## Supply and Demand: Why Markets Tick

## Source details

**Canonical URL:** [Supply and Demand: Why Markets Tick](https://www.imf.org/en/publications/fandd/issues/series/back-to-basics/supply-and-demand)

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- [Markdown version](/en/publications/fandd/issues/series/back-to-basics/supply-and-demand/index.md)
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## Bibliographic details
- Authors: Irena Asmundson
- Published: January 2, 2019

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### Core concepts: supply, demand, and price
- In any market transaction between a seller and a buyer, the price of the good or service is determined by supply and demand in a market.
- Supply is summarized by the supply curve: the quantities suppliers are willing to produce at each price. The higher the price, the more suppliers are likely to produce.
- Demand is summarized by the demand curve: the quantities consumers are willing to buy at each price. The lower the price, the more consumers buy.
- The intersection of the supply and demand curves represents the market-clearing price—the price at which demand and supply are the same.
- Suppliers will keep producing as long as they can sell the good for a price that exceeds their marginal cost of production.
- Buyers will purchase as long as the marginal utility of consumption exceeds the price.

### Market structures and competition
- Perfect competition:
  - Large numbers of identical suppliers and demanders.
  - Buyers and sellers can find one another at no cost.
  - No barriers prevent new suppliers from entering the market.
  - No individual agent can affect prices; both sides take the market price as given.
- Monopoly and monopsony:
  - Monopoly: one supplier of a good for which there is no simple substitute; the supplier can set price rather than take it as given.
  - Monopsony: one buyer, usually a government, often facing many suppliers.
- Intermediate market structures:
  - Many markets fall between perfect competition and monopoly; in those cases, prices are higher and production is lower than under perfect competition.

### Elasticity and responsiveness
- The relationship between supply and demand and changes in price is called elasticity.
- Inelastic goods are relatively insensitive to price changes; elastic goods are very responsive.
- Examples:
  - Energy is cited as a classic inelastic good (at least in the short term).
  - Steak is cited as an elastic good.

### Barriers to competition and regulatory responses
- Monopolies typically arise from natural or legal barriers to entry.
- Utilities often operate as natural monopolies (inefficient for multiple firms to duplicate infrastructure).
- Governments usually regulate such monopolies to ensure they do not abuse market power by setting prices too high.
- Regulatory responses cited:
  - Allow a company to operate as sole provider in return for requirements for minimum services to everyone.
  - Caps on prices that can be charged, typically set to allow companies to recover fixed costs.

### Monopoly behavior and welfare implications
- A monopolist faces the entire market demand curve and chooses output to maximize profit, typically resulting in:
  - Higher prices than under perfect competition.
  - Lower supply than under perfect competition.
- Numerical illustration from the text:
  - Firm in perfect competition: earns 5 cents a unit selling 1,000 units—or $50—in a total market of 100,000 units.
  - If it lowers its price by 1 cent and gains an additional 1,000 units in sales, profits become $80 on sales of 2,000 units.
  - Monopolist: controls all 100,000 units at a nickel a share, earning a profit of $5,000.
  - If monopolist lowers price by a penny and increased demand by 1,000 units:
    - That adds $40 to revenues.
    - But loses a penny in profit on each of the 100,000 units previously sold—or $1,000.
- Key outcome: monopolists usually set higher prices and restrict quantity relative to perfect competition.

### Product differentiation and temporary monopolies
- Product variety allows substitution across types; differentiated products give producers limited market power even in competitive markets.
- When main features are expensive to create but cheap to imitate (books, drugs, computer software), complications arise:
  - High fixed costs and low marginal costs make imitation profitable for competitors.
  - Governments often grant a temporary monopoly (copyright for books) so price exceeds marginal cost, allowing authors and publishers to recoup fixed costs and incentivize future production.

### Determinants of market outcomes
- Production technologies, consumer preferences, and difficulties in matching sellers with buyers influence markets and determine the market-clearing price.
- Prices can change for many reasons, including technology, consumer preference, and weather conditions.

*Source: Supply and Demand: Why Markets Tick; F&D Magazine; Irena Asmundson.*

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_Source: https://www.imf.org/en/publications/fandd/issues/series/back-to-basics/supply-and-demand_