Assumptions

Introduction

When economists talk about prices, they are interested in gaining a practical understanding of what determines prices and why prices change. Consider a price most of us contend with weekly: that of a gallon of gas. Why was the average price of gasoline in the United States $3.40 per gallon in January 2012? Why did the price for gasoline rise to $3.93 per gallon only months later, by April 2012? To explain these price movements, economists focus on the determinants of what gasoline buyers are willing to pay and what gasoline sellers are willing to accept.

As it turns out, the price of gasoline in June of any given year is nearly always higher than the price in January of that same year; over recent decades, gasoline prices in midsummer have averaged about 10 cents per gallon more than their midwinter low. The likely reason is that people drive more in the summer, and are also willing to pay more for gas. However, in 2009, gasoline prices rose by more than the average winter-to-summer rise, which suggests that other factors were at work during those six months. (4)

This module introduces the economic model of demand and supply — one of the most powerful models in all of economics. The discussion here begins by examining how demand and supply determine the price and the quantity sold in markets for goods and services, and how changes in demand and supply lead to changes in prices and quantities. (1)

Assumptions

Before we get started, two important assumptions about the demand and supply model in this module need to be pointed out.

Ceteris paribus

The assumption behind a demand curve or a supply curve is that no relevant economic factors, other than the product’s price, are changing. Economists call this assumption ceteris paribus , a Latin phrase meaning “other things being equal.” Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. A demand curve or a supply curve is a relationship between two, and only two, variables when all other variables are kept constant. If all else is not held equal, then the laws of supply and demand will not necessarily hold.

Ceteris paribus is typically applied when we look at how changes in price affect demand or supply, but ceteris paribus can be applied more generally. In the real world, demand and supply depend on more factors than just price.

For example, a consumer’s demand depends on income and a producer’s supply depends on the cost of producing the product. How can we analyze the effect on demand or supply if multiple factors are changing at the same time—say price rises and income falls? The answer is that we examine the changes one at a time, assuming the other factors are held constant.

For example, we can say that an increase in the price reduces the amount consumers will buy (assuming income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged). This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the higher price and second because of the lower income. (4)

Competitive Market

The second assumption made throughout this module is that the market is a competitive one. Markets vary in the intensity of competition, ranging from highly competitive, such as the models of Perfect Competition and Monopolistic Competition to less competitive, such as the Oligopoly model , or no competition, such as the Monopoly model where the only operating firm faces no competition from other firms in the market. This module studies a competitive market (closer to the Perfectly Competitive model), which is a market that has many buyers and many sellers, so no single buyer or seller can influence the market price.

In such a market, no coordinated action on the part of government or any other central authority is required to make markets work efficiently, because highly competitive markets tend to work very efficiently on their own. This is related to the concept of the “invisible hand” first introduced by Adam Smith. (5)