Student Resource 6.7
Reading: Supply and Demand and Market Equilibrium
This presentation brings together the concepts of supply and demand and explains how they interact with
one another in order to set the price of a good or service. Supply and demand schedules are introduced
in a single table and then graphed in a supply and demand diagram, which presents key concepts such
as price equilibrium, surplus, and shortage through the running example of chocolate bars.
Graphs showing the impact of factors that cause changes in supply, such as the arrival of competition in
the marketplace, the introduction of new technologies, and the cost of resources used to produce certain
goods are presented and described. These graphs make clear the importance of the price mechanism
and the dynamic nature of a market economy and its responsiveness to consumers.
Supply and demand are both driven by price. However, it becomes clear from the example of the
chocolate bar production and consumption schedules (which correspond to supply and demand curves)
that price is pushing consumers and producers in opposite directions. Higher prices reduce consumption,
but stimulate increased production, and vice versa. The market generally finds the price that balances
supply and demand, so there is no surplus or shortage in terms of goods offered and goods purchased.
This is known as price equilibrium. Finding the equilibrium of supply and demand is the dynamic force of
a adjustment in a market system.
Using the supply and demand schedules here, it becomes clear that the producers and the consumers
are on the same page—that is, they are acting consistently so that they produce and consume the same
amount—at only one point (corresponding to a price of $0.75 per chocolate bar). This price reflects the
chocolate’s utility to the consumer and a profit to the producer sufficient to make it worth their while to
keep producing the corresponding quantity of chocolate bars. At this point, no resources are inefficiently
used, no consumers who want one (and can afford one at the going price) go without a chocolate bar,
and the producers are producing the product for a price that gives them a profit that’s enough to keep
them producing at this scale.
For economists and businesses alike, the information that a supply and demand curve graph presents is
extremely important. It allows businesses to plan production and make predictions about revenues,
income, and production capabilities.
Communication in the marketplace between consumers and producers is a process of trial and error.
Consumers communicate the highest price they are willing to pay for a good, and producers
communicate the lowest cost at which they are willing to sell the good. Eventually, through the process of
trial and error, the consumer and producer find equilibrium, a price they can agree on (though this does
not always work perfectly in practice). But what happens when they can’t agree on a price?
As mentioned already, from time to time external factors affect both supply and demand, shifting both the
supply curve and the demand curve. Producers try to track consumer behavior in order to get the best
price for the goods they sell. This, however, is not an exact science. Producers often overshoot or
undershoot the mark. They may be stuck with surplus (extra) goods that must be priced lower in order to
be sold. Conversely, they may find themselves missing out on a sale because they have a shortage (they
have under-produced) and have less than the market demands. By keeping an eye on price, producers
look to stay as close to equilibrium as possible to avoid both scenarios.
Despite companies getting better at matching supply with demand, new products and new producers
continue to create market disequilibrium on the demand side by shifting the demand curve. Changing
tastes, employment levels, and consumer expectations can do this. All together, this makes for a highly
dynamic and fluid marketplace.
Many factors affect supply and demand. Competition, input costs, and technology all play a major part in
the way economists and businesses understand and track changes in supply, demand, and the
relationship between the two. The feedback mechanism is through price.
The balance between price and demand reflects the two forces at work in a free market economy. On one
hand, consumers want to pay as little as possible for the goods and services they buy. On the other hand,
producers want to sell as many of their goods and services for as high a price as possible. The meeting
point between these two objectives reflects a properly functioning market.