Bringing demand and supply together

Up to now, demand and supply have been studied on their own. The model becomes useful for real markets when the two curves are placed on the same axes and read together. The vertical axis shows price, and the horizontal axis shows quantity. The downward sloping line is the demand curve, which records how much buyers are willing and able to purchase at each possible price, other things held constant. The upward-sloping line is the supply curve, which records how much firms are willing and able to sell at each possible price, other things held constant. Where the two lines cross there is a single price at which the quantity buyers want to purchase exactly matches the quantity firms plan to sell. This point is the market equilibrium. The corresponding price is the equilibrium price and the corresponding quantity is the equilibrium quantity. At that price, no buyer wishes he or she had paid less, and no seller wishes he or she had charged more, given the conditions summarized by the two curves.

It is helpful to keep the economic meaning clear while looking at the picture. Each point on the demand curve can be read as a willingness to pay for the last unit bought by the market at that price. Each point on the supply curve can be read as the minimum price that just covers the cost of producing the last unit sold at that quantity. The equilibrium price is therefore the one price at which buyers’ willingness to pay for the last unit equals sellers’ minimum acceptable price for producing that same unit. When the price settles at this level the market clears, which means the whole quantity offered at that price is purchased.

What happens when the price is not at equilibrium

Real markets do not always start at the crossing point. The model shows what forces push the price toward the crossing. Suppose the price is set higher than the equilibrium price. At this high price, buyers cut back their purchases while firms find it profitable to offer a larger quantity, as they end up with unsold stock, incurring opportunity cost. The quantity firms wish to sell is greater than the quantity buyers wish to purchase. There is excess supply (excess supply is a situation in which the quantity that firms are willing and able to supply exceeds the quantity that consumers wish to demand at the going price). Firms have an incentive to lower the price in order to clear this stock. As the price is reduced, buyers move along the demand curve and take more, while firms move along the supply curve and offer less. These movements continue until the price reaches the level where quantity demanded equals quantity supplied. The market returns to equilibrium.

Suppose instead the price is set below the equilibrium price. At this low price buyers wish to purchase more than firms are willing to sell. There is excess demand (excess demand is a situation in which the quantity that consumers wish to demand at the going price exceeds the quantity that firms are willing and able to supply). Some buyers leave the shop empty handed while others would have been prepared to pay more. Firms can raise the price and still sell everything they bring to market. As price rises, buyers move back along the demand curve and reduce the quantity they wish to buy, while firms move along the supply curve and increase the quantity they wish to sell. The price moves toward the level where the two quantities are equal. The market again returns to equilibrium. When the price is above or below the crossing and is moving toward it, the market is in disequilibrium.

The model therefore explains why a competitive market tends to converge on a single price at which planned purchases and planned sales match. That price is not chosen by a central authority. It is the outcome of buyers and sellers reacting to the presence of unsold stock or queues and adjusting their actions accordingly.

Changes in the market equilibrium when demand shifts

Market conditions can change on the buyer side or the seller side, so the position of one of the curves can shift. When an influence on demand changes, such as tastes and preferences, or when the price of a related good or consumer incomes changes, the whole demand curve moves to a new position. A rightward shift means that at every price buyers wish to purchase a larger quantity than before. A leftward shift means that at every price they wish to purchase a smaller quantity than before.

For example, let's take the dried pasta market. Begin at an initial equilibrium in which the demand curve and the supply curve cross at a starting price and quantity. Suppose a health campaign convinces a larger number of consumers to include more pasta in their diet. This change in preferences increases willingness to buy at any given price, so the demand curve shifts to the right. The new crossing with the original supply curve lies at a higher price and a larger equilibrium quantity. Buyers move along the unchanged supply curve from the original crossing toward the new one. The movement along supply is called an extension of supply because the higher price makes it profitable for firms to offer more output.

Another important case arises when the price of a substitute changes. Fresh pasta is likely to be a substitute for dried pasta. If the price of fresh pasta falls, some consumers will switch toward fresh pasta and away from dried pasta, other things held constant. The demand curve for dried pasta shifts to the left. The new crossing with the unchanged supply curve gives a lower equilibrium price and a lower equilibrium quantity than before. The market contracts along the supply curve because the lower price makes it less attractive to produce large quantities.

Using the demand and supply model to analyse changing conditions

The same method can be applied to other markets. Take cocoa and chocolate, which provide a good case. Chocolate producers demand cocoa as an input, while consumers demand chocolate as a final product. Weather, disease and farming decisions influence the supply of cocoa. Changes in the availability of cocoa shift the supply curve for cocoa. Because cocoa is an input into chocolate, changes in cocoa prices alter the costs faced by chocolate producers. A rise in cocoa prices will tend to shift the chocolate supply curve to the left, which raises the equilibrium price of chocolate and lowers the equilibrium quantity, other things held constant. If a poor cocoa harvest is followed by a normal harvest the next year, the supply curve for cocoa could shift left and then back toward its original position. The demand and supply model is flexible enough to represent these changes year by year and to give a clear narrative about the movement of prices and quantities.

For a commodity like cocoa there may be a run of bad harvests that push supply to the left repeatedly, after which a bumper harvest shifts the curve rightward again. The sequence of shifts produces a sequence of equilibrium points and helps to explain why market prices can be high in one period and lower in the next.