On the use of models, an example

Let' s model the market for wine. We want to simplify things, so assume there is only one quality of wine (a stringent assumption, of course). Assume also that all trade takes place at one site.

If you are a producer of wine, and you expect prices to go up, then you will want to increase your production level. However, if prices go down, you'd rather lower your production level and produce something else that is more profitable. If you are a wine buyer, well you will buy more if the price is low, less if the price is high. Despite the producers desires, short term price is determined in large part by the buyers willingness to pay.

If there are many wine makers and many buyers, no one will be able to set prices: if you increase over the market price, all customers go to the next merchant who sells at the market price and nobody will buy from you. So how is the market price determined? Well, it is the price at which the total quantity of wine produced is equal to the total quantity of wine demanded.

In a simple example, let's say there are 10 wine buyers. They like wine, but if it's too expensive, they will buy beer instead. The buyers have the following secret profile.

Now let's take our 3 sellers of wine. In our market let's assume the sale of wine happens one day in the town center. The sellers come with 300 bottles, feeling good and start by asking for $4.00 per bottle. What happens? Then 10 Buyers offer to buy only 200 of the bottles. The sellers are stuck with 100 bottles left. Instead, they offer $3.00 per bottle, which sells all the bottles available, for $100 more in total proceeds.

Suppose there is frost in the late spring, so wine makers cannot make as much wine as they used to. They now only have 100 bottles. What is the effect on the market price and the quantity sold? If demand fundamentals do not change, then at the "no frost" price, there is more demanded than supplied, so the price has to be greater. And at a higher price, demand will be lower. So the result is an increase in price when there is a decrease in production. In our example, the sellers will get $5.00 per bottle to sell their 100 bottles, versus $3.00 the year before, when 300 bottles were available.