Assumptions
The supply and demand model does not describe all markets—there is too much diversity in the ways buyers and sellers interact for one simple model to explain every market. When we use the supply and demand model to explain a market, we are implicitly making a number of assumptions about that market.
Supply and demand analysis assumes competitive markets. For a supply curve to exist, there must be a large number of sellers in the market; and for a demand curve to exist, there must be many buyers. In both cases there must be enough so that no one believes that what he does will influence price. In terms that were first introduced into economics in the 1950s and that have become quite popular, everyone must be a price taker and no one can be a price searcher. If there is only one seller, that seller can search along the demand curve to find the most profitable price.1 A price taker cannot influence the price, but must take or leave it. The ordinary consumer knows the role of price taker well. When he goes to the store, he can buy one or twenty gallons of milk with no effect on price. The assumption that both buyers and sellers are price takers is a crucial assumption and often it is not true with regard to sellers. If it is not true with regard to sellers, a supply curve will not exist because the amount a seller will want to sell will depend not on price but on marginal revenue.
The model of supply and demand also requires that buyers and sellers be clearly defined groups. Notice that in the list of factors that affected buyers and sellers, the only common factor was price. Few people who buy hamburger know or care about the price of cattle feed or the details of cattle breeding. Cattle raisers do not care what the income of the buyers is or what the prices of related goods are unless they affect the price of cattle. Thus, when one factor changes, it affects only one curve, not both. When buyers and sellers cannot be clearly distinguished, as on the New York Stock Exchange, where the people who are buyers one minute may be sellers the next, one cannot talk about distinct and separate supply and demand curves.
The model of supply and demand also assumes that both buyers and sellers have good information about the product's qualities and availability. If information is not good, the same product may sell for a variety of prices. Often, however, what seems to be the same product at different prices can be considered a variety of products. A pound of hamburger for which one has to wait 15 minutes in a check-out line can be considered a different product from identical meat that one can buy without waiting.
Finally, for some uses the supply and demand model needs well-defined private-property rights. Elsewhere, we discussed how private-property rights and markets provide one way of coordinating decisions. When property rights are not clearly defined, the seller may be able to ignore some of the costs of production, which will then be imposed on others. Alternatively, buyers may not get all the benefits from purchasing a product; others may get some of the benefits without payment.
Even if the assumptions underlying supply and demand are not met exactly, and they rarely are, the model often provides a fairly good approximation of a situation, good enough so that predictions based on the model are in the right direction. This ability of the model to predict even when some assumptions are not quite satisfied is one reason economists like the model so much.
Next we discuss the process of adjustment.
1 The price searcher can be a buyer, in which case the buyer searches along the supply curve for the best position. In this case a demand curve will not exist, since the amount the buyer will want to buy will depend not on price, but on marginal cost. Price and marginal cost are identical for a price taker.
Copyright Robert Schenk