Theory of Demand and Supply

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1.Supply and Demand
Economists Are a Joke?
A smarty-pants old story says that if you want a "learned economist," all you have to do is get a parrot and train the bird to squawk "supply and demand" in response to every question. Not fair, but ...

It's true that the "theory of supply and demand" is a central part of economics. It is widely applicable, and also is a model of the way economists try to think most problems through, even when the theory of supply and demand is not applicable.

A Theory of Price
What is it? The theory of supply and demand is a theory of price and output in competitive markets. Adam Smith had argued that each good or service has a "natural price." If the price (of beer, for example), were above the natural price, then more resources would be attracted into the trade (brewing, in the example), and the price would return to its "natural" level. Conversely if the price began below its "natural" level. The modern theory of supply and demand differs from Smith's theory in some important ways. Economists have made some progress in the last 200 years, and great economists such as John Stuart Mill and Alfred Marshall (and many others) have played their part in the growth of the modern theory of supply and demand. Nevertheless, the theory of supply and demand is the modern expression of Smith's great insight about "the natural price." To make a long story short, before about the 1850's most economists accepted the Labor Theory of Value as the theory of the "natural price." But there were some cases it did not apply to: international trade, for example. John Stuart Mill suggested a "supply and demand" solution for prices in international trade. Other economists extended it to apply to prices in general. Unlike the "natural price," a long-run theory only, the theory of supply and demand applies in the short run as well as the long.

Supply, Demand, and Allocation
As we have seen, one of the key words in economics is "allocation." To allocate resources is to determine who gets the use of what resources. An obvious case of allocation of resources is when the government decides who will get the use of the resources. But market processes of bidding, buying and selling can also determine who gets the use of what resources. That is, in effect, markets can allocate resources. Accordingly, economics is centrally concerned with the workings of markets, and with the question, how do markets allocate resources? One answer to that question is expressed in the familiar phrase, "Supply and Demand." Here, again, we encounter "models." The allocation of resources through markets is a complex process. The economist's approach to understanding this complex process is to 1.conceive a model based on some of the key aspects of the market system, 2.abstract from other aspects, and investigate the workings of the model,
with the idea that the answers will then be applicable (at least as hypotheses to be checked) to the actual market system. While there are several models of resource allocation through markets, the model of "Supply and Demand" is the best known and most widely used model. It is the starting point for the others (though most of the other models begin by contradicting some aspect of the Supply and Demand model). The main objective of this chapter will be to introduce the Supply and Demand model, together with very brief sketches of some alternative models. We are concerned with efficiency in the allocation of resources, so a natural question to ask is whether the market allocation of resources is efficient. This is a large and complex question. Over the next few chapters, we will explore some of the dimensions of the question and its answer.

Analysis of Markets
Our approach to market theory will be first analytic and then...
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