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Macroeconomics 4: The Market Forces of Supply and Demand

The most important concept in economics, without a doubt, is the concept of supply and demand. Most people understand this intuitively: if something is in demand, buyers are willing to pay higher prices for it in order to out-compete others who may be vying for the same item. Sellers are, of course, more than happy to oblige with higher prices. In this, and the next two articles, we will mathematically formalize the concept of these forces of supply and demand, so that we may study their effects and implications from a scientific perspective.

In order to begin, we must first understand the context within which these forces apply. It is assumed that we are working with a market-based economy. A market is simply a collection of buyers and sellers of a particular good or service. The forces of supply and demand refer to the behavior of the buyers and sellers (or market participants). The buyers provide demand in the market, while the sellers provide supply. There are also many different types of markets: there is an ice cream market, a stock market, a cattle market, etc. Each one of these markets functions in a somewhat different way. Without going into too much detail about the differences, we will assume that all the markets we deal with are "competitive markets". This means that there are so many buyers and sellers, that none of them can, on their own, can affect market prices (no "market power"). This assumption is safe to make when talking about most markets that you will come across in your daily life. If a certain seller, for instance, raises their prices, many of his customers will simply go elsewhere to obtain the same (or similar) good or service. This already touches on this additional assumption: we will also assume that the markets we deal with are "perfectly competitive", meaning that, in addition to our previous assumption about market participants being unable to influence market prices, the goods or services offered for sale are all identical to one another. For example, we assume that Robinson's ice cream parlor sells the exact same ice cream as Friday's.

In reality, many markets behave very close to our assumption of a perfectly competitive market. For example, the corn market is very close to a perfectly competitive market, because there are so many corn farmers (sellers), and so many corn buyers, that they are all price takers. That is, they cannot affect the market price, but can only accept the price determined by the market. As we will see, the market determines price by balancing supply and demand at an equilibrium price. It should also be noted that for many real-world markets, our assumptions do not make for a very accurate model. There are monopolies, oligopolies, and competitive monopolies, just to name a few. Since our study of macroeconomics focuses on the forex market, which is perfectly competitive, we will not delve into the other possiblities. It is also just our luck that perfectly competitive markets, such as the forex, are the easiest to study.

In the following article, we will discuss market demand in more detail, followed by an article on supply.

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