How supply and demand work

Demand and the law of demand

Demand describes how much of a good buyers are willing and able to buy at each possible price, during a set period, with everything else held the same. The law of demand says that as the price rises, the quantity demanded falls, and as the price falls, the quantity demanded rises.

Why? At a higher price, some buyers switch to substitutes (tea instead of coffee), and everyone's money buys less. A demand schedule lists this as a table, for example 120 cups of lemonade a day at 1 dollar, 80 at 2 dollars, 40 at 3 dollars. Plotted with price on the vertical axis and quantity on the horizontal axis, those points form a demand curve that slopes down from left to right.

Supply and the law of supply

Supply describes how much sellers are willing and able to offer at each possible price. The law of supply says that as the price rises, the quantity supplied rises.

A higher price makes it worth producing more: existing sellers can cover the higher cost of extra output, such as overtime pay, and new sellers are drawn in. The supply curve therefore slopes up from left to right.

Equilibrium: where the curves cross

The equilibrium price is the price at which the quantity buyers want equals the quantity sellers offer. On a graph it is where the two curves cross. At that price, the market clears: no unsold pile and no unmet line of buyers.

Markets tend to move toward equilibrium. If the price is above it, sellers offer more than buyers want, a surplus, and sellers cut prices to sell their stock. If the price is below it, buyers want more than sellers offer, a shortage, and sellers find they can raise prices. Either way the price is pushed toward the point where the curves meet.

Worked example: finding equilibrium from equations

Suppose the daily demand for sandwiches at a food stand is Q = 100 − 2P and the supply is Q = 20 + 2P, where P is the price in dollars and Q is the number of sandwiches. Equilibrium is where the two quantities are equal.

Now suppose a nearby office opens and demand rises to Q = 120 − 2P at every price. Setting 120 − 2P equal to 20 + 2P gives 100 = 4P, so the new price is 25 dollars and the quantity is 70. An increase in demand raised both the equilibrium price and quantity, just as the graph would show.

Shifts of a curve vs movements along a curve

This is the distinction students most often get wrong. A change in the good's own price causes a movement along the curve: a change in quantity demanded or quantity supplied. A change in anything else shifts the whole curve: a change in demand or a change in supply.

Demand shifts right (increases) or left (decreases) when these change:

• Income: more income raises demand for most goods.
• Prices of related goods: if coffee gets more expensive, demand for tea (a substitute) rises; if hot dog buns get cheaper, demand for hot dogs (a complement) rises.
• Tastes and trends: a popular video about a snack raises demand for it.
• Expectations: if people expect prices to rise next month, demand rises now.
• Number of buyers: a growing town has more demand for housing.
• Supply shifts with input costs (wages, materials), technology, the number of sellers, taxes and subsidies, sellers' expectations, and natural events such as a frost that destroys part of an orange crop.

What happens when curves shift

Four basic cases cover most textbook questions:

• Demand increases: price rises and quantity rises.
• Demand decreases: price falls and quantity falls.
• Supply increases: price falls and quantity rises.
• Supply decreases: price rises and quantity falls. A frost that cuts the orange harvest is the classic example: orange juice costs more, and less is sold.
• When both curves shift at once, you can predict one result but not the other without numbers. If demand and supply both increase, quantity rises for sure, but price could go up, down or stay the same.

Price ceilings and price floors

Governments sometimes set prices by law. A price ceiling is a maximum price, such as rent control. If it is set below equilibrium, it creates a shortage, because quantity demanded exceeds quantity supplied at that price. A price floor is a minimum price, such as a minimum wage or a guaranteed crop price. If it is set above equilibrium, it can create a surplus.

Economists debate how large these effects are in real markets and whether the benefits to some people outweigh the costs to others. The supply and demand model shows the direction of the pressure; how big it is depends on the details of each market.

Common mistakes and how to check your work

Watch out for these errors:

To check a graph answer, ask three questions in order: which curve moves (demand or supply), which direction (right is more, left is less), and what happens to price and quantity at the new crossing point. Draw a quick before and after sketch every time; it takes ten seconds and catches most errors. For equation problems, substitute your price into both equations; they should give the same quantity.

• Saying "a higher price increases demand." A higher price decreases the quantity demanded; demand itself (the whole curve) does not move.
• Shifting both curves when only one factor changed. A frost affects sellers, so only supply shifts.
• Reading an increase in supply as a shift up. On the usual graph an increase in supply is a shift to the right, toward larger quantities, which looks lower, not higher.
• Putting quantity on the vertical axis. By convention, price goes on the vertical axis.