Supply and demand

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The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product. Supply-and-demand.svg
The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

In microeconomics, supply and demand is an economic model of price determination in a market. It postulates that, holding all else equal, in a competitive market, the unit price for a particular good, or other traded item such as labor or liquid financial assets, will vary until it settles at a point where the quantity demanded (at the current price) will equal the quantity supplied (at the current price), resulting in an economic equilibrium for price and quantity transacted.

Microeconomics branch of economics that studies the behavior of individual households and firms in making decisions on the allocation of limited resources

Microeconomics is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

Economic model simplified representations of economic reality

In economics, a model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified, often mathematical, framework designed to illustrate complex processes. Frequently, economic models posit structural parameters. A model may have various exogenous variables, and those variables may change to create various responses by economic variables. Methodological uses of models include investigation, theorizing, and fitting theories to the world.

Market (economics) Mechanisms whereby supply and demand confront each other and deals are made, involving places, processes and institutions in which exchanges occur.

A market is one of the many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers. It can be said that a market is the process by which the prices of goods and services are established. Markets facilitate trade and enable the distribution and resource allocation in a society. Markets allow any trade-able item to be evaluated and priced. A market emerges more or less spontaneously or may be constructed deliberately by human interaction in order to enable the exchange of rights of services and goods. Markets generally supplant gift economies and are often held in place through rules and customs, such as a booth fee, competitive pricing, and source of goods for sale.

Contents

Graphical representations

Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the goods, the standard graphical representation, usually attributed to Alfred Marshall, has price on the vertical axis and quantity on the horizontal axis.

Function (mathematics) Mapping that associates a single output value to each input

In mathematics, a function is a relation between sets that associates to every element of a first set exactly one element of the second set. Typical examples are functions from integers to integers or from the real numbers to real numbers.

Alfred Marshall British economist

Alfred Marshall, FBA was one of the most influential economists of his time. His book, Principles of Economics (1890), was the dominant economic textbook in England for many years. It brings the ideas of supply and demand, marginal utility, and costs of production into a coherent whole. He is known as one of the founders of neoclassical economics. Although Marshall took economics to a more mathematically rigorous level, he did not want mathematics to overshadow economics and thus make economics irrelevant to the layman.

Since determinants of supply and demand other than the price of the goods in question are not explicitly represented in the supply-demand diagram, changes in the values of these variables are represented by moving the supply and demand curves (often described as "shifts" in the curves). By contrast, responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.

Supply schedule

A supply schedule is a table that shows the relationship between the price of a good and the quantity supplied. Under the assumption of perfect competition, supply is determined by marginal cost. That is, firms will produce additional output while the cost of producing an extra unit of output is less than the price they would receive.

In economics, specifically general equilibrium theory, a perfect market is defined by several idealizing conditions, collectively called perfect competition. In theoretical models where conditions of perfect competition hold, it has been theoretically demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

Marginal cost factor in economics

In economics, marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit; that is, it is the cost of producing one more unit of a good. Intuitively, marginal cost at each level of production includes the cost of any additional inputs required to produce the next unit. At each level of production and time period being considered, marginal costs include all costs that vary with the level of production, whereas other costs that do not vary with production are fixed and thus have no marginal cost. For example, the marginal cost of producing an automobile will generally include the costs of labor and parts needed for the additional automobile but not the fixed costs of the factory that have already been incurred. In practice, marginal analysis is segregated into short and long-run cases, so that, over the long run, all costs become marginal. Where there are economies of scale, prices set at marginal cost will fail to cover total costs, thus requiring a subsidy. Marginal cost pricing is not a matter of merely lowering the general level of prices with the aid of a subsidy; with or without subsidy it calls for a drastic restructuring of pricing practices, with opportunities for very substantial improvements in efficiency at critical points.

A hike in the cost of raw goods would decrease supply, shifting costs up, while a discount would increase supply, shifting costs down and hurting producers as producer surplus decreases.

By its very nature, conceptualizing a supply curve requires the firm to be a perfect competitor (i.e. to have no influence over the market price). This is true because each point on the supply curve is the answer to the question "If this firm is faced with this potential price, how much output will it be able to and willing to sell?" If a firm has market power, its decision of how much output to provide to the market influences the market price, therefore the firm is not "faced with" any price, and the question becomes less relevant.

Economists distinguish between the supply curve of an individual firm and the market supply curve. The market supply curve is obtained by summing the quantities supplied by all suppliers at each potential price. Thus, in the graph of the supply curve, individual firms' supply curves are added horizontally to obtain the market supply curve.

Economists also distinguish the short-run market supply curve from the long-run market supply curve. In this context, two things are assumed constant by definition of the short run: the availability of one or more fixed inputs (typically physical capital), and the number of firms in the industry. In the long run, firms have a chance to adjust their holdings of physical capital, enabling them to better adjust their quantity supplied at any given price. Furthermore, in the long run potential competitors can enter or exit the industry in response to market conditions. For both of these reasons, long-run market supply curves are generally flatter than their short-run counterparts.

In economics, physical capital or just capital is a factor of production, consisting of machinery, buildings, computers,etc.Its is divided into 2 categories-working and fixed capital.The production function takes the general form Y=f(K, L, N), where Y is the amount of output produced, K is the amount of capital stock used, L is the amount of labor used, and N is the amount of natural resources used. In economic theory, physical capital is one of the three primary factors of production; the others are natural resources, and labor—the stock of competences embodied in the labor force. Physical capital is distinct from human capital, circulating capital, and financial capital. Physical capital is fixed capital, which is any kind of real physical asset that is not used up in the production of a product. Usually the value of land is not included in physical capital as it is not a reproducible product of human activities.

Market entry strategy is a planned distribution and delivery method of goods or services to a new target market. In the import and export of services, it refers to the creation, establishment, and management of contracts in a foreign country.

The determinants of supply are:

  1. Production costs: how much a good costs to be produced. Production costs are the cost of the inputs; primarily labor, capital, energy and materials. They depend on the technology used in production, and/or technological advances. See: Productivity
  2. Firms' expectations about future prices
  3. Number of suppliers

Demand schedule

A demand schedule, depicted graphically as the demand curve, represents the amount of some goods that buyers are willing and able to purchase at various prices, assuming all determinants of demand other than the price of the good in question, such as income, tastes and preferences, the price of substitute goods, and the price of complementary goods, remain the same. Following the law of demand, the demand curve is almost always represented as downward-sloping, meaning that as price decreases, consumers will buy more of the good. [1]

Demand curve graph depicting the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price

In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity and the quantity of that commodity that is demanded at that price. Demand curves may be used to model the price-quantity relationship for an individual consumer, or more commonly for all consumers in a particular market. It is generally assumed that demand curves are downward-sloping, as shown in the adjacent image. This is because of the law of demand: for most goods, the quantity demanded will decrease in response to an increase in price, and will increase in response to a decrease in price.

Substitute good The economic concept of a product that can replace another product

A substitute good is a good that can be used in place of another. In consumer theory, substitute goods or substitutes are goods that a consumer perceives as similar or comparable, so that having more of one good causes the consumer to desire less of the other good. Formally, good is a substitute for good if, when the price of rises, the demand for rises. Let be the price of good . Then, is a substitute for if

Complementary good good with a negative cross elasticity of demand

In economics, a complementary good is a good whose appeal increases with the popularity of its complement. Technically it displays a negative cross elasticity of demand and that demand for it increases when the price of another good decreases. If "A" is a complement to "B", an increase in the price of "A" will result in a negative movement along the demand curve of "A" and cause the demand curve for "B" to shift in; less of each good will be demanded. This is in contrast to a substitute good whose demand decreases when its substitute's price decreases.

Just like the supply curves reflect marginal cost curves, demand curves are determined by marginal utility curves. [2] Consumers will be willing to buy a given quantity of a good, at a given price, if the marginal utility of additional consumption is equal to the opportunity cost determined by the price, that is, the marginal utility of alternative consumption choices. The demand schedule is defined as the willingness and ability of a consumer to purchase a given product in a given frame of time.

In economics, utility is the satisfaction or benefit derived by consuming a product; thus the marginal utility of a goods or service is the change in the utility from an increase in the consumption of that good or service.

In microeconomic theory, the opportunity cost, or alternative cost, of making a particular choice is the value of the most valuable choice out of those that were not taken. When an option is chosen from alternatives, the opportunity cost is the "cost" incurred by not enjoying the benefit associated with the best alternative choice. The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen." In simple terms, opportunity cost is the benefit not received as a result of not selecting the next best option. Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice". The notion of opportunity cost plays a crucial part in attempts to ensure that scarce resources are used efficiently. Opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered an opportunity cost. The opportunity cost of a product or service is the revenue that could be earned by its alternative use. In other words, opportunity cost is the cost of the next best alternative of a product or service. The meaning of the concept of opportunity cost can be explained with the help of following examples:

The demand curve is generally downward-sloping, but some goods have upward-sloping demand curves. Two different types of goods with upward-sloping demand curves are Giffen goods (an inferior but staple good) and Veblen goods (goods made more fashionable by a higher price).

By its very nature, conceptualizing a demand curve requires that the purchaser be a perfect competitor—that is, that the purchaser has no influence over the market price. This is true because each point on the demand curve is the answer to the question "If this buyer is faced with this potential price, how much of the product will it purchase?" If a buyer has market power, so its decision of how much to buy influences the market price, then the buyer is not "faced with" any price, and the question is meaningless.

Like with supply curves, economists distinguish between the demand curve of an individual and the market demand curve. The market demand curve is obtained by summing the quantities demanded by all consumers at each potential price. Thus, in the graph of the demand curve, individuals' demand curves are added horizontally to obtain the market demand curve.

The determinants of demand are:

  1. Income.
  2. Tastes and preferences.
  3. Prices of related goods and services.
  4. Consumers' expectations about future prices and incomes that can be checked.
  5. Number of potential consumers.

Microeconomics

Fig5 Supply and demand curves.jpg

Equilibrium

Generally speaking, an equilibrium is defined to be the price-quantity pair where the quantity demanded is equal to the quantity supplied. It is represented by the intersection of the demand and supply curves. [3] The analysis of various equilibria is a fundamental aspect of microeconomics:

Market equilibrium: A situation in a market when the price is such that the quantity demanded by consumers is correctly balanced by the quantity that firms wish to supply. In this situation, the market clears. [4]

Changes in market equilibrium: Practical uses of supply and demand analysis often center on the different variables that change equilibrium price and quantity, represented as shifts in the respective curves. Comparative statics of such a shift traces the effects from the initial equilibrium to the new equilibrium.

Demand curve shifts:

When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted to the right. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. (A movement along the curve is described as a "change in the quantity demanded" to distinguish it from a "change in demand," that is, a shift of the curve.) The increase in demand has caused an increase in (equilibrium) quantity. The increase in demand could come from changing tastes and fashions, incomes, price changes in complementary and substitute goods, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity. Note in the diagram that the shift of the demand curve, by causing a new equilibrium price to emerge, resulted in movement along the supply curve from the point (Q1, P1) to the point (Q2, P2).

If the demand decreases, then the opposite happens: a shift of the curve to the left. If the demand starts at D2, and decreases to D1, the equilibrium price will decrease, and the equilibrium quantity will also decrease. The quantity supplied at each price is the same as before the demand shift, reflecting the fact that the supply curve has not shifted; but the equilibrium quantity and price are different as a result of the change (shift) in demand.

Supply curve shifts:

When technological progress occurs, the supply curve shifts. For example, assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases. Otherwise stated, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward, to S2—an increase in supply. This increase in supply causes the equilibrium price to decrease from P1 to P2. The equilibrium quantity increases from Q1 to Q2 as consumers move along the demand curve to the new lower price. As a result of a supply curve shift, the price and the quantity move in opposite directions. If the quantity supplied decreases, the opposite happens. If the supply curve starts at S2, and shifts leftward to S1, the equilibrium price will increase and the equilibrium quantity will decrease as consumers move along the demand curve to the new higher price and associated lower quantity demanded. The quantity demanded at each price is the same as before the supply shift, reflecting the fact that the demand curve has not shifted. But due to the change (shift) in supply, the equilibrium quantity and price have changed.

The movement of the supply curve in response to a change in a non-price determinant of supply is caused by a change in the y-intercept, the constant term of the supply equation. The supply curve shifts up and down the y axis as non-price determinants of demand change.

Partial equilibrium

Partial equilibrium, as the name suggests, takes into consideration only a part of the market to attain equilibrium.

Jain proposes (attributed to George Stigler): "A partial equilibrium is one which is based on only a restricted range of data, a standard example is price of a single product, the prices of all other products being held fixed during the analysis." [5]

The supply-and-demand model is a partial equilibrium model of economic equilibrium, where the clearance on the market of some specific goods is obtained independently from prices and quantities in other markets. In other words, the prices of all substitutes and complements, as well as income levels of consumers are constant. This makes analysis much simpler than in a general equilibrium model which includes an entire economy.

Here the dynamic process is that prices adjust until supply equals demand. It is a powerfully simple technique that allows one to study equilibrium, efficiency and comparative statics. The stringency of the simplifying assumptions inherent in this approach makes the model considerably more tractable, but may produce results which, while seemingly precise, do not effectively model real world economic phenomena.

Partial equilibrium analysis examines the effects of policy action in creating equilibrium only in that particular sector or market which is directly affected, ignoring its effect in any other market or industry assuming that they being small will have little impact if any.

Hence this analysis is considered to be useful in constricted markets.

Léon Walras first formalized the idea of a one-period economic equilibrium of the general economic system, but it was French economist Antoine Augustin Cournot and English political economist Alfred Marshall who developed tractable models to analyze an economic system.

Other markets

The model of supply and demand also applies to various specialty markets.

The model is commonly applied to wages, in the market for labor. The typical roles of supplier and demander are reversed. The suppliers are individuals, who try to sell their labor for the highest price. The demanders of labor are businesses, which try to buy the type of labor they need at the lowest price. The equilibrium price for a certain type of labor is the wage rate. [6] However, economist Steve Fleetwood revisited the empirical reality of supply and demand curves in labor markets and concluded that the evidence is "at best inconclusive and at worst casts doubt on their existence." For instance, he cites Kaufman and Hotchkiss (2006): "For adult men, nearly all studies find the labour supply curve to be negatively sloped or backward bending." [7]

In both classical and Keynesian economics, the money market is analyzed as a supply-and-demand system with interest rates being the price. The money supply may be a vertical supply curve, if the central bank of a country chooses to use monetary policy to fix its value regardless of the interest rate; in this case the money supply is totally inelastic. On the other hand, [8] the money supply curve is a horizontal line if the central bank is targeting a fixed interest rate and ignoring the value of the money supply; in this case the money supply curve is perfectly elastic. The demand for money intersects with the money supply to determine the interest rate. [9]

Empirical estimation

Demand and supply relations in a market can be statistically estimated from price, quantity, and other data with sufficient information in the model. This can be done with simultaneous-equation methods of estimation in econometrics. Such methods allow solving for the model-relevant "structural coefficients," the estimated algebraic counterparts of the theory. The Parameter identification problem is a common issue in "structural estimation." Typically, data on exogenous variables (that is, variables other than price and quantity, both of which are endogenous variables) are needed to perform such an estimation. An alternative to "structural estimation" is reduced-form estimation, which regresses each of the endogenous variables on the respective exogenous variables.

Macroeconomic uses

Demand and supply have also been generalized to explain macroeconomic variables in a market economy, including the quantity of total output and the general price level. The aggregate demand-aggregate supply model may be the most direct application of supply and demand to macroeconomics, but other macroeconomic models also use supply and demand. Compared to microeconomic uses of demand and supply, different (and more controversial) theoretical considerations apply to such macroeconomic counterparts as aggregate demand and aggregate supply. Demand and supply are also used in macroeconomic theory to relate money supply and money demand to interest rates, and to relate labor supply and labor demand to wage rates.

History

The 256th couplet of Tirukkural, which was composed at least 2000 years ago, says that "if people do not consume a product or service, then there will not be anybody to supply that product or service for the sake of price". [10]

According to Hamid S. Hosseini, the power of supply and demand was understood to some extent by several early Muslim scholars, such as fourteenth-century Syrian scholar Ibn Taymiyyah, who wrote: "If desire for goods increases while its availability decreases, its price rises. On the other hand, if availability of the good increases and the desire for it decreases, the price comes down." [11]

Adam Smith AdamSmith.jpg
Adam Smith

John Locke's 1691 work Some Considerations on the Consequences of the Lowering of Interest and the Raising of the Value of Money. [12] includes an early and clear description of supply and demand and their relationship. In this description demand is rent: “The price of any commodity rises or falls by the proportion of the number of buyer and sellers” and “that which regulates the price... [of goods] is nothing else but their quantity in proportion to their rent.”

The phrase "supply and demand" was first used by James Denham-Steuart in his Inquiry into the Principles of Political Economy, published in 1767. Adam Smith used the phrase in his 1776 book The Wealth of Nations , and David Ricardo titled one chapter of his 1817 work Principles of Political Economy and Taxation "On the Influence of Demand and Supply on Price". [13] Thomas Robert Malthus used the phrase "supply and demand" twenty times in the second edition of the Essay on Population in 1803. [14]

In The Wealth of Nations, Smith generally assumed that the supply price was fixed but that its "merit" (value) would decrease as its "scarcity" increased, in effect what was later called the law of demand also. Ricardo, in Principles of Political Economy and Taxation, more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand. Antoine Augustin Cournot first developed a mathematical model of supply and demand in his 1838 Researches into the Mathematical Principles of Wealth, including diagrams.

During the late 19th century the marginalist school of thought emerged. The main innovators of this approach where Stanley Jevons, Carl Menger, and Léon Walras. The key idea was that the price was set by the subjective value of a good at the margin. This was a substantial change from Adam Smith's thoughts on determining the supply price.

In his 1870 essay "On the Graphical Representation of Supply and Demand", Fleeming Jenkin in the course of "introduc[ing] the diagrammatic method into the English economic literature" published the first drawing of supply and demand curves in English, [15] including comparative statics from a shift of supply or demand and application to the labor market. [16] The model was further developed and popularized by Alfred Marshall in the 1890 textbook Principles of Economics . [13]

Artificial intelligent buying platforms

Much of the buying and selling are now conducted online using platforms such as Amazon and eBay, where the profiles of the customers are captured and analyzed. Tshilidzi Marwala and Evan Hurwitz in their book [17] observed that the advent of artificial intelligence and related technologies such as flexible manufacturing offers the opportunity for individualized demand and supply curves to be generated. This has been found to reduce the degree of arbitrage in the market, allow for individualized pricing for the same product and brings fairness and efficiency into the market.

Criticism

The philosopher Hans Albert has argued that the ceteris paribus conditions of the marginalist theory rendered the theory itself an empty tautology and completely closed to experimental testing. [18] In essence, he argues, the supply and demand curves (theoretical functions which express the quantity of a product which would be offered or requested for a given price) are purely ontological.

Cambridge economist Joan Robinson attacked the theory in similar line, arguing that the concept is circular: "Utility is the quality in commodities that makes individuals want to buy them, and the fact that individuals want to buy commodities shows that they have utility" [19] :48 Robinson also pointed out that if we take changes in peoples' behavior in relation to a change in prices or a change in the underlying budget constraint, then we can never be sure to what extent the change in behavior was due to the change in price or budget constraint and how much was due to a change in preferences. [20] [ better source needed ]

Piero Sraffa's critique focused on the inconsistency (except in implausible circumstances) of partial equilibrium analysis and the rationale for the upward slope of the supply curve in a market for a produced consumption good. [21] The notability of Sraffa's critique is also demonstrated by Paul Samuelson's comments and engagements with it over many years, for example:

What a cleaned-up version of Sraffa (1926) establishes is how nearly empty are all of Marshall's partial equilibrium boxes. To a logical purist of Wittgenstein and Sraffa class, the Marshallian partial equilibrium box of constant cost is even more empty than the box of increasing cost. [22]

Some economists criticize the conventional supply and demand theory for failing to explain or anticipate asset bubbles that can arise from a positive feedback loop. [23] Conventional supply and demand theory assumes that expectations of consumers do not change as a consequence of price changes. In scenarios such as the United States housing bubble, an initial price change of an asset can increase the expectations of investors, making the asset more lucrative and contributing to further price increases until market sentiment changes, which creates a positive feedback loop and an asset bubble. [24] Asset bubbles cannot be understood in the conventional supply and demand framework because the conventional system assumes a price change will be self-correcting and the system will snap back to equilibrium.

See also

Related Research Articles

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In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium. General equilibrium theory contrasts to the theory of partial equilibrium, which only analyzes single markets.

Economic surplus economic supply that exceeds demand

In mainstream economics, economic surplus, also known as total welfare or Marshallian surplus, refers to two related quantities. Consumer surplus or consumers' surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay. Producer surplus or producers' surplus is the amount that producers benefit by selling at a market price that is higher than the least that they would be willing to sell for; this is roughly equal to profit.

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In economics, economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. For example, in the standard text perfect competition, equilibrium occurs at the point at which quantity demanded and quantity supplied are equal. Market equilibrium in this case is a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes, and the quantity is called the "competitive quantity" or market clearing quantity. However, the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.

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This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

References

  1. Note that regardless of the way Supply and Demand may be described, Price is plotted as the dependent variable (y-axis) because in a market today's prices are determined by the quantity available today (independent variable plotted on the x-axis), not the other way around. Tomorrow's prices are a different function.
  2. "Marginal Utility and Demand" . Retrieved 2007-02-09.
  3. "Microeconomics – Supply and Demand" . Retrieved 2014-12-31.
  4. Mankiw, N.G.; Taylor, M.P. (2011). Economics (2nd ed., revised ed.). Andover: Cengage Learning.
  5. Jain, T.R. (2006–2007). Microeconomics and Basic Mathematics. New Delhi: VK Publications. p. 28. ISBN   978-81-87140-89-4.
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Further reading