In Microeconomics, the graphs of supply and demand are a fundamental concept. In short, the supply curve shows how much of a good producers are willing to supply at a given price. The demand curve shows how much consumers are willing to purchase at a given price.
When the demand and supply curves cross, we have a point where the amount supplied and demanded is perfectly matched. In an ideal world, markets would find this price and remain level.
If the market price for a good is above this level, then producers will be willing to supply more than consumers are willing to buy. This gives us an excess of supply.
Conversely, if the price for a good is below the market price, the demand will overtake supply and we will have and excess of demand.
These excesses will mean that all market participants will have an incentive to be at the equilibrium price. If a consumer offers less than the equilibrium price, they will not find a seller. If a producers demands more than the equilibrium price, they will not find a buyer. In this situation, we say that the producers and consumers are both price takers.
Being a price taker means that if you don’t take the price, you will be forced out of the market.
Following on from this idea, we can start developing an idea of what we actually gain from being at the market equilibrium. To get this, we need to determine what each side of the trade is hoping to gain.
The producer, obviously, is trying to sell their product for a higher price than what it cost for them to make it, thus making a profit. The consumer on the other hand, is trying to pay as low as possible, and thus as far below their reservation price as possible. We can think of the difference between the consumer reservation price and the market price in the same way we think of profit. We call it consumer surplus.
The surplus is therefore quite easy to visualise. It is the area between the relevant curve and the line of y = market price.
In general, the higher the total surplus, the better for the economy. At equilibrium, the surplus is at a maximum. At this point, we say that the market is ‘pareto efficient’. Essentially, this means that no change can be made without decreasing the surplus. Or, alternatively, nobody can be made better off without making someone else worse off.
The Invisible Hand
The Invisible Hand principle operate in the long term, and is quite simple.
We define the long term as the time horizon where there are no fixed costs, and all factors of production are variable. A firm can change all of its factors of production, or choose to exit a market.
If firms are making a positive profit, there is incentive for new firms to enter the market. As new firms enter the market, the supply increases and hence the equilibrium must decrease.
Therefore, we say that the invisible hand reduces the price in the long term. If our firms are price takers, they must take this new equilibrium price.
Over the long run, we therefore see that the supply is completely inelastic. That is, the curve is horizontal, and producers are willing to produce any amount for the same price. If there is more demand, in the long run more firms will enter the market to increase supply.