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, letâ€™s first consider more fully, what we mean by the terms market and competition.
What is a market?
A market is 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 one time. 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 to buy at each store. Nonetheless, these consumers and producers of ice cream are closely connected. The ice cream buyers are choosing from the various ice-cream sellers to satisfy tier hunger, and the ice cream sellers are all trying to appeal to the same ice cream buyers to make their businesses successful. Even though it is not organized, the group of ice cream buyers and ice cream sellers forms a market.
What Is Competition?
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 to that 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 market place.
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 are 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, ad (2) the buyers and sellers are so numerous that no single buyer or seller has any influence over the market rice. 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.
There are some markets in which the assumption of perfect competition applies perfectly. In the wheat market, for example, there are thousands of farmers who sell wheat and millions of consumers who use wheat and wheat products. Because no single buyer or seller can influence the price of wheat, each takes the price as given.
Not all goods and services, however, are sold in perfectly competitive markets. Some markets have only one seller, and this seller sets the price. Such a seller is called a monopoly. Your local cable television company, for instance, may be a monopoly. Residents of a town probably have only one Cable Company from which to buy this service. Some markets fall between the extremes of perfect competition and monopoly.
Despite the diversity of market types we find in the world, assuming perfect competition is a useful simplification and therefore, a natural place to start. Perfectly competitive markets are the easiest to analyze because everyone participating in the market takes the price as given by market conditions. Moreover, because some degree of competition is present in most markets, many of the lessons that we learn by studying supply and demand under perfect competition apply in more complicated markets as well.