The fundamentals

The intersection of supply and demand curves determines equilibrium price (P0) and quantity (Q0).

Strictly speaking, the model of supply and demand applies to a type of market called perfect competition in which no single buyer or seller has much effect on prices, and prices are known. The quantity of a product supplied by the producer and the quantity demanded by the consumer are dependent on the market price of the product. The law of supply states that quantity supplied is related to price. It is often depicted as directly proportional to price: the higher the price of the product, the more the producer will supply, ceteris paribus ("all other things being equal"). The law of demand is normally depicted as an inverse relation of quantity demanded and price: the higher the price of the product, the less the consumer will demand, ceteris paribus. The respective relations are called the supply curve and demand curve, or supply and demand for short.

The supply-and-demand model (sometimes described as the law of supply and demand) posits that a market tends toward equilibrium price and quantity of a commodity at the intersection of consumer demand and producer supply. At this point, quantity supplied equals quantity demanded. If the price for a good is below equilibrium, consumers demand more of the good than producers are prepared to supply. This defines a shortage of the good. A shortage results in producers increasing the price until equilibrium is reached. If the price of a good is above equilibrium, there is a surplus of the good. Producers are motivated to eliminate the surplus by lowering the price, until equilibrium is reached.

Supply schedule

The supply schedule, graphically represented by the supply curve, is the relationship between market price and amount of goods produced. In short-run analysis, where some input variables are fixed, a positive slope can reflect the law of diminishing marginal returns, which states that beyond some level of output, additional units of output require larger amounts of input. In the long-run, where no input variables are fixed, a positively-sloped supply curve can reflect diseconomies of scale.

For a given firm in a perfectly competitive industry, if it is more profitable to produce than to not produce, profit is maximized by producing just enough so that the producer's marginal cost is equal to the market price of the good.

The supply curve of labour is an example of increasing net input(e.g., wages) above a certain point resulting in decreased net output (hours worked).

Occasionally, supply curves bend backwards. A well known example is the backward bending supply curve of labour. Generally, as a worker's wage increases, he is willing to work longer hours, since the higher wages increase the marginal utility of working, and the opportunity cost of not working. But when the wage reaches an extremely high amount, the employee may experience the law of diminishing marginal utility. The large amount of money he is making will make further money of little value to him. Thus, he will work less and less as the wage increases, choosing instead to spend his time in leisure. The backwards-bending supply curve has also been observed in non-labor markets, including the market for oil: after the skyrocketing price of oil caused by the 1973 oil crisis, many oil-exporting countries decreased their production of oil.

The supply curve for public utility production companies is unusual. A large portion of their total costs are in the form of fixed costs. The supply curve for these firms is often constant.