Fundamental theory
El modelo establece que en un mercado libre, la cantidad de productos ofrecidos por los productores y la cantidad de productos demandados por los consumidores dependen del precio de mercado del producto.
La ley de la oferta indica que la oferta es directamente proporcional al precio; cuanto más alto sea el precio del producto, más unidades se ofrecerán a la venta. Por el contrario, la ley de la demanda indica que la demanda "Demanda (economía)") es inversamente proporcional al precio; cuanto más alto sea el precio, menos demandarán los consumidores. Por tanto, la oferta y la demanda hacen variar el precio del bien.
Según la ley de la oferta y la demanda "Demanda (economía)"), y asumiendo esa competencia perfecta, el precio de un bien se sitúa en la intersección de las curvas de oferta y demanda.[14] Si el precio de un bien está demasiado bajo y los consumidores demandan más de lo que los productores pueden poner en el mercado, se produce una situación de escasez, y por tanto los consumidores estarán dispuestos a pagar más. Los productores subirán los precios hasta que se alcance el nivel al cual los consumidores no estén dispuestos a comprar más si sigue subiendo el precio. En la situación inversa, si el precio de un bien es demasiado alto y los consumidores no están dispuestos a pagarlo, la tendencia será a que baje el precio, hasta que se llegue al nivel al cual los consumidores acepten el precio y se pueda vender todo lo que se produce.[15].
The supply curve
The second law stated (see II above) establishes that, in the event of an increase in the price of a good, and assuming a competitive market, the quantity supplied of that good will be greater; That is, producers of goods and services will increase production. This is generally referred to as the “Law of Supply”.[16].
The above is conceptualized in the supply curve, which is the graphic representation of the relationship – or elasticity "Elasticity (economics)") – existing between the price of a good and the quantity supplied of the same.[17].
The slope of this curve determines how the quantity supplied of a good increases or decreases when its price decreases or increases. Price elasticity of supply is called #Elasticity_of_the_price-supply_relationship "Elasticity (economics)") to the degree of variation of the quantity supplied to a change in the price. This ranges from a totally inelastic response (vertical line) meaning that production does not respond to changes in prices to a totally elastic one (horizontal line), meaning that changes in production are greater than changes in prices.
The determinants of this elasticity include: ease or not of acquiring inputs. Existence or not of excessive production capacity and/or accumulated inventories. Complexity of the production process, or relative difficulty of implementing extensions or modifications to that process, including the time and cost necessary to implement those modifications. More general considerations about the company's position in relation to the market, including possible desirability of simply taking advantage of rising prices, etc.
Because supply is proportional to price, supply curves are, generally but not always, increasing.[18].
Additionally, and due to the law of diminishing returns, the slope of a supply curve can be decreasing (i.e., it is usually a concave function), although not necessarily. An example is the labor market supply curve. Generally, when a worker's salary increases, he is willing to offer a greater number of hours of work, because a higher salary increases the marginal utility of work (and increases the opportunity cost of not working). But when such compensation reaches certain levels, the worker may experience the law of diminishing returns in relation to his pay. The amount of money he is making will make another raise of little value to him. Therefore, from that point on you could dedicate fewer hours to work as your salary increases, deciding to invest your time in leisure. We find an example of this in the salaries of the members of the Board of Directors. While it is relatively easy to motivate manual workers or professionals to work overtime, it is difficult to motivate members of such councils, whose “working hours” generally range from one meeting (morning or afternoon) once a month to five or six, or even once or twice a year[19][20] with salaries ranging from, for small businesses, a “retention salary” of between $5,000 to $10,000 annually and “attendance bonuses” between 500 and 2000 for each meeting attended, plus "reimbursement" for "travel expenses", etc.,[21] at salaries such as £250,000 per year (the lowest among directors of the Barclays banking group), which, however, is increased by "performance related pay" to £10.7 million per year,[22] that, not counting a variety of bonuses for "achieving objectives", gains on stock "options", etc. It is easy to see how remunerations at that level do not produce the necessary motivation to perform functions with due attention, which ended in the economic crisis of 2008-2011.
This type of supply curves has also been observed in other markets, such as oil: after the record price caused by the 1973 crisis, the US decreased its oil production.[23].
The demand curve
The demand curve represents the relationship between the quantity of a good or set of goods and services that consumers want and are willing to buy in relation to its price, assuming that the rest of the factors remain constant. The demand curve is generally decreasing, that is, at a higher price, consumers will buy less. This is generally known as the “law of demand”.[24].
The determinants of an individual's demand are the price of the good, the level of income, personal tastes, the price of substitute goods, and the price of complementary goods.
The slope and shape of the demand curve represents the price elasticity of demand, with ends on a vertical line (inelastic demand, representing the case in which the change in demand is less than the change in prices) and a horizontal line, or elastic demand, with changes in demand greater than the changes in prices (for example, in a perfectly competitive market, raising prices by a company can lead to that company losing all its sales).
As mentioned before, the demand curve is almost always decreasing. But there are some examples of goods that have increasing demand curves. A good whose demand curve is increasing is known as either a Veblen good or a luxury good; or as a Giffen good or an inferior good. The classic example of the latter, provided by Alfred Marshall[25] are basic foods, whose demand is defined by poverty, which does not allow consumers to consume better quality food. As prices of either food or general foods increase, consumers cannot afford to purchase other types of food, so they have to increase their consumption of basic foods.
Changes in demand and quantity demanded
The price of a product on the market is determined by a balance between supply (what one is willing to produce at a certain price) and demand (what one wants to buy at a certain price). The graph shows an increase in demand from D1 to D2, causing an increase in the relative price and quantity produced.
The more people want something, the quantity demanded at all prices will tend to increase. This is an increase in demand.
Increasing demand can be represented on the graph as the curve to the right, because at each price point, a greater quantity is demanded.
This increase in demand causes the initial curve D1 to shift to the new curve D2. This raises the equilibrium price from P1 to P2.
This raises the equilibrium quantity from Q1 to Q2. Conversely, if demand decreases, the opposite happens, it goes from curve D2 to D1.
Demand is what the consumer wants, when demand increases, prices increase. EX: the demand for ice cream on an ordinary day can be 40 units, but on a hot day the demand for ice cream can be 100, this is because there are more people who want to consume ice cream due to the heat, even when the price of ice cream has not changed. But as the demand for ice cream increases, it is most likely that its price will increase.
The quantity demanded is what you are willing to consume at a certain price. EX: if you have 30 dollars and the ice cream is worth 15 dollars, the quantity demanded at that price will be two ice creams, but, if the price of ice cream decreases to 10 dollars, there will now be an increase in the quantity demanded since now three ice creams can be consumed (one more than before): the quantity demanded increased because the price decreased.
In short: if demand increases, prices rise and therefore the quantity demanded decreases. On the contrary, if demand decreases, prices decrease and the quantity demanded increases.
Example: supply and demand in an economy of 6 people
The supply and demand model can be studied through individuals interacting in a market. Suppose a simplified economy in which the following six individuals participate:.
There are many possible transactions that would please both people involved, but not all of them will happen. For example, Place and Master hotels would be interested in doing your business at any price between 25 and 30. If the price was higher than 30, Cristina would not be interested, since it is too high a price. If the price dropped below 25, then it would be Master Hotels that would not be satisfied with the transaction. However, Cristina will discover that there are other producers in the market who are willing to sell below 25, so she will not negotiate with Fernando. In an efficient market, each seller will receive the highest possible price, and each buyer will pay the lowest possible price.
Imagine that Cristina and Master Hotels are arguing about the price. Master Hotels offers a rental for 25. Before Cristina accepts it, Place Hotels offers it for 24. Fernando is not willing to sell at 24, so he leaves. At that moment, our company is offered for 12. Place is obviously not going to sell at that price, so it seems that the sale is decided. However, Fernando appears and offers 14, but only one person is willing to sell at that price (our company). Cristina finds out and since she does not want to lose this great opportunity, she offers our company 16 per room. Now Place is also willing to sell, so we have two buyers and two sellers at that price (note that any price between 15 and 20 could have been set). Here it seems that all four are in agreement. But what happens with Master and Alicia Hotels? Both are not willing to negotiate with each other, because Alicia is only willing to pay 10 and Master Hotels does not want to accept anything below 25. Alicia cannot improve Fernando and Cristina's offers to buy from our company, so Alicia cannot negotiate with them. Master cannot lower the sales price as much as our company or Place hotels, so now he can no longer negotiate with Cristina. In other words, a point of equilibrium has been achieved.
A graph with supply and demand curves can be drawn from this data.
The demand would be:
The offer would be in this case:
Supply and demand coincide when the negotiated quantity is two rooms and the price is set between 15 and 20. Whether our company sells to Cristina, and Place to Fernando, or if our company sells to Fernando, and Place sells to Cristina, an agreement can be reached. However the exact agreed price cannot be determined. This is the only limitation of this simplified model. If this example is transferred to a perfectly competitive market, with enough participants, then the price could be established exactly. For example, if the last transaction was between someone who was willing to sell at 15.50 and someone willing to pay 15.51, then the price could be determined to the nearest cent. The more participants enter the market, the more likely it is that a price will be found as close to the equilibrium point as possible.