Supply and demand is the basic model economists use to explain how prices are set in a competitive market. Each of the two laws below assumes everything else stays the same (ceteris paribus).
The two laws
- Law of demand: when the price rises, the quantity buyers want falls. The demand curve slopes down.
- Law of supply: when the price rises, the quantity sellers offer rises. The supply curve slopes up.
Finding equilibrium
Equilibrium is where quantity demanded equals quantity supplied. Suppose Qd = 100 − 2P and Qs = 20 + 2P.
- Set them equal:
100 − 2P = 20 + 2P - Solve:
80 = 4P, so P = 20. - Quantity:
Q = 100 − 2(20) = 60. Check with supply: 20 + 2(20) = 60 ✓.
Shortages and surpluses
- At P = 15 (below equilibrium): Qd = 70 and Qs = 50, a shortage of 20. Buyers compete and the price tends to rise.
- At P = 25 (above equilibrium): Qd = 50 and Qs = 70, a surplus of 20. Sellers cut prices to clear stock.
Movement along a curve vs. a shift
A change in the good's own price moves you along a curve. Anything else that changes behavior shifts the whole curve.
- Demand shifters: income, tastes, prices of substitutes and complements, expectations, and the number of buyers.
- Supply shifters: input costs, technology, the number of sellers, expectations, and taxes or subsidies.
Predicting the result
- Demand increases: price and quantity both rise.
- Supply increases: price falls and quantity rises.
- Supply decreases, for example after a drought ruins a crop: price rises and quantity falls.
Common mistakes
- Saying a price change "shifts demand." It moves along the demand curve.
- Mixing up a shortage (price too low) with a surplus (price too high).