Supply and Demand Basics
How price is determined in a competitive market, and what shifts the curves.
In a competitive market, prices tend to be set by the interaction of buyers and sellers.
Demand
Demand is the quantity of a good that buyers are willing and able to buy at each price. The law of demand states that, other things equal, as price rises, quantity demanded falls. The demand curve slopes downward.
Supply
Supply is the quantity that sellers are willing and able to sell at each price. The law of supply states that, other things equal, as price rises, quantity supplied rises. The supply curve slopes upward.
Equilibrium
Equilibrium occurs where quantity demanded equals quantity supplied. The price at that point is the equilibrium price.
- If the price is above equilibrium, there is a surplus (supply exceeds demand), which pushes prices down.
- If the price is below equilibrium, there is a shortage, which pushes prices up.
Movement along the curve vs shift of the curve
A change in the good's own price causes a movement along the curve. A change in another factor causes the whole curve to shift.
Factors that shift demand:
- Consumer income.
- Prices of substitutes and complements.
- Tastes and preferences.
- Expectations.
- Number of buyers.
Factors that shift supply:
- Costs of production.
- Technology.
- Number of sellers.
- Taxes and subsidies.
- Expectations.
Example
If a new study makes a fruit popular, demand rises. The demand curve shifts right. With the supply curve unchanged, the equilibrium price and quantity both increase.
If a frost damages the fruit crop, supply falls. The supply curve shifts left. The equilibrium price rises and the quantity falls.
Common mistakes
- Saying "demand falls" when only the price changed. A price change moves along the curve.
- Mixing up a shortage and a surplus.
- Drawing the shift in the wrong direction.
Quick recap
Price moves toward the level where demand equals supply. Other factors shift the curves; price changes move you along them.