Supply & demand

Supply and demand is the first model every economics student meets, and for good reason: it explains how prices are set in markets without anyone planning them. From the cost of a coffee to the price of housing, the interaction of buyers and sellers tends to settle on a price at which the quantity people want to buy matches the quantity producers want to sell. Mastering this model — and avoiding its classic pitfalls — is the foundation for almost everything else in microeconomics.

The two laws

The model rests on two simple regularities, each stated ceteris paribus — Latin for “other things being equal,” meaning we hold all other influences constant to isolate the effect of price.

The law of demand says that, other things equal, as the price of a good rises, the quantity demanded falls, and as price falls, quantity demanded rises. Buyers economise when things get dearer and buy more when they get cheaper. This inverse relationship gives the demand curve its downward slope.

The law of supply says the opposite for producers: as price rises, quantity supplied rises, because higher prices make production more profitable, so firms offer more. This direct relationship gives the supply curve its upward slope.

Equilibrium

Put the two curves on the same diagram and they cross at a single point: the market equilibrium. Here the quantity demanded equals the quantity supplied, fixing the equilibrium price and quantity. At this price the market “clears” — there is neither surplus nor shortage, and no automatic pressure for price to change.

What if the price is wrong? Markets have a self-correcting tendency:

Above equilibrium, a surplus forms and pushes prices down; below equilibrium, a shortage forms and pushes prices up.

If price sits above equilibrium, quantity supplied exceeds quantity demanded, producing a surplus of unsold goods that drives the price down. If price sits below equilibrium, quantity demanded exceeds quantity supplied, producing a shortage that drives the price up. Either way, the market is nudged back toward equilibrium.

Shifts versus movements

The single most common error in using this model is to confuse a movement along a curve with a shift of the curve.

• A movement along a curve is caused purely by a change in the good’s own price. The curve stays put; you simply move from one point on it to another.
• A shift of a curve is caused by a change in something other than the good’s own price. The whole curve moves to a new position.

The rule of thumb is straightforward: a change in the good’s own price moves you along the curve; a change in anything else shifts it.

So what shifts the curves? Demand shifts with changes in income, the prices of substitutes and complements, tastes, expectations of future prices and the number of buyers. For example, a rise in income usually shifts demand for a normal good to the right. Substitutes are goods used in place of one another (tea and coffee), so a rise in the price of one raises demand for the other; complements are used together (cars and petrol), so a rise in the price of one lowers demand for the other.

Supply shifts with changes in input or production costs, technology, taxes and subsidies, the prices of related goods firms could produce instead, expectations and the number of sellers. Cheaper inputs or better technology typically shift supply to the right, lowering the equilibrium price and raising the quantity traded.

Elasticity in brief

The basic model tells us the direction a price or quantity moves, but not by how much. For that, economists use elasticity. The price elasticity of demand measures how responsive quantity demanded is to a change in price: the percentage change in quantity demanded divided by the percentage change in price.

Demand is called elastic when quantity responds strongly to price (an elasticity greater than 1 in size) and inelastic when it responds weakly (less than 1). The difference matters enormously in practice. For an inelastic good, a price rise barely dents sales, so revenue rises; for an elastic good, the same rise can drive buyers away.

What makes demand more elastic? Several factors:

• Close substitutes are available, so buyers can switch easily.
• The good takes a large share of income, so price changes are keenly felt.
• It is a luxury rather than a necessity.
• A longer time period allows buyers to adjust their habits.

By contrast, necessities with few substitutes — certain medicines, say — tend to be inelastic, because buyers must keep purchasing them whatever the price.

Why it matters

This simple framework underlies a huge range of real-world questions: how a tax or subsidy changes prices, why rent controls can create shortages, how a bumper harvest affects farmers’ incomes, and how markets respond to shocks. Used carefully — keeping shifts and movements straight, and remembering the ceteris paribus assumption — supply and demand remains one of the most powerful tools in economics.