Supply and demand is a fundamental concept of all economic insights and the foundation of the majority of modern economics. The basic theory states that the "market mechanism" of supply and demand will result in an equilibrium price for a good or service such that there will be equilibrium between the cost of the good to society as well as the benefit of the good to consumers. Economists who believe in an infallible market believe that the market will determine the optimum output of all goods, so long as the costs and benefits of the goods are "internalized" to the market, and prices are left free to fluctuate.
The supply and demand curves are both graphed with quantity "Q" on the "X" axis and price "P" on the "Y" axis. The supply curve shows the relationship between the quantity of a good that producers are willing to sell at a price. The supply curve, shown here in red, slopes upward because, at a generally higher price, suppliers will be induced to sell more. For example, if a paper products firm found that a certain type of paper now sold for twice the price it used to, the company might stock more of it. If a plastics company found out that plastics were selling for especially high prices this month, they might try to hire more help or increase production in other ways to take advantage of the opportunity.
Demand, and the Model using Curves
The demand curve, shown here in blue, shows how much of a good those consumers are willing to purchase as the price per unit changes. When the price per unit is high, consumers will likely find other goods and services that are cheap substitutes for the good or learn to do without entirely, meaning they will buy less; if the price is low compared to other goods, they will have the incentive to buy more compared to other goods. The demand curve and the supply curve can be manipulated by economists to experiment with different hypothetical situations, to find out the resulting price and quantity demanded.
The point of supply and demand is to come up with one equilibrium price, sometimes called the "market clearing" price. If the price is forbidden from moving on its own, this can be prevented and, in fact, government price controls illustrate well the concepts of supply and demand by illustrating what happens when the market fails to function. In Figure 1, the graph shows three prices, P1, P2 and P3. Imagine that the government mandates the price of this good to be P1, below the point where the supply and demand curves intersect. At this price, buyers are interested in buying more than sellers are interested in selling (the line intersects the demand curve further along the X axis than the supply curve). This means there will be a shortage, as buyers line up to try to buy the good at a low price and sellers only produce a little, because of a low price not providing incentives enough for them to produce more. This shortage is a direct result of government price controls.
Surplus and Market Motion
Likewise, if the government were to mandate a price of P3 above the intersection of supply and demand, there would be a problem. At this high price, sellers would produce more of it than buyers would want. This would lead to a surplus, as inventory backed up and no product is moved off the shelves. As can be seen, both P1 and P3 do not lead to efficient economic outcomes. Now, imagine that all of a sudden government lifts these price controls. Sellers will produce less almost immediately, because they are not selling enough products right now and so lower the price to start moving more inventory. More buyers become interested, thanks to a lower price. Eventually, economics tells us that the price will eventually come to be the point at which supply and demand cross, where there will be neither shortage nor surplus.
Equilibrium, or the Market Clearing Price
Therefore, we have seen what happens when government mandates a price that is not the price where supply and demand meet. When sellers are free to set a price initially, they are interested in creating the greatest competitive profit possible, but the market tells them at what price is the greatest profit. When sellers set price, they will initially not be sure what the market clearing price is, but they learn. If there is a shortage, they will increase price to take advantage of the situation. If there is a surplus, they will know to reduce price to get their inventory moving. This will lead to the price being the equilibrium price, the price where supply and demand intersect and the quantity of the good traded can be found on the X axis. Only at equilibrium will there be neither a surplus nor a shortage. Supply and demand is a powerful concept because any time certain assumptions are met and prices are free to fluctuate, its effects can be seen.
- Figure 1. Photo by Collin Fitzsimmons.