his hypotheses concerning the directions and relative magnitudes of the influences of each variable upon directly related variables in complete demand, supply, and price structures for farm and food products. Inspection of the arrow diagram for a given commodity frequently disclosed that the consumer demand function and certain other functions could be estimated appropriately by least squares. Debate concerning alternative estimators of simultaneous equation models, which was active in the early 1960s, has some implications for demand analysis as well as for other branches of econometrics.

Changes in data networks and objectives

The Keynesian revolution in macroeconomic theory, by demonstrating the important analytical and policy uses of estimates of the national income and its components, stimulated many countries to develop comprehensive national income and product accounts. This interest reflected a growing recognition that governments must take a great deal of responsibility for economic stabilization and the avoidance of unemployment. Tinbergen’s econometric models and Leontief s input–output models also required comprehensive coverage (at appropriate levels of aggregation) of all sectors of a national economy.

The prospective uses of economic data in comprehensive models have given a more analytical focus to the design of data systems in recent years than generally existed prior to World War ii. At the same time, comprehensive models not only encourage but logically require certain restrictions upon the coefficients of demand functions for different commodities. These restrictions were generally disregarded in the pre-1939 tradition, except for a few studies (by Schultz, Waugh, and Ezekiel) of commodities closely related in demand, such as beef, pork, lamb, and chicken. Hence, empirical work in the 1960s has shown a much greater tendency to use “extraneous” or a priori information to supplement time series data and to rely on theoretical considerations in supplying coefficients that cannot be estimated directly from the data.

Major empirical works

Wold (1953 ) published an excellent exposition of Paretian demand theory, of the theory of stationary random processes as it affects the analysis of economic time series, and of the theory of regression analysis. While the scope of Wold’s theoretical chapters is similar to that of Schultz, Wold incorporates a number of major theoretical developments that had been made after 1938, by himself and others. Wold’s book requires a higher level of mathematical and statistical competence on the part of its readers than does Schultz’s, and in the 1950s it largely supplanted the latter as a graduate text and reference work. Wold’s empirical chapters, however, were not particularly distinguished.

Stone’s comprehensive book (1954) establishes him as a “complete demand analyst” in the Schultz tradition, and he had indeed been influenced by Schultz’s writings. Stone explicitly covers those portions of economic theory and estimation procedures that are relevant to demand analysis. The mathematical level of his exposition is less demanding than Wold’s, but the implications he draws for empirical work are equally authoritative. The volume and quality of the econometric results presented by Stone are also impressive. An interesting feature of his work is the use of income elasticities of demand, estimated from family budget data, to adjust time series of per capita consumption before regressing them on time series of prices.

Fox (1958 and articles noted therein) published the largest array of empirical demand functions that had so far been produced in the United States for farm products and foods, taking advantage of the many improvements achieved by the Bureau of Agricultural Economics between 1938 and 1950 in data on retail prices, per capita food consumption, disposable personal income, and food marketing margins. His demand studies covered both farm products and foods, whereas Wold and Stone dealt only with foods. Fox used logarithmic first-difference transformations and took explicit cognizance of identification problems.

Special adaptations of demand theory. Strotz (1957) put forward the concept of a “utility tree,” which justified the aggregation of consumer goods into budget categories that were assumed to be want independent of one another. Cross elasticities of demand between individual commodities in two want-independent groups could then be ignored in applied work; nonzero cross elasticities might continue to exist and be recognized between groups of commodities. Strotz was motivated by a desire “to exchange some realism [in assumptions] for greater relevance [in applications]” (1957, p. 270) and stated that his hypothesis “implies certain empirically meaningful and interesting conditions on the price coefficients of the demand functions” (p. 269).

Frisch (1959) published a complete scheme for computing all direct and cross elasticities of demand in a model with many sectors. He noted that it was easier to obtain estimates of budget proportions and Engel (income) elasticities than of elasticities with respect to price but that by making certain want-independence assumptions the price elasticities could be deduced from the knowledge of budget proportions and Engel elasticities. Frisch noted further that the direct elasticities with respect to price could, as a rule, be estimated more easily than the cross elasticities. If we are willing to assume that the behavior of the market can be described by the behavior of a representative individual and are also willing to make stipulated assumptions about want independence, all the cross elasticities of demand in a model including many commodities could be supplied in a reproducible way consistent with the other assumptions of demand theory.

Brandow (1961) followed Frisch’s suggestions in specifying a complete matrix of price and income elasticities of demand at retail prices, for 24 foods or food groups and for the aggregate of all nonfood consumer goods and services. This matrix represented a careful synthesis of results obtained from United States data by other investigators, together with additional analyses of his own. He presented equations for converting each of his 24 consumer demand functions into demand functions at the farm price level and derived other equations for determining the internal balance of the livestock and feed economy. Brandow did not attempt to develop equations for forecasting acreages and supplies of crops, although adjustments of livestock supplies to quantities of feed available were endogenous in his model. As of 1965, Brandow’s study was the most comprehensive and internally consistent application of demand analysis yet completed.

Apart from Schultz (who died in 1938), Waugh has been the most sophisticated of the American demand analysts in his command of economic theory and the most imaginative in his application of statistical techniques. His methodological and empirical contributions have extended from 1923 to 1964. His bulletin Demand and Price Analysis (1964), while written on an expository level, reports many methodological experiments, including a symmetric matrix of direct and cross elasticities of demand for three competing commodities; an empirically derived “indifference surface” for beef and pork; an orthogonal regression; an appendix on relationships between demand coefficients (along the lines of Frisch’s 1959 article); and an appendix on the optimal allocation of commodity supplies among independent markets to maximize producer returns. Waugh’s bulletin pro vides a brief, clear, and interesting survey of the theory and techniques of demand analysis, with many illustrations.

Smith (1964) applied linear programming to the electronic computation of human diets, drawing his data from time series of weekly purchases of some 600 food products by 176 families in Lansing, Michigan [seeProgramming]. The retail prices of the products were also obtained. Smith showed that the solutions for least-cost diets meeting stated requirements for nutrients, specified complementarity restrictions, and “food-habit” or palatability stipulations could, under certain very special assumptions, be made to yield estimates of the marginal utilities of commodities and the marginal costs of the effective restraints. It remains to be seen whether this approach will converge with that of Frisch and Brandow. Ladd and Martin (1964) used the Lansing data to demonstrate the existence of distributed lags in the adjustment of consumer demand for some foods to price and income changes when the units of observation were four-week (and in some cases 13-week) periods [seeDistributed lags].

Econometric studies of supply

Prior to the late 1950s, econometric studies of supply were much less exciting to economists than were studies of demand. The theory of consumer demand embraces all consumer goods and services and embodies principles of rational choice applicable to consumers in general. But the technology (and geography) of supply may be highly specialized to particular commodities, and such conceptual unity as the field possesses may be submerged in these details.

In some countries and periods, agricultural production takes place under atomistic competition and provides data for econometric analysis. In the industrial sector, oligopoly and monopolistic competition are common; many firms operate at less than full capacity, and statistical studies suggest that their supply curves are nearly horizontal over the usual ranges of output. Data on the cost functions of individual firms are often closely held [seeProduction and cost analysis].

Published econometric studies of supply have for the most part dealt with agricultural commodities. Moore used least squares regression methods to estimate the response of potato yields in a given year to prices in the preceding year. Bean (1929) and other agricultural economists used regression techniques to estimate the responses of crop acreages to prices lagged one or two years and the responses of hog numbers to the lagged relative prices of hogs and corn.

In the United States, interest in econometric supply analysis was largely dissipated by the depression of the 1930s, by government programs to control acreages (after 1932), and by the severe droughts of 1934 and 1936. Some local interest continued in supply response studies for minor crops that were not subject to acreage allotments. In 1928 Schultz gave considerable attention to estimating the supply curve for sugar, in addition to the demand curve. It is significant that he had little to say about supply functions in his 1938 book.

Nerlove (1958) injected a new idea into the traditional type of supply response study. He hypothesized that farmers adjust their planted acreage of a crop in response to the difference between the most recently experienced actual price and their concept of the “long-run normal price” for the same year. The technique proposed for inferring the long-run normal price was ingenious, but it only momentarily dispelled the apathy of economists toward regression studies of acreage response in an era of government programs controlling acreage.

In the 1950s the popularization of linear programming methods among agricultural economists by Heady and others opened the way for a normative analysis of supply response. An individual farmer could be represented as adjusting his planted acreages of different crops in an effort to maximize net income, subject to his resource constraints and given his expectations concerning the prices at which the various crops would sell after harvest. The existence of support prices permitted accurate predictions in some cases.

Day (1963) applied recursive linear programming to a homogeneous eleven-county area in the Mississippi Delta, which he treated as though it were a single profit-maximizing unit. Day’s model included nine possible outputs (counting cotton lint and cotton seed as separate products) and about 27 possible production inputs. He specified input and output vectors for a total of 97 different production processes, each process representing a particular crop grown on a particular soil type with a stated level of application of commercial fertilizer and a particular combination of machinery, labor, and pesticides.

Day applied his model recursively, year by year, from 1939 through 1958. New production activities, for example, mechanical cotton picking, were introduced into the profit-maximizing solution only when they had become more profitable than all previously existing activities on at least one soil type. The model generated time series for all outputs and inputs, as well as “shadow prices” for all the restrictions (including government acreage allotments) that were effective in each year’s optimal solution.

In the early 1960s Heady and others applied linear programming to each farm in representative samples of farms to arrive at aggregative supply response functions. Heady and Egbert (1964) developed a linear programming model of agricultural production in the United States for more than 120 regions and for all major crops in each region. By 1965 plans were under way to include livestock production in the model and to increase the number of regions.

By 1965 the most ambitious econometric studies of demand and supply had achieved a (partly synthetic) comprehensiveness that would have astonished the early critics of Moore. But Moore himself would not have been astonished. In his last book, Synthetic Economics (1929), Moore had proposed an implementation of the general equilibrium model of Walras, the principal elements of which would be comprehensive sets of empirical demand and supply functions!

Karl a. fox

BIBLIOGRAPHY

Bean, L. H. 1929 The Farmers’ Response to Price. Journal of Farm Economics 11:368–385.

Benini, Rodolfo 1907 Sull’uso delle formole empiriche neir economia applicata. Giornale degli economisti Series 2 35:1053–1063.

Brandow, G. E. 1961 Interrelations Among Demands for Farm Products and Implications for Control of Market Supply. Pennsylvania, Agricultural Experiment Station, University Park, Bulletin No. 680. University Park: The Station.

Day, Richard H. 1963 Recursive Programming and Production Response. Contributions to Economic Analysis, No. 30. Amsterdam: North-Holland Publishing. EZEKIEL, MORDECAI 1928 Statistical Analyses and the”Laws” of Price. Quarterly Journal of Economics 42: 199–227.

Ezekiel, Mordecai (1930) 1941 Methods of Correlation Analysis. 2d ed. New York: Wiley. → A third edition, with Karl A. Fox as co-author, was published in 1959 as Methods of Correlation and Regression Analysis: Linear and Curvilinear.

Fox, Karl A. 1958 Econometric Analysis for Public Policy. Ames: Iowa State College Press.

Frisch, Ragnar 1926 Sur un probléme d’économie pure. Norsk matematisk forenings skrifter 1st Series 16: 1–40.

Frisch, Ragnar 1934 Statistical Confluence Analysis by Means of Complete Regression Systems. Oslo: Civil-tryckeri. → Also published in the Nordic Statistical Journal, Volume 5.

Frisch, Ragnar 1959 A Complete Scheme for Computing All Direct and Cross Demand Elasticities in a Model With Many Sectors. Econometrica 27:177–196. HAAVELMO, TRYGVE 1943 The Statistical Implications of a System of Simultaneous Equations. Econometrica 11:1–12.

Hanau, Arthur (1927) 1930 Die Prognose der Schweinepreise. 3d ed. Vierteljahrshefte zur Konjunkturforschung, Sonderheft 18. Berlin: Reimar Hobbing. → The first edition was issued as Sonderheft 2, the second as Sonderheft 7.

Heady, Earl O.; and EGBERT, ALVIN C. 1964 Regional Programming of Efficient. Agricultural Production Patterns. Econometrica 32:374–386.

Ladd, George W.; and Martin, James E. 1964 Application of Distributed Lag and Autocorrelated Error Models to Short-run Demand Analysis. Iowa Agricultural Experiment Station, Research Bulletin No. 526. Ames: The Station.

Lenoir, Marcel 1913 Etudes sur la formation et le mouvement des prix. Paris: Girard & Briere. LEONTIEF, WASSILY 1929 Ein Versuch zur statistischen Analyse von Angebot und Nachfrage. Weltwirtschaftliches Archiv 30:l*-53*. → The asterisks are a part of the pagination system of this volume.

Marschak, Jakob 1931 Elastizitdt der Nachfrage. Tubingen (Germany): Mohr.

Moore, Henry L. 1914 Economic Cycles: Their Law and Cause. New York: Macmillan.

Moore, Henry L. 1917 Forecasting the Yield and the Price of Cotton. New York: Macmillan.

Moore, Henry L. 1929 Synthetic Economics. New York: Macmillan.

Nerlove, Marc 1958 The Dynamics of Supply: Estimation of Farmers’ Response to Price. Studies in Historical and Political Science, Series 76, No. 2. Baltimore: Johns Hopkins Press.

Roy, Rene 1935 Études économetriques. Paris: Sirey. SCHULTZ, HENRY 1938 The Theory and Measurement of Demand. Univ. of Chicago Press.

Smith, Victor E. 1964 Electronic Computation of Human Diets. East Lansing: Michigan State Univ., Graduate School of Business Administration, Bureau of Business and Economic Research.

Stigler, George J. 1954 The Early History of Empirical Studies of Consumer Behavior. Journal of Political Economy 62:95–113.

Stigler, George J. 1962 Henry L. Moore and Statistical Economics. Econometrica 30:1–21.

Stone, Richard 1954 The Measurement of Consumers’ Expenditure and Behaviour in the United Kingdom: 1920–1938. Cambridge Univ. Press.

Strotz, Robert H. 1957 The Empirical Implications of a Utility Tree. Econometrica 25:269–280. TINBERGEN, JAN 1929 Bestimmung und Deutung von Angebotskurven: Ein Beispiel. Zeitschrift fur Nationalokonomie 1:669–679.

Tukey, John W. 1954 Causation, Regression, and Path Analysis. Pages 35–66 in Oscar Kempthorne et al. (editors), Statistics and Mathematics in Biology. Ames: Iowa State College Press.

Waugh, Frederick V. 1964 Demand and Price Analysis: Some Examples From Agriculture. U.S. Department of Agriculture, Technical Bulletin No. 1316. Washington: U.S. Department of Agriculture, Economic and Statistical Analysis Division.

Wold, Herman 1953 Demand Analysis: A Study in Econometrics. New York: Wiley.

Working, E. J. (1927) 1952 What Do Statistical “Demand Curves” Show? Pages 97–115 in American Economic Association, Readings in Price Theory. Edited by G. J. Stigler and K. E. Boulding. Homewood, III.: Irwin. → First published in Volume 41 of the Quarterly Journal of Economics.

Wright, Sewall 1934 The Method of Path Coefficients. Annals of Mathematical Statistics 5:161–215.

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Demand

Demand

BIBLIOGRAPHY

In economics, demand theory examines the purchasing behavior of an individual, or of a group of individuals, in terms of its responses to changes in purchasing constraints or other institutional factors. In the most basic setting, an individual chooses a bundle of commodities, considering both their prices and a maximum income that he or she can spend. It is assumed that the individual compares bundles of commodities according to his or her own preferences, and that he or she chooses to purchase the best bundle that is affordable; in economics, this type of behavior is called rational or preference maximizing. The first systematic analysis of this problem was done by Leon Walras in 1874. In 1886 Giovanni Antonelli studied the problem of constructing preferences that can explain a given demand function, and in 1915 Eugene Slutsky obtained a full set of implications of preference maximization on demand behavior. In the mid-twentieth century, the economist Paul Samuelson called for a revision of the theory, whereby observable behavior, rather than unobservable preferences, would constitute the foundation of demand theory. This proposal led to the development of revealed-preference analysis, an exhaustive series of conditions that must be satisfied by demand behavior, if it is consistent with preference maximization.

The standard problem of demand theory is that of an individual who chooses a bundle of L commodities, ranking different bundles according to his or her preferences. The individual faces prices p = (p 1, , p L) and can spend up to a nominal income of m. Consumption bundles are denoted by x = (x 1, , xL). A rational individual chooses a bundle x̑ that is:

  1. feasible: p x = p 1x 1 + + pLxL m ; and
  2. optimal: there does not exist an alternative bundle that the consumer can afford and prefers to x̑.

Under well-known assumptions on the preferences of the individual, one such x̑ is guaranteed to exist, and is uniquely defined. Then, x (p, m ) = x̑ is known as the Marshallian demand of the individual, and constitutes the central element of demand theory: It says how much of each commodity the consumer demands, as a function of the prices he or she encounters in the market and of the income he or she has.

Function x is homogeneous of degree zero: multiplying all prices and income by the same positive number does not change demand. When a consumer prefers more to less consumption of at least one commodity, Marshallian demand satisfies Walrass law: the consumer will spend all his or her income, so p x (p, m ) = m. When Marshallian demand is differentiable, these properties impose restrictions on the derivatives of the demand with respect to prices and income, which can be used to restrict empirical estimations of demand. More importantly, the substitution matrix, S, defined by S (p, m ) = Dp x (p, m ) + Dm x (p, m ) x (p, m ), and which isolates the effects of changes in relative prices, is a symmetric, negativesemi definite matrix of rank L 1. Suppose that the preferences of the consumer are represented by a utility function u. Then, the indirect utility function, v, defined by v (p, m ) = u (x (p, m ), and which measures the utility that the consumer obtains when he or she faces income m and prices p, is homogeneous of degree zero and, remarkably, satisfies Roys identity: the negative of the ratio of the derivative of the indirect utility with respect to the price of a commodity to the marginal utility of income equals the Marshallian demand for that commodity; formally, (Dm v (p, m )1 Dp v (p, m ) = x (p, m ).

Representability of preferencesvia utility functions that assigned higher utility levels to more preferred bundles than to less preferred bundlesallows for an auxiliary problem: fixing a benchmark utility level ū, and given prices p, determine a bundle x̂ that:

  1. gives at least that level of utility: û (x̂ ) û ; and
  2. minimizes expenditure: every other bundle that gives utility of at least ú costs at least p x̂.

The solution to this problem defines the Hicksian demand function, h (p, ū ) = x̂, whose cost defines the expenditure function, e (p, ū ) = p h (p, ū ). Functions h (p, ū ) and e (p, ū ) are, respectively, homogeneous of degrees zero and one in prices. When small changes of consumption only induce small changes of utility (a condition known as continuity of preferences), the utility level given by the expenditure-minimizing bundle is exactly the required level: u (h (p, ū )) = û. Function e is strictly increasing in û and nondecreasing and concave in p, while Hicksian demand satisfies the compensated law of demand (this is not true for Marshallian demand), in a sense that Hicksian demands are nonincreasing in prices: (p p ) (h (p, ū ) h (p, û )). Under differentiability, Hicksian demand satisfies Shephards lemma: the derivative of the expenditure function with respect to the price of a commodity equals the Hicksian demand for that commodity, Dpe (p, ū ) = h (p, ū ).

Duality theory establishes, with minor qualifications, that Marshallian and Hicksian demands mirror each other: (1) the solution of the expenditure minimization problem also solves the preference maximization problem at income equal to the minimized expenditure: x (p, e (p, ū )) = h (p, ū ); (2) the solution of the utility maximization problem also solves the expenditure minimization problem at benchmark utility equal to the maximized utility: h (p, v (p, m )) = x̂ (p, m ); (3) the maximal utility achievable with income equal to the minimized expenditure is the benchmark utility, v (p, e (p, ū )) = û ; and (4) with lower income, it is impossible to obtain at least the maximized utility level, e (p, v (p, m ) = m. Shephards lemma shows that the first equality yields the Slutsky decomposition: Dph h (p, ū ) = S (p, e (p, ū )), which allows for empirical estimations of Hicksian demand. A commodity is said to be inferior if its demand decreases when the consumer has more income, and Giffen if it increases when the price of the commodity increases. It follows from Slutsky decomposition and the compensated law of demand (for Hicksian demands) that Giffen commodities are inferior.

Samuelsons program looked for conditions on demand data that were equivalent to the existence of the unobservable preferences: Given a series of observations of prices, incomes, and demanded bundles, do there exist preferences such that, at every observation, the observed demand is rational according to those preferences (x (pt, mt) = xt)? A necessary condition for the existence of such preferences is the Weak Axiom of Revealed Preference, or WARP: If pt xt mt and xt xt, then pt xt > mt; that is, if the bundle purchased at observation t, xt, could have been purchased at t (since it was affordable) but bundle xt was purchased instead, then it must be that the consumer prefers bundle xt to bundle xt. Then, at observation t, when the consumer actually purchased bundle xt, it must be that the more preferred bundle, xt, was not affordable. WARP is not, however, a sufficient condition. It compares only pairs of bundles, whereas rationality requires comparisons of sequences of bundles, since it implies that preference is a transitive relation. A transitive chain of reasoningslike the ones posed by WARP, known as the Strong Axiom of Revealed Preference is a necessary and sufficient condition for rationality.

Antonellis integrability result shows that homogeneity of degree zero, symmetry and negative semi-definiteness of the substitution matrix, and Walrass law exhaust the necessary conditions of a rational Marshallian demand. Using the solution to the system of differential equations implied by S, one can construct an expenditure function whose variation with respect to prices can be used to preferences that, when maximized, would yield the observed demand behavior.

The separability problem, first considered by John Hicks, studies how a group of commodities whose prices are kept in fixed proportions can be treated as a single, composite commodity whose price is constructed through the aggregation of the individual prices. This analysis provides the basis for the construction of price indices. A related problem assumes that preferences satisfy the following separability property: a group of commodities exists whose variation is ranked by the individual independently of the level of consumption of all other commodities. In this case, there is a subutility function, defined for the group in question, and the overall utility depends on the consumption of the group only via the subutility level. When preferences satisfy this separability condition, demand can be determined in a two-stage process: first, the individual decides how much to spend in the group, and then the individual decides how to allocate expenditures across commodities in the group.

Suppose that there is a set of consumers {1, , i, , I }, with individual variables indexed by i. The aggregate demand function is x (p, m 1, , m I ) = x 1(p, m 1) + + x I (p, m I ). The aggregation (or representative consumer) problem asks whether one can find an individual demand function x̄ such that x̂ (p, m 1, , m I ) = x̂ (p, m 1 + + m I ). The answer to this question is, in general, no, for it requires that all individuals have parallel wealth-expansion paths (the trajectories defined by changing individual incomes at given prices). Also, even under aggregation, individual satisfaction of WARP does not imply its satisfaction in the aggregate. WARP, in the aggregate, is obtained whenever individual Marshallian demands satisfy the law of demand, a condition that does not generally occur. (The definition of aggregate demand given here should not be confused with Hickss aggregate demand, which is used in macroeconomic models and in national accounts.)

In the standard setting, commodities can be interpreted to accommodate intertemporal problems. If there is only one commodity in each time period, relative prices represent interest rates, and an impatient consumer will anticipate consumption unless interest rates compensate for his or her impatience. In general, if intertemporal preferences are convex, an individual prefers a consumption plan that smooths consumption, in the sense that it avoids high levels of consumption in some periods and low levels in other periods. A canonical case for consumption smoothing is the life-cycle model originally proposed by Franco Modigliani, who divided life into three periods: (1) youth, when income is low; (2) adulthood, when income is high; and (3) retirement, when income is once again low. A consumer without restrictions will choose a smooth consumption plan that includes accruing debt during youth, repaying this debt and saving during adulthood, and spending savings during retirement. Consumption is determined by lifetime (discounted) income, while temporary deviations from this permanent income are accommodated by savings. A more general version of this model, involving different individuals at different stages in life, is known as the overlapping generations model. This model constitutes the basic tool for the economics of Social Security.

When the interpretation of commodities includes different states of nature, the model permits the study of uncertainty. In this case, convexity of preferences means that the individual dislikes risk and will avoid large consumption in some states if it implies low consumption in other states, unless prices compensate for this effect. This effect means that, if available, the individual will use insurance opportunities, or, alternatively, that groups of individuals will prefer risk-sharing schemes that disseminate risks.

Applied work usually imposes particular functional forms useful for estimation. An important, flexible functional form is the Almost Ideal Demand System (AIDS), which imposes an expenditure function of the form e(p,û) = α(p) + β(p)û where ,and some conditions on the parameters of these two functions are imposed. Applied work also uses hedonic models to impose additional structure on demand systems. It is assumed that individuals do not directly care about the commodities, but only about their attributes (physical features), which are, normally, objectively observable.

SEE ALSO Aggregate Demand; Aggregate Supply; Equilibrium in Economics; Excess Demand; Hedonic Prices; Markets; Rationality; Samuelson, Paul A.; Supply; Utility Function

BIBLIOGRAPHY

Ando, Albert, and Franco Modigliani. 1963. The Life-Cycle Hypothesis of Savings: Aggregate Implications and Tests. American Economic Review 53 (1): 55-84.

Deaton, Angus, and John Muelbauer. 1980. Economics and Consumer Behavior. Cambridge, U.K.: Cambridge University Press.

Hildenbrand, Werner. 1994. Market Demand. Princeton, NJ: Princeton University Press.

Samuelson, Paul. 1938. A Note on the Pure Theory of Consumers Behaviour. Economica 5: 61-71.

Andrés Carvajal

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Supply and Demand

SUPPLY AND DEMAND

The market process is generally modeled using the economic concepts of supply and demand. The plans/desires of consumers are embedded in the concept of demand and the plans/desires of producers in the concept of supply. The plans of these two types of economic actors are brought together in markets, which are the entities in which transactions occur. In a modern economy, markets do not require that the buyers and sellers meet in a geographic place, so markets no longer require actual "marketplaces."

The concept of demand represents the market activity of consumers. Demand is defined as the quantity of a good or service that consumers will be both willing and able to purchase at any given price during a specific period of time, holding all other factors constant. Demand is, therefore, a relationship between price and quantity demanded. Many factors other than price affect the amount consumers

Widgets
Quantity supplied Price Quantity demanded
50 $13 10
40 $11 20
30 $ 9 30
20 $ 7 40
10 $ 5 50

choose to purchase, and these factors are what is being held constant within the concept of demand.

Demand can be illustrated in a schedule that shows how many units of a good or service consumers will purchase at several distinct prices. Table 1 shows how many units of a good (widgets) consumers will purchase at a number of different prices. This relationship between price and quantity demanded can also be represented graphically. A demand curve represents the maximum price that consumers would be willing to pay for a particular quantity of the good. Consumers are willing to purchase something because they value that product more than its opportunity cost. The opportunity cost is the value of the best alternative they could purchase with the same money. That is, when a consumer chooses to spend $2 on a hamburger, he or she has decided that the hamburger provides more satisfaction (at that moment in time) than anything else that could be bought with that $2. Thus, the demand curve represents the value of the product to the consumer. The area under the demand curve provides a measure of the total value that consumers receive from consuming that amount of the product.

The nature of this relationship between price and quantity demanded is so consistent that it is called the law of demand. This law states that the relationship defined by the concept of demand is an inverse or indirect one. When prices rise, other factors held constant, consumers will purchase less of the good, and vice versa. The rationale for the law is that when the price of a product changes relative to the price of other products, consumers will change their purchasing patterns by buying less of the now higher-priced good and purchasing more of other goods which are now relatively less expensive that satisfy the same basic wants. Goods that satisfy the same basic wants are called substitutes. For example, if the price of beef rises relative to the price of pork, chicken, and turkey, consumers will shift some of their purchases from beef to pork, chicken, and turkey.

Supply can be defined as the relationship between the price of a good or service and the quantity producers are willing and able to make available for sale in a given period of time, holding other things constant. A supply schedule showing how many widgets producers will make available for sale at several distinct prices is also shown in Table 1. Supply represents graphically the minimum price that consumers are willing to accept in order to make a given amount of the good or service available for sale. As such, it is the opportunity cost to society of producing that particular good.

The law of supply states that this relationship is a direct one. When the price of a good rises, holding other factors constant, producers will be willing to supply more of the product. The rationale for this law is that resource owners will want to use their resources in the most valuable way possible. For example, if the market price of corn rises relative to that of wheat, farmers will choose to plant more of the land available to them in corn and less in wheat.

EQUILIBRIUM

A market is a place where suppliers and demanders meet to conduct an exchange. Modern markets do not require these two parties to be in the same place or even to communicate their desires at the same time. The market process can be thought of as a type of "auction process." Given the supply and demand curves shown in Figure 1, if an auctioneer was to call out a price of $5, consumer would be willing and able to purchase 50 units (the quantity demanded), but producers would be willing and able to supply only 10 units (the quantity supplied). If consumers want to buy 50 units and there are only 10 for sale, there is a shortage of 40 units (quantity demanded minus quantity supplied). Whenever there is a greater quantity demanded than supplied, there will be a shortage. Consumers will then attempt to compete for the scarce units. This competition will take the form of bidding up the price.

To continue with the auction illustration, the auctioneer sees that people want to buy more than is available, and so he calls out a new, higher price of $7 per unit. At $7, the consumers who valued the product more than $5, but less than $7, drop out of the market. That is, the quantity demanded falls from 50 units to 40 units. However, the law of supply tells us that the new, higher price will induce producers to increase the quantity supplied. The quantity supplied rises from 10 to 20 units. Consumers still want to buy more than producers want to sell, so there continues to be a shortage, but the shortage has been reduced from 40 units to 20 units. Consumers still must attempt to out-compete other consumers, and the price is bid up again. Only when the auctioneer calls out a price of $9 is the quantity consumers demand equal to the quantity that producers supply. This is called the market clearing price. This price "clears" the market because


everyone who wants to buy at that price is able to and everyone who wants to sell at that price is able to. This makes the market stable because consumers no longer have a need to bid up the price. Thus, the market is at an equilibrium at the price for which the quantity demanded is equal to the quantity supplied.

If the price is above the market clearing price, consumers will be willing and able to buy less than producers are willing and able to make available for sale. For example, if the price is $13 (in Figure 1), quantity demanded will be 10 units and quantity supplied will be 50 units. Whenever quantity supplied is greater than quantity demanded, there will be a surplus. In this case, the surplus is equal to 40 units (quantity supplied minus quantity demanded). If there is a surplus in a market, producers will compete with each other for scarce buyers by bidding down the price. When the price falls to $11, consumers will increase the amount they want to buy to 20 units and producers will reduce the amount they want to sell to 40 units, so that the surplus falls to 20 units. But here, the producers will continue to try to outcompete other producers for the consumers in the market by offering their product for an even lower price. It is not until the price falls to the market clearing level of $9 that the surplus disappears and producers no longer need to bid the price down in order to sell their product.

If the price is below the market clearing price, consumers will up bid the price, and if the price is above the equilibrium price, producers will bid down the price. It is only at the equilibrium price that quantity demanded equals quantity supplied and the market price stabilizes. This is the only price for which consumers have no reason to offer a higher price and producers have no reason to offer a lower price.

NONPRICE DETERMINANTS OF DEMAND

Consumers base their purchasing decisions on several factors other than price. These nonprice determinants of demand are the things that are held constant in the definition of demand. When these factors change, the relationship between price and quantity demanded changes; that is, the demand curve itself shifts. An increase in demand is represented graphically as a shift in the demand curve in a northeasterly direction (for example, from D 0 to D 1 in Figure 2), and a decrease in demand is represented as a shift of the demand curve in a southwesterly direction (for example, from D 0 to D 2 in Figure 2). The two main nonprice determinants of demand are consumers' incomes and wealth, and the prices of related goods. An increase in income and/or wealth can cause the demand for a good to either increase or decrease. If an increase in income/wealth causes the demand for a good to increase, the good is called a normal good. This increase in demand is illustrated in Figure 2 by a shift from D 0 to D 1, causing the market equilibrium to change from E 1 to E 2, resulting in an increase in the market price (from $9 to $11) and an increase in quantity bought and sold (from 30 to 40 units). If an increase in income/wealth causes the demand for a good to decrease, the good is called an inferior good. This is illustrated in Figure 2 by a shift in demand from D 0 to D 2. The market then clears at E 3 with a lower market price ($7) and a smaller quantity (20 units). Likewise, the impact of a change in the price of a related good on a good's demand depends on whether the goods are related as substitute goods or complementary goods. Two goods are substitutes if an increase in the price of one causes the demand for the other to increase, and the goods are complements if an increase in the price of one causes the demand for the other to decrease.

NONPRICE DETERMINANTS OF SUPPLY

Producers base their decisions about what to produce with the productive resources they have at their disposal on more factors than just the prices of the different goods. These other factors are called the nonprice determinants of supply. The major nonprice determinants of supply are the prices of the inputs used to produce the product, the state of technology used to produce the product, and the prices of other goods that are related in production. An increase in supply is represented graphically as a shift in the supply curve in a southeasterly direction and a decrease in supply is shown as a shift in a northwesterly direction (see Figure 2). An increase (decrease) in the price of an input into the production of a good, which would increase (decrease) the cost of production, will cause the supply to fall (rise). For example, an increase in the price


of fertilizer will cause the supply of corn to fall, holding other factors constant. If the supply curve were to shift from S 0 to S 2, everything else being equal, the market equilibrium would change from point E1 to E5, causing the market clearing price to rise (from $9 to $11) and quantity transacted to fall (from 30 to 20 units). An advancement in technology that lowers the cost of production will also cause supply of the good to rise. For example, the discovery of a new chemical agent that increases the yield of an acre of land planted in corn will increase the supply of corn, holding other factors constant. If the supply curve were to shift from S 0 to S 1, the market equilibrium would change from point E 1 to E 4, causing the market clearing price to fall (from $9 to $7) and the quantity transacted to rise (from 30 to 40 units). An increase (decrease) in the price of a different good that is produced using the same inputs (goods that are related in production) will cause producers to increase their production of the now higher-priced, and hence more profitable, good. In order to do this, resources will need to be reallocated away from the production of other goods. For example, an increase in the price of wheat (relative to the price of corn) will cause producers to shift factors of production toward the production of wheat and away from the production of corn.

see also Macroeconomics/Microeconomics ; Pricing

John L. Conant

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Supply and Demand

Supply and Demand

Supply and demand is a fundamental factor in shaping the character of the marketplace, for it is understood as the principal determinant in establishing the cost of goods and services. The availability, or "supply," of goods or services is a key consideration in determining the price at which those goods or services can be obtained. For example, a landscaping company with little competition that operates in an area of high demand for such services will in all likelihood be able to command a higher price than will a business operating in a highly competitive environment. But availability is only one-half of the equation that determines pricing structures in the marketplace. The other half is "demand." A company may be able to produce huge quantities of a product at low cost, but if there is little or no demand for that product in the marketplace, the company will be forced to sell units at a very low price. Conversely, if the marketplace proves receptive to the product that is being sold, the company can establish a higher unit price. "Supply" and "demand," then, are closely intertwined economic concepts; indeed, the law of supply and demand is often cited as among the most fundamental in all of economics.

FACTORS IMPACTING SUPPLY AND DEMAND

When using the term "demand" most people think the word means a certain volume of spending, as when we say that the demand for cars has fallen off or the demand for paper is high. But that is not what economists mean when using the term. For economists, demand means not just how much we are spending for a given item, but how much we are spending for that item at its price, and how much we would spend if its price changed.

The demand for products and services is predicated on a number of factors. The most important of these are the tastes, customs, and preferences of the target market, the consumer's income level, the quality of the goods or services being offered, and the availability of competitors' goods or services. All of the above elements are vital in determining the price that a business can command for its products or services, whether the business in question is a hair salon, a graphic arts firm, or a cabinet manufacturer.

The supply of goods and services in the marketplace is predicated on several factors as well, including production capacity, production costs (including wages, interest charges, and raw materials costs), and the number of other businesses engaged in providing the goods or services in question. Of course, some factors that are integral in determining supply in one area may be inconsequential in another. Weather, for example, is an important factor in determining the supplies of wheat, oranges, cherries, and myriad other agricultural products. But weather rarely impacts on the operations of businesses such as bookstores or auto supply stores except under the most exceptional of circumstances.

"When we are willing and able to buy more, we say that demand rises, and everyone knows that the effect of rising demand is to lift prices," summarized Robert Heilbroner and Lester Thurow in their book Economics Explained: Everything You Need to Know About How the Economy Works and Where It's Going. "Of course the mechanism works in reverse. If incomes fall, so does demand, and so does price." They point out that supply can also dwindle as a result of other business conditions, such as a rise in production costs for the producer or changes in regulatory or tax policies. "And of course both supply and demand can change at the same time, and often do," added Heilbroner and Thurow. "The outcome can be higher or lower prices, or even unchanged prices, depending on how the new balance of market forces works out."

SUPPLY AND DEMAND ELASTICITY

The demand for goods depends on the price for those goods, as well as on consumer income and on the prices of other goods. Similarly, supply depends on price, as well as on variables that affect production cost. How much the supply and demand will rise or fall is often difficult to predict. This measurement of a product or service's responsiveness to market changes is known as elasticity. Elasticity is a measure of the responsiveness of one economic variable to another. For example, price elasticity is the relationship between a change in the supply of a good and the demand for that good. Economists are often interested in the price elasticity of demand, which measures the response of the quantity of an item purchased to a change in the item's price. A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in demand for the product or service. Products and services that are highly elastic are usually more discretionary in naturereadily available in the market and something that a consumer may not necessarily need in his or her daily life. On the other hand, an inelastic good or service is one for which changes in price result in only modest changes in demand. These goods and services tend to be necessities.

The quality and degree of marketplace reaction to price changes depend on several factors. These include: 1) the presence or absence of alternative sources for the product or service in question; 2) the time available to customers to investigate alternatives; 3) the size of the investment made by the purchaser. Elasticity, then, is an important factor for small business owners to consider when entertaining thoughts about changing the prices of the goods or services that they offer.

see also Elasticity; Product Costs

BIBLIOGRAPHY

Hall, Robert Ernest. Microeconomics: Principles and Applications. Thomson South-Western, January 2004.

Heilbroner, Robert, and Lester Thurow. Economics Explained: Everything You Need to Know About How the Economy Works and Where It's Going. Revised Edition. Touchstone, 1998.

Langabeer II, Jim R. "Aligning Demand Management with Business Strategy." Supply Chain Management Review. May 2000.

"No Conspiracy: Law of Supply and Demand At Work." Paducah Sun. 5 May 2006.

                                  Hillstrom, Northern Lights

                                    updated by Magee, ECDI

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supply and demand

supply and demand, in classical economics, factors that are said to determine price, by correlating the amount of a given commodity producers hope to sell at a certain price (supply), and the amount of that commodity that consumers are willing to purchase (demand). Supply refers to the varying amounts of a good that producers will supply at different prices; in general, a higher price yields a greater supply. Demand refers to the quantity of a good that is demanded by consumers at any given price. According to the law of demand, demand decreases as the price rises. In a perfectly competitive economy, the combination of the upward-sloping supply curve and the downward-sloping demand curve yields a supply and demand schedule that, at the intersection of the two curves, reveals the equilibrium price of an item. Theories of supply and demand had their roots in the early 20th cent. theories of Alfred Marshall, which recognized the role of consumers in determining prices, rather than taking the classical approach of focusing exclusively on the cost for the producer as a determinant. Marshall's work brought together classical supply theory with more recent developments concentrating on the utility of a commodity to the consumer (see value). More recent theories, such as indifference-curve analysis and revealed preference, offer more flexibility to the supply and demand theories created by proponents of marginal utility. The theory of elasticity is significant as well: it shows how certain commodities will bear a substantial rise in price if there is not an equitable substitute available, while other easily replaceable commodities cannot do so without losing business to competitors. See also competition.

See L. Klein, The Economics of Supply and Demand (1983); K. Cuthbertson, The Supply and Demand for Money (1985).

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Supply and Demand

SUPPLY AND DEMAND


"Supply and demand" refers to the idea that the price of a product is dependent on the amount of that product available to sell (the supply) and the desirability of the product to consumers (the demand). Sellers want high prices and buyers want low prices, and the strength of these conflicting desires will determine the price. In economic terms, supply refers to a schedule of quantities that people are willing to sell at different prices at a given time, and demand refers to a schedule of quantities people are willing to buy at different prices at a given time. The two terms in economics are linked together, like the terms "buyer" and "seller." The interaction between the supply of goods and services and the demand for them brings about a price, for each item and service, at which suppliers and demanders are willing and able to sell and buy the same quantity of goods. When the supply and demand are equal, the price of any product is said to be at an equilibrium price. The marketplace, the arena of business competition, is not only where the clash of interest between buyer and seller is worked out by the opposition of supply and demand, but it is also where buyers contend against buyers, and sellers against sellers. Supply and demand is always changing. Changes in willingness or ability to buy or sell are always occurring. The rise or fall of income alters the ability to buy. Fluctuations of desire or need alter the willingness to buy. On the seller's side, when the price of labor, land, or capital change, then the seller may alter his ability or willingness to offer his products on the markets at reduced or increased prices. Supply and demand in the marketplace is never a static phenomenon. The marketplace is always dynamic and changing, as supply changes, as demand changes, and as quantities of supplies and demands change.

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"Supply and Demand." Gale Encyclopedia of U.S. Economic History. 2000. Encyclopedia.com. 25 Jun. 2016 <http://www.encyclopedia.com>.

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supply and demand, law of

supply and demand, law of Economic balance between goods required and produced. The law of supply indicates that, other things being equal, as the price of an item increases, suppliers are willing to produce more, and as the price decreases producers are willing to produce less. Thus, price and quantity supplied are directly related. The law of demand states the reverse: as prices increase, consumers demand less, and as prices decrease, consumers demand more. Thus, prices and quantity demanded are inversely related.

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"supply and demand, law of." World Encyclopedia. 2005. Encyclopedia.com. 25 Jun. 2016 <http://www.encyclopedia.com>.

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demand and supply

demand and supply: see supply and demand.

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