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Supply and Demand Before looking at the details of a supply and demand graph it is useful to have an idea of what the graph shows. Price is measured on the vertical axis and quantity is measured on the horizontal axis. Therefore, the graph shows the relationship between price and quantity - the quantity demanded or supplied at various prices. The two curves (supply and demand) represent the two sides of the market - producers (or sellers) and consumers (or buyers). The demand curves shows the quantity consumers will buy at various prices and the supply curve shows the quantity producers will sell at various prices. Just as the actions of buyers and sellers determine the price and quantity in the market, the interaction of supply and demand curves determine the market price and quantity on the graph. It is best to understand what is behind each curve before attempting to interpret the supply and demand graph. The demand curve shows the quantity demanded by consumers at various prices (if everything else is held constant). The curve illustrates what happens to the quantity consumers will buy when price changes. "Everything else held constant" means that the graph shows the effect of a different price on the quantity demanded without mixing in other changes that could effect quantity demanded. The demand curve shows a negative relationship between price and quantity demanded. As you would expect, consumers buy more when the price is low and less if the price is high (wouldn't you?). This is why the demand curve has a negative slope - it illustrates the "Law of Demand" discussed in the textbook.
The supply curve represents producers in the market the same way the demand curve represents consumers in the market. The supply curve shows he quantity supplied by producers at various prices (if everything else is held constant). The curve illustrates what happens to the quantity producers will sell when price changes. "Everything else held constant" means that the graph shows the effect of a price change on the quantity supplied without mixing in other changes that cold effect quantity supplied. The supply curve shows a positive relationship between price and quantity supplied. As you might expect, producers will sell more only if the price is higher. It generally costs producers more to produce more and therefore they will only sell more if they receive a higher price for the quantity they sell. Producers will sell less when the price is lower. This is why the supply curve has a positive slope - it illustrates the "Law of Supply" discussed in the textbook.
It is the interaction of supply and demand curves that determine MARKET price and quantity. Equilibrium price and quantity occurs where the supply and demand curves intersect, as shown on the graph below.
To understand the idea of market equilibrium, it is useful to remember the general concept of equilibrium. Equilibrium refers to a balance, where opposing forces are equal and there is no tendency for change. The concept of equilibrium is not unique to economics or to the supply and demand model - it is found in many models in many disciplines. In the supply and demand graph, equilibrium occurs at the price where quantity demanded equals quantity supplied - the point where the supply and demand curves cross. The best way to understand why this is an equilibrium is to think about what happens at prices that are NOT the equilibrium price. If price is ABOVE the equilibrium price, quantity demanded is relatively low (consumers buy less when the price is higher). On the other hand, quantity supplied is relatively high (the higher price causes producers to supply more). At a price above equilibrium, quantity supplied is greater than quantity demanded. This is illustrated on the graph below.
If the quantity that producers supply exceeds the quantity demanded by consumers, the market has a surplus. That is, consumers do not buy all that was supplied. The unsold quantity (surplus) increases producers' inventories. Producers, seeing that they are not selling all that they produce, lower the price (put the surplus "on sale") and decrease quantity supplied. Consumers respond to the lower price by increasing quantity demanded. This continues until the surplus disappears - when quantity supplied equals quantity demanded. Any price above equilibrium will cause a surplus and lead firms to lower price until the surplus is gone (at equilibrium). Above equilibrium, there is a tendency for price to change (decrease) - at equilibrium there is no tendency for change. In equilibrium, quantity supplied and quantity demanded are in balance - supply and demand forces are equal. If the price is BELOW the equilibrium price, quantity demanded is relatively high (consumers buy more when the price is lower). On the other hand, quantity supplied is relatively low (the lower price causes producers to sell less). At this price, quantity demanded is greater than quantity supplied. This is illustrated on the graph below.
If the quantity that consumers demand exceeds the quantity that producers supply, the market has a shortage. That is, consumers want to buy more than producers supply. The excess demand for the product signals producers to raise price. Producers see that consumers want to buy more than is supplied and realize that they can sell their product for a higher price. The higher price causes quantity demanded to decrease and quantity supplied to increase (those Laws of Demand and Supply!). Producers continue to raise price until the shortage disappears - when quantity demanded equals quantity supplied. Any price below equilibrium will cause a shortage and lead firms to raise price until the shortage is gone (at equilibrium). Below equilibrium, there is a tendency for price to change (increase) - at equilibrium there is no tendency for change. In equilibrium, quantity demanded and quantity supplied are in balance - supply and demand forces are equal. Shortages and surpluses signal firms (through changes in inventories) to raise or lower prices. The desire of firms to maximize their profits by adjusting price to prevent surpluses and shortages moves markets to the equilibrium price and quantity. This process that moves the market to equilibrium is powerful. On the supply and demand graph, markets that are allowed to operate without interference will always move to equilibrium But what about "everything else" that was held constant along demand and supply curves? Others things CAN change and lead to changes in the graph. If any other factors change, the quantity demanded or supplied at various prices will change for EVERY price. That is, the entire demand or supply curve will shift. Consider each side of the market separately. Other factors (in addition to price) affect the quantity of a product consumers will buy. Consumer's income and tastes determine how much they will purchase. Also, consumers will consider the price of substitute goods (things they can purchase instead - for example they could buy donuts instead of muffins for breakfast) and the price of complements (things that are consumed together - for example they could buy coffee with their donuts). Consumer expectations and the number of buyers can also affect demand for a good. If any of these change, the quantity demanded at any price will increase or decrease - the demand curve will shift to the right or left. If changes in other factors lead to an increase in demand, the curve will shift right. Notice that on the graph, quantities are higher to the right on the horizontal axis (as you move away from the origin). To the left on the horizontal axis, quantities are lower - if the demand curve moves left it shows the change in a factor has led to a decrease in demand. Increases and decreases in demand are shown on the graph below.
Since price is measured on the vertical axis, a change in price causes a moves ALONG the demand curve. This is referred to as a change in quantity demanded (the DEMAND curve hasn't changed - there has been a movement to a new point on the same curve). When another factor (NOT measured on the vertical axis) changes - like tastes or income - the entire demand curve shifts. Quantities are higher or lower AT EVERY PRICE. This is referred to as a change in demand. The entire demand relationship has changed. Be very careful about distinguishing between a change in quantity demanded and a change in demand. Other factors (in addition to price) affect the quantity of a product producers will sell. The costs of production, technology, the number of sellers, and sellers' expectations also affect producers' decisions about how much to supply. If any of these change, the quantity supplied at any price will increase or decrease - the supply curve will shift to the right or left. If changes in other factors lead to an increase in supply, the curve will shift right. Notice that on the graph, quantities are higher to the right on the horizontal axis (as you move away from the origin). To the left on the horizontal axis, quantities are lower - if the suply curve moves left it shows the change in a factor has led to a decrease in supply. Increases and decreases in supply are shown on the graph below.
Since price is measured on the vertical axis, a change in price causes a move ALONG the supply curve. This is referred to as a change in quantity supplied (the SUPPLY curve hasn't changed - there has been a movement to a new point on the same curve). When another factor (NOT measured on the vertical axis) changes - like costs of production or technology - the entire supply curve shifts. Quantities are higher or lower AT EVERY PRICE. This is referred to as a change in supply. The entire supply relationship has changed. Be very careful about distinguishing between a change in quantity supplied and a change in supply. If there is a change in a factor that affects demand, the entire demand curve shifts. The old demand curve no longer exists, so the market moves to a new equilibrium. The new equilibrium is found where the new demand curve intersects the supply curve (which hasn't changed). For example, if consumer tastes change and causes demand to increase, the change in equilibrium is illustrated on the graph below.
The graph shows that if consumers develop a taste or preference for a good, the price and quantity sold will increase in the market. If there is a change in a factor that affects supply, the entire supply curve shifts. The old supply curve no longer exists, so the market moves to a new equilibrium. The new equilibrium is found where the new supply curve intersects the demand curve (which hasn't changed). For example, if the cost of production increases and causes a decrease in supply, the change in equilibrium is illustrated on the graph below.
The graph shows that as costs increase and lead to a decrease in supply, price will rise and quantity will fall in the market. The supply and demand graph describes the relationship between price and quantity in the market. It can be used to illustrate the effect of changes in the market on equilibrium price and quantity. The ability to predict how an expected change will affect market price or quantity can be very useful. For example, a firm can more accurately determine how much to produce, a consumer can determine whether the price of a good they plan to buy will increase or decrease and an investor can better predict when to "buy low" or "sell high"! |
