Demand, Supply, and Equilibrium
Demand, Supply, and Equilibrium in Markets for Goods and Services
Learning Objectives
By the end of this section, you will be able to:
- Explain demand, quantity demanded, and the law of demand
- Identify a demand curve and a supply curve
- Explain supply, quantity supply, and the law of supply
- Explain equilibrium, equilibrium price, and equilibrium quantity
First let's first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.
Demand for Goods and Services
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is based on needs and wants – a consumer may be able to differentiate between a need and a want, but from an economist's perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand.
What a buyer pays for a unit of the specific good or service is called price. The total number of units purchased at that price is called the quantity demanded.
A rise in price of a good or service almost always decreases the
quantity demanded of that good or service. Conversely, a fall in price
will increase the quantity demanded. When the price of a gallon of
gasoline goes up, for example, people look for ways to reduce their
consumption by combining several errands, commuting by carpool or mass
transit, or taking weekend or vacation trips closer to home. Economists
call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (to be explained in the next module) are held constant.
An example from the market for gasoline can be shown in the form of a
table or a graph. A table that shows the quantity demanded at each
price, such as Table 1, is called a demand schedule.
Price in this case is measured in dollars per gallon of gasoline. The
quantity demanded is measured in millions of gallons over some time
period (for example, per day or per year) and over some geographic area
(like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like Figure 1,
with quantity on the horizontal axis and the price per gallon on the
vertical axis. (Note that this is an exception to the normal rule in
mathematics that the independent variable (x) goes on the horizontal
axis and the dependent variable (y) goes on the vertical. Economics is
not math.)
The demand schedule shown by Table 1 and the demand curve shown by the graph in Figure 1 are two ways of describing the same relationship between price and quantity demanded.
Figure 1. A Demand Curve for Gasoline. The demand
schedule shows that as price rises, quantity demanded decreases, and
vice versa. These points are then graphed, and the line connecting them
is the demand curve (D). The downward slope of the demand curve again
illustrates the law of demand – the inverse relationship between prices
and quantity demanded.
Price (per gallon) | Quantity Demanded (millions of gallons) |
---|---|
$1.00 | 800 |
$1.20 | 700 |
$1.40 | 600 |
$1.60 | 550 |
$1.80 | 500 |
$2.00 | 460 |
$2.20 | 420 |
Table 1. Price and Quantity Demanded of Gasoline |
Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. So demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.
In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to the (specific) point on the curve.
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants where it can be refined into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied – that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied – the law of supply. The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.
Is supply the same as quantity supplied?
In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that can be illustrated with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to the (specific) point on the curve.
Figure 2. A Supply Curve for Gasoline. The supply
schedule is the table that shows quantity supplied of gasoline at each
price. As price rises, quantity supplied also increases, and vice versa.
The supply curve (S) is created by graphing the points from the supply
schedule and then connecting them. The upward slope of the supply curve
illustrates the law of supply – that a higher price leads to a higher
quantity supplied, and vice versa.
Price (per gallon) | Quantity Supplied (millions of gallons) |
---|---|
$1.00 | 500 |
$1.20 | 550 |
$1.40 | 600 |
$1.60 | 640 |
$1.80 | 680 |
$2.00 | 700 |
$2.20 | 720 |
Table 2. Price and Supply of Gasoline |
The shape of supply curves will vary somewhat according to the product:
steeper, flatter, straighter, or curved. Nearly all supply curves,
however, share a basic similarity: they slope up from left to right and
illustrate the law of supply: as the price rises, say, from $1.00 per
gallon to $2.20 per gallon, the quantity supplied increases from 500
gallons to 720 gallons. Conversely, as the price falls, the quantity
supplied decreases.
Equilibrium – Where Demand and Supply Intersect
Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.
Figure 3 illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 1. The supply curve (S) is identical to Figure 2. Table 3 contains the same information in tabular form.
Figure 3. Demand and Supply for Gasoline. The demand
curve (D) and the supply curve (S) intersect at the equilibrium point E,
with a price of $1.40 and a quantity of 600. The equilibrium is the
only price where quantity demanded is equal to quantity supplied. At a
price above equilibrium like $1.80, quantity supplied exceeds the
quantity demanded, so there is excess supply. At a price below
equilibrium such as $1.20, quantity demanded exceeds quantity supplied,
so there is excess demand.
Price (per gallon) | Quantity demanded (millions of gallons) | Quantity supplied (millions of gallons) |
---|---|---|
$1.00 | 800 | 500 |
$1.20 | 700 | 550 |
$1.40 | 600 | 600 |
$1.60 | 550 | 640 |
$1.80 | 500 | 680 |
$2.00 | 460 | 700 |
$2.20 | 420 | 720 |
Table 3. Price, Quantity Demanded, and Quantity Supplied |
Remember this: When two lines on a diagram cross, this intersection
usually means something. The point where the supply curve (S) and the
demand curve (D) cross, designated by point E in Figure 3, is called the equilibrium. The equilibrium price
is the only price where the plans of consumers and the plans of
producers agree – that is, where the amount of the product consumers want
to buy (quantity demanded) is equal to the amount producers want to sell
(quantity supplied). This common quantity is called the equilibrium quantity.
At any other price, the quantity demanded does not equal the quantity
supplied, so the market is not in equilibrium at that price.
In Figure 3,
the equilibrium price is $1.40 per gallon of gasoline and the
equilibrium quantity is 600 million gallons. If you had only the demand
and supply schedules, and not the graph, you could find the equilibrium
by looking for the price level on the tables where the quantity demanded
and the quantity supplied are equal.
The word "equilibrium" means "balance". If a market is at its
equilibrium price and quantity, then it has no reason to move away from
that point. However, if a market is not at equilibrium, then economic
pressures arise to move the market toward the equilibrium price and the
equilibrium quantity.
Imagine, for example, that the price of a gallon of gasoline was above
the equilibrium price – that is, instead of $1.40 per gallon, the price is
$1.80 per gallon. This above-equilibrium price is illustrated by the
dashed horizontal line at the price of $1.80 in Figure 3.
At this higher price, the quantity demanded drops from 600 to 500. This
decline in quantity reflects how consumers react to the higher price by
finding ways to use less gasoline.
Moreover, at this higher price of $1.80, the quantity of gasoline
supplied rises from the 600 to 680, as the higher price makes it more
profitable for gasoline producers to expand their output. Now, consider
how quantity demanded and quantity supplied are related at this
above-equilibrium price. Quantity demanded has fallen to 500 gallons,
while quantity supplied has risen to 680 gallons. In fact, at any
above-equilibrium price, the quantity supplied exceeds the quantity
demanded. We call this an excess supply or a surplus.
With a surplus, gasoline accumulates at gas stations, in tanker trucks,
in pipelines, and at oil refineries. This accumulation puts pressure on
gasoline sellers. If a surplus remains unsold, those firms involved in
making and selling gasoline are not receiving enough cash to pay their
workers and to cover their expenses. In this situation, some producers
and sellers will want to cut prices, because it is better to sell at a
lower price than not to sell at all. Once some sellers start cutting
prices, others will follow to avoid losing sales. These price reductions
in turn will stimulate a higher quantity demanded. So, if the price is
above the equilibrium level, incentives built into the structure of
demand and supply will create pressures for the price to fall toward the
equilibrium.
Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in Figure 3
shows. At this lower price, the quantity demanded increases from 600 to
700 as drivers take longer trips, spend more minutes warming up the car
in the driveway in wintertime, stop sharing rides to work, and buy
larger cars that get fewer miles to the gallon. However, the
below-equilibrium price reduces gasoline producers' incentives to
produce and sell gasoline, and the quantity supplied falls from 600 to
550.
When the price is below equilibrium, there is excess demand, or a shortage – that
is, at the given price the quantity demanded, which has been stimulated
by the lower price, now exceeds the quantity supplied, which had been
depressed by the lower price. In this situation, eager gasoline buyers
mob the gas stations, only to find many stations running short of fuel.
Oil companies and gas stations recognize that they have an opportunity
to make higher profits by selling what gasoline they have at a higher
price. As a result, the price rises toward the equilibrium level. Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model.
Key Concepts and Summary
A demand schedule is a table that shows the quantity demanded at different prices in the market. A demand curve shows the relationship between quantity demanded and price in a given market on a graph. The law of demand states that a higher price typically leads to a lower quantity demanded.
A supply schedule is a table that shows the quantity supplied at
different prices in the market. A supply curve shows the relationship
between quantity supplied and price on a graph. The law of supply says
that a higher price typically leads to a higher quantity supplied.
The equilibrium price and equilibrium quantity occur where the supply
and demand curves cross. The equilibrium occurs where the quantity
demanded is equal to the quantity supplied. If the price is below the
equilibrium level, then the quantity demanded will exceed the quantity
supplied. Excess demand or a shortage will exist. If the price is above
the equilibrium level, then the quantity supplied will exceed the
quantity demanded. Excess supply or a surplus will exist. In either
case, economic pressures will push the price toward the equilibrium
level.
Source: Rice University, https://opentextbc.ca/principlesofeconomics/chapter/3-1-demand-supply-and-equilibrium-in-markets-for-goods-and-services/
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