Key Takeaways
- Demand describes buyers: A change in price moves quantity demanded along a demand curve; other factors can shift the curve itself.
- Supply describes sellers: Price changes quantity supplied, while costs, technology, expectations, and other conditions can shift supply.
- Equilibrium balances the market: It occurs where quantity demanded equals quantity supplied.
- Elasticity measures sensitivity: The size of a response can matter as much as the direction of the change.
The Law of Demand
Quantity demanded is the amount buyers are willing and able to purchase at a particular price. With other conditions held constant, a higher price generally reduces quantity demanded and a lower price increases it.
Price changes create movement along the existing demand curve. Changes in income, preferences, population, expectations, or the price of related goods can instead shift the entire curve.
The Law of Supply
Quantity supplied is the amount sellers are willing and able to offer at a given price. Higher prices often create an incentive to produce or sell more, assuming other conditions remain unchanged.
Production costs, technology, taxes, regulation, expectations, weather, and the number of sellers can shift supply. A cheaper production process, for example, can make sellers willing to provide more output at the same price.
Exceptions exist, so the upward-sloping supply curve should be treated as a basic model rather than a rule that describes every market perfectly.
Market Equilibrium, Shortages, and Surpluses
Market equilibrium is the point where quantity demanded equals quantity supplied. The St. Louis Fed describes this as the point at which there is neither a shortage nor a surplus.
Prices below equilibrium can create shortages because buyers want more than sellers offer. By contrast, prices above equilibrium can create surpluses as sellers offer more than buyers want.
In competitive markets, price changes can help move the market toward a new balance. Real-world adjustment may be slow when contracts, regulations, production constraints, or search costs keep prices and quantities from changing quickly.
Elasticity: How Much Does Quantity Respond?
Direction alone does not tell you the magnitude of a response. Price elasticity of demand compares the percentage change in quantity demanded with the percentage change in price.
Demand is called elastic when quantity responds proportionally more than price, inelastic when it responds proportionally less, and unit elastic when the percentage changes are equal in magnitude.
Substitutes, necessity, budget share, and time to adjust can all influence elasticity. Gasoline demand may be relatively unresponsive over a very short period because commuters cannot instantly change vehicles or jobs, while longer periods can allow more adjustment.
What Shifts Supply or Demand?
| Side | Common shift factors |
|---|---|
| Demand | Income, tastes, population, expectations, prices of substitutes and complements |
| Supply | Input costs, technology, taxes, regulation, expectations, number of sellers, natural conditions |
Identifying the shifting curve is often more useful than memorizing a headline. A crop failure is primarily a supply shock; a surge in consumer preference for the product is primarily a demand shock.
Why the Model Matters
Supply and demand provide a framework for interpreting prices, shortages, inventory, wages, housing, commodities, and many other markets. The model also helps separate a price increase caused by stronger demand from one caused by restricted supply.
Policy can change the outcome. Taxes, subsidies, price ceilings, price floors, quotas, and regulation may alter incentives or prevent the market from reaching the unconstrained equilibrium.
Economic models simplify reality, so the framework should be paired with institutional details. Market power, information gaps, externalities, and legal constraints can all affect actual outcomes.
Frequently Asked Questions (FAQs)
What happens when demand increases?
If supply is unchanged, an outward demand shift generally creates upward pressure on equilibrium price and quantity.
What happens when supply decreases?
With demand unchanged, a reduction in supply generally raises equilibrium price and lowers equilibrium quantity.
What is the difference between demand and quantity demanded?
Demand refers to the whole relationship between price and desired purchases. Quantity demanded is the amount buyers want at one specific price.