Supply and demand

Every price you pay is the outcome of a quiet negotiation between two groups who never meet: the people who want to buy something and the people who want to sell it. Supply and demand is the model economists use to describe that negotiation. It is almost embarrassingly simple — two lines on a chart — and yet it explains a surprising amount of the world.

Two groups, two curves

Start with buyers. The cheaper something is, the more of it people want: some buy more of it, others who had given up on it come back. Plot price against the quantity people are willing to buy and you get the demand curve, which slopes downward.

Sellers behave the other way round. A higher price makes it worth producing more: existing firms push their capacity, and new ones find it profitable to enter. Plot price against the quantity offered for sale and you get the supply curve, which slopes upward.

In the simplest version of the model both are straight lines. Writing $P$ for price and $Q$ for quantity:

\text{Demand: } P = 100 - Q \qquad \text{Supply: } P = 20 + Q

Where the curves meet

There is exactly one price at which the quantity buyers want equals the quantity sellers offer. Economists call it the equilibrium. Setting the two equations equal gives it directly:

100 - Q = 20 + Q \;\Rightarrow\; Q^* = 40, \quad P^* = 60

Why would the market end up there? Suppose the price were 80 instead. Sellers would bring 60 units to market, but buyers would only want 20. Unsold stock piles up and sellers start cutting prices. Suppose instead the price were 40: buyers want 60 units, sellers offer only 20, queues form and prices get bid up. Whichever side of the equilibrium you start from, the pressure points back towards it.

Try it: shift the curves

The chart below is the same model. The sliders shift each curve left or right; the dashed line shows where it was before.

Figure 1A market for a single good

Shift demand0Shift supply0

Equilibrium price

Equilibrium quantity

Consumer surplus

Producer surplus

Demand: P = 100 + shift − Q. Supply: P = 20 − shift + Q. The dot marks the equilibrium; the numbers below update as you move the sliders.

A few experiments worth trying:

Raise demand (first slider to the right). Both the price and the quantity go up — think of a heatwave and the market for ice cream.
Raise supply (second slider to the right). Quantity goes up but the price goes down — think of a bumper harvest.
Move both at once. When demand and supply both rise, quantity certainly increases, but what happens to the price depends on which shift is larger.

Who gains from trade

Switch on Show surplus. The blue triangle is the consumer surplus: the gap between what buyers would have been willing to pay and the price they actually pay, added up over every unit sold. The orange triangle is the producer surplus: the gap between the price sellers receive and the lowest price they would have accepted.

Together they measure how much better off everyone is because the market exists. In the starting position each one is worth 800. Shift the curves and watch the gains change: when supply falls, both triangles shrink — buyers pay more, and fewer units change hands.

Moving along a curve vs. shifting it

What to remember

Demand slopes down, supply slopes up; the price settles where they cross.
Away from equilibrium, shortages push prices up and surpluses push them down.
A shift in demand moves price and quantity in the same direction; a shift in supply moves them in opposite directions.
Consumer and producer surplus measure the gains from trade, and shifts change how they are shared.