When a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the country. When the weather turns in New England every summer, the price of hotels rooms in the Caribbean plummets. When a war breaks out in the Middle East, the price of gasoline in the US rises, and the price of a used Cadillac falls, what do these events have in common? They all show the workings of supply and demand.
Supply and demand are the two words economists use most often and for good reason. Supply and demand are the forces that make market economies work. They determine the quantity of each good produced and the price at which it is sold. If you want to know how any event or policy will affect supply and demand?
The theory of supply and demand considers how buyers and sellers behave and how the interact with one another. It shows how supply and demand determine prices in a market economy and how prices, in turn, allocate the economy’s scarce resources.
Markets and competition
The terms supply and demand refer to the behavior of people as they interact with one another in competitive markets. Before discussing how buyers and sellers behave, let’s first consider more fully what we mean by the terms market and competition.
What is a market?
A group of buyers and sellers of a particular good or service The buyers as a group determine the demand for the product and the sellers as a group determine the supply of the product.
Markets take many forms. Sometimes markets are highly organized such as the markets for many agricultural commodities. In these markets, buyers and sellers meet at a specific time and place, where an auctioneer helps set prices and arrange sales.
More often markets are less organized. For example consider the market for ice cream in a particular town. Buyers of ice cream do not meet together at any onetime. The sellers of ice cream are in different locations and offer somewhat different products. There is no auctioneer calling out the price of ice cream. Each seller posts a price for an ice cream cone, and each buyer decides how much ice cream is closely connected. The ice cream buyers are choosing from the various ice cream sellers to satisfy their hunger, and the ice cream sellers are all trying. Even though it is not organized the group of ice cream buyers and ice cream sellers form a market.
What is Competition?
A market in which there are many buyers and many sellers so that each has a negligible impact on the market price.
The market for ice cream, like most markets in the economy is highly competitive. Each buyer knows that there are several sellers from which to choose, and each seller is aware that his product is similar tot hat offered by other sellers. As a result, the price of ice cream and the quantity of ice cream sold are not determined by any single buyer or seller. Rather price and quantity are determined by all buyers and sellers as they interact in the marketplace.
Economists use the term competitive market to describe a market in which there are so many buyers and so many sellers that each has a negligible impact on the market price. Each seller of ice cream has limited control over the price because other sellers are offering similar products. A seller has little reason to charge less than the going price, and if he charges more, buyers will make their purchases elsewhere. Similarly, no single buyer of ice cream can influence the price of ice cream because each buyer purchases only a small amount.
We assume that markets re perfectly competitive. To reach this highest form of competition a market must have two characteristics: (1) the goods offered for sale are all exactly the same and (2) the buyers and sellers are so numerous that no single buyer or seller has any influence over the market price. Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers. At the market price, buyers can buy all they want, and sellers can sell all they want.