Outline:

  • How many goods are available vs how many people want them;
  • Demand can increase instantly but supply takes time;
  • Equilibrium is the most efficient allocation of resources - when the amount of goods supplied is equal to the amount of goods in demand.

Supply and demand are fundamental concepts that form the basis of our economy.

In fact, they form the basis of economics. If ever you're confused about an economic or financial problem, boil it down to supply and demand.

At its most basic, supply is how much of a good or service is on offer in a market.

Demand is how much of the good or service the market wants to buy.

It's easy to think of examples where these two forces don't match up, i.e. the demand for $2 coins for the price of $1 is infinite. But the supply is likely zero.

This brings us onto two important concepts. The quantity supplied and the quantity demanded.

Think of quantity supplied as the amount suppliers are willing to sell, at a certain price point, and quantity demanded as the amount people are willing to buy at a certain price point.

So, to go back to the example above. The quantity supplied for $2 at $1 is zero, and the quantity demanded is infinite.

The relationship between price and supply is known as the supply relationship, and the relationship between price and demand is known as the demand relationship.

It's pretty easy to understand both supply and demand relationships. At a higher price suppliers want to sell more, and at a lower price people demand more. Now you can explain what you already knew intuitively, price is a reflection of the relationship between supply and demand.

This is why economists believe that the best way to allocate resources is by letting supply and demand decide. To understand why, let's take a closer look at the laws of supply and demand.

The law of supply

Economists say nthere is a positive relationship between price and quantity supplied. All this means is the higher the price of something, the more people who are willing to supply it.

Imagine flipping the example above, how many people would be willing to be sell $1 for $2, if demand was there? Everyone.

Chart of supply relationship.

Points A, B, and C are on the supply curve with each point reflecting the quantity supplied (Q) and the price (P). So, at point C, the price is P3 and the quantity is Q3.

The higher the price of a good, the higher the quantity supplied, and the lower the price, the lower the quantity supplied.

The law of demand

The law of demand is easy to understand, it's an observation about human behaviour above all else, and one that we all understand well. The higher the price of something, the less the market demands it. The opposite is also true, the lower the price the more demand. As long as all else remains equal.

When the price of an iPhone falls, we can expect more people to buy iPhones. If the price of a mortgage falls (interest rates fall), we can expect people to purchase more houses.

Chart of demand relationship.

Points A, B, and C are on the demand curve, and each point reflects the quantity demanded (Q) and price (P). So, at point A, Q1 is the quantity demanded and the price is P1. As you can see, as the price increases the quantity demanded decreases. Economics would say there is a negative relationship between price and quantity demanded.

The higher the price of a good, the lower the quantity demanded, and the lower the price, the higher the quantity demanded.

Remember, increasing supply takes time

Demand can increase instantly but supply takes time. For most goods or services it takes time to ramp up supply. This means suppliers cannot always react quickly to changes in demand or price.

This forces suppliers to decide if a price change is driven by temporary or permanent demand.

If you're selling gumboots in a particularly wet season, there is an increased demand. The law of supply states that you'd be willing to supply more at the higher price point.

However, if you think this is an anomaly, you may decide to accommodate demand by raising your prices rather than producing more gumboots.

If this wet season is driven by global warming then you may opt to produce more gumboots because you believe the demand will continue.

The relationship between supply and demand

Now it's time to think about how supply and demand affect prices.

Imagine that you want to buy a limited edition book for $100, the publisher decides that consumers won't buy the book at a price higher than $100, so only 500 books are printed. If the publisher turns out to be wrong, and consumers demand 10,000 books, the price will rise (as demand increases, so does price). This rise in price should then prompt the publisher to print more books because the higher the price, the higher the quantity supplied.

The inverse should also be true, if a publisher decides consumers will demand 10,000 books at a price point of $100, but they only demand 500, the price should fall as the publisher attempts to sell the remaining, oversupply books to recover their costs.

What is equilibrium?

When supply and demand meet, the market is said to be in equilibrium. Equilibrium is the most efficient allocation of resources because the amount of goods demanded is equal to the amount of goods supplied.

Economists would say that all economic actors are satisfied. Consumers aren't demanding any more at the current price, and suppliers don't want to supply more either. Everything that is produced is sold and consumers are happy, too.

Chart of equilibrium relationship

The above chart shows equilibrium as the intersection between the demand and supply curves. While equilibrium can only ever be reached in theory, it gives us a good mental model of how to think about the allocation of resources and how that relates to price.

Disequilibrium occurs whenever demand and supply are not in equilibrium, in real life, that's all the time...

What happens there is excess supply and excess demand?

Excess supply (often driven by the price of a good set too high) can cause an inefficient allocation of resources.

This is because suppliers want to produce more goods at the price point, in hopes of profit, but those who buy the goods find the product less attractive (too expensive) and purchase less.

Chart of supply demand relationship

Excess demand occurs when the price of a good is set below the equilibrium price. What happens is the price is so low, that consumers demand far more of the good than any producer is willing to make.

This is the opposite situation to excess supply, consumers are willing to buy heaps of the product (it's a bargain), but suppliers can't (or don't want to) sell at the price point.

Chart of excess demand

What do movements on supply and demand curves represent?

A movement refers to a change along a curve.

A movement on the supply curve means the relationship between price and quantity supplied remains consistent. The price of the good changes and the quantity supplied changes in relation to the existing supply curve.

An easy way to remember this is a movement occurs when a change in quantity supplied is caused by a change in price.

Chart of price changes

Likewise, a movement along the demand curve refers to a change in both price and quantity demanded from one point of the existing supply curve to another. Remember, the relationship between price and quantity demanded remains consistent during a movement.

Chart of demand curve

What do shifts on supply and demand curves represent?

A shift happens when the quantity demanded or quantity supplied changes but the price doesn't. If the price of a glass of wine was $12 and the quantity supplied decreased from Q1 to Q2, then you would say that there was a shift in the supply of wine.

Chart of supply and demand curve shifts

This implies that the quantity supplied is being affected by something other than price. As an example, this could occur if there was a season where winemakers were unable to get enough grapes due to bad weather forcing them to supply less wine for the same price.

Likewise, a shift in demand could occur if the price of the glass of wine was $2 but demand increased from Q1 to Q2. Again, this means that the relationship between price and quantity demanded has changed. As an example, this could be driven by an increased tax on beer and spirits which has driven more people to drink wine.

Chart of demand shift