Thermodynamics and Economics
Supply and Demand
By Mark Ciotola
First published on February 15, 2019
Supply and Demandtheory models at which prices consumers will purchase a product, at what prices will producers sell a product, and the resulting market price for the product. Supply and demand provides a framework for understanding pricing and sales volume. Although real life pricing sometimes deviates from this idealized theory, the Supply and Demand approach can help identify why those deviations exist.
The supplyfunction is the price at which producers will sell a product as a function of quantity sold. According to theory, producers will demand a higher price for each additional unit of product sold, due to increasing marginal costs. Let’s use gold as an example. Each additional unit of gold mined requires gold producers to mine more deeply into the ground (or use lower grade ore), which is more expensive. In summary, suppliers tend to charge more money per additional unit demanded, at least in the short run.
The demandfunction is the price at which consumers will buy a product as a function of quantity purchased. According to theory, consumers will only pay a lower price for each additional unit of product purchased, due to a decreasing marginal utility. (Utility means the value the the product to consumers). Continuing with gold for an example, consumers only really need so much gold. They might be willing to pay all their savings for a small amount of gold engagement ring. They might still be willing to pay a lot of money per gram for additional gold jewelry. Beyond that, most people do not have a high need or desire for moregold, and would not be willing to pay as much for more of it. In summary, as supply increases, prices consumers are willing to pay tend to fall. Once supply sufficiently increases, producers literally cannot even give away their product for free and price drops to zero.
Determining the Market Price
These functions can be plotted, with the axes being price and quantity. Where these two functions intersect indicates both market price and quantity produced. The plots shown are examples. Actual plots may vary.
Although some plots may be straight lines, the plots will often form concave curves in real life. This means the the marginal affects are accelerating for supply while decelerating for demand.
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