The Demand and Supply Model by Peter Smith, Economic Review Vol 25, Nov 2007 (adapted)

The demand and supply model is a powerful device that enables us to analyse a wide range of market situations. Learning to use it appropriately is an important step towards becoming an economist.

This model is relatively straightforward, but there are some pitfalls that students should be aware of when using it. This involves the important distinction between “movements along” and “shifts of” the demand or supply curve.

Market equilibrium

Fig 1: Market Equilibrium

Fig 1 shows the market for palm oil. Most of us consume palm oil in one form or another eg in the form of instant noodles, breakfast bars, doughnuts, margarine, crackers, crisps or French fries. Palm oil is also used in the manufacture of skin and body care products, toiletries, cosmetics, candles and soap products. In drawing it, demand is assumed to be at D0 and supply at S0 . As there are many small producers, so market supply curve is upward-sloping – an increase in the market price of palm oil would encourage producers to increase the output of the product. Supply is drawn to be relatively inelastic, on the assumption that it is quite difficult to increase production in the very short run, as it may take some time to plant new trees in order to do so. The market equilibrium will occur when the price is given by P0 and the quantity traded is Q0.

This is an equilibrium in the sense that the quantity that consumers wish to buy is just matched by the quantity that producers wish to sell – at the going price. P0 is the unique price at which this balance occurs.

Comparative statics

Much of the power of the demand and supply model comes in analyzing how this market equilibrium changes if there is a change in market conditions. We can then