Supply-Demand Market Equilibrium

Consider a farmers market, where the farmers are selling cantaloupes. On the first day, they offer their cantaloupes for $5 apiece, but few people buy them, so as the end of the day draws near, the farmers find that they have a surplus of cantaloupes. Consequently, the farmers drop the price of their cantaloupes to $1, quickly selling their surplus. For most products, as their price increases, the supply increases but the demand decreases. If the sellers raise their price too high, where the demand is less than what they must offer, then they will have a surplus that will force them to lower their price until they can sell their entire supply.

On the other hand, if the sellers set their price too low, then they will sell their entire supply before they can satisfy the demands of the market, thereby causing a shortage for the buyers and lesser profits or greater losses for the sellers. Some people who wanted to buy the product will be unable to obtain it. Surpluses and shortages reduces the allocative efficiency of the economy, because the distribution of goods and services is less than optimal.

Supply increases with prices because the suppliers earn greater profits and can easily cover their costs; higher prices increase the producer surplus for the sellers. Demand increases with lower prices because the products become more affordable and the buyers get more value for their money, i.e. consumer surplus. Because people only buy a product if the benefit at least equals its cost, and because people's preferences vary widely, a lower product price will have a benefit worth the cost for more people, thus increasing demand. This is why when demand and supply quantities are plotted according to price, the supply curve moves upward with price, while the demand curve moves downward with price. When the amount demanded equals the amount supplied, then market equilibrium (aka supply-demand equilibrium) is achieved, where the quantity equals the equilibrium quantity and the price equals the equilibrium price. Furthermore, if prices are different from the equilibrium price, then the law of supply and demand states that the price of any product will adjust until the supply equals the demand.

Diagram showing the demand and supply curves, the market equilibrium, and a surplus and a shortage.
In the short term, supply is inelastic. For instance, if farmers bring their product to market, then they have a specific quantity to sell, and they cannot change that quantity while they are at the market, so allocation efficiency is maximized only if the right price is set. If sellers price their product too low, then they may not be able to provide the quantity demanded by the buyers, since buyers demand more at lower prices, resulting in a supply shortage. If sellers price their product too high, then they will not be able to sell all that they have, since buyers demand less at higher prices, resulting in a supply surplus. In either case, sellers must adjust their price toward the market equilibrium price to maximize profits. The market equilibrium price is the highest price that sellers can charge and still be able to sell all that they have, with no surplus or shortage.

Prices Ration the Production and Distribution of Products and Services

In a highly competitive market, sellers must set the price of their product so that they can sell what they have. Hence, prices have a rationing function in that those sellers willing to sell at the equilibrium price will be able to sell all their product, while buyers willing to pay the equilibrium price will be able to buy all they want. Sellers, who are unable or unwilling to sell their product for the equilibrium price, will stop producing it. Likewise, only the buyers who are willing to pay the equilibrium price will get the product. Those who do not desire the product as much will be unwilling to pay the equilibrium price. This is how the resources of an economy are allocated to produce the most desirable products.

How Market Equilibrium Changes in Response to Non-Price Changes in Supply and Demand

Although prices change both supply and demand quantities, demand and supply determinants other than prices can also change either demand or supply, in which case, they will also change the market equilibrium. If only prices change, then the law of supply and demand will cause both quantity and price to revert back to the equilibrium. However, if other determinants causes changes in either demand or supply, then the market equilibrium also changes, because either the demand curve or the supply curve or both shifts.

Supply determinants other than prices include the prices of the factors of production used to create the product, technology, taxes and subsidies, number of sellers, price expectations, and the prices of other related goods. If supply determinants increase supplies, while the demand remains constant, then the equilibrium price will decline, because it must adjust to the new, higher equilibrium quantity, which can only be sold at lower prices. Supply determinants that decrease supplies will cause the equilibrium price to rise, since it will take fewer buyers to buy the product at the higher price and only those willing to pay the higher price will buy it.

Demand determinants other than price include consumer preferences, income, prices of substitutes and complements, and the number of buyers. If the supply remains constant, but non-price demand determinants increase demand, then the equilibrium price will rise, since the equilibrium quantity will also increase, and the suppliers will only supply more product at a higher price. Likewise, if demand decreases because of factors other than price, then the equilibrium price will decline, since suppliers will only be able to sell the new, lower equilibrium quantity of their product.

Diagrams showing how shifts in the demand and supply curves changes the market equilibrium.
These diagrams shows how changes in non-price demand and supply determinants can change the market equilibrium. In the first diagram, the supply curve shifts rightward, from S1 to S2, representing an increase in supply caused by non-price supply determinants, causing the equilibrium price to decline from P1 to P2 and the equilibrium quantity to increase from Q1 to Q2. In the 2nd diagram, it is the demand curve that shifts rightward, from D1 to D2, representing an increase in demand from demand determinants other than price, causing the equilibrium price to increase from P1 to P2 and the equilibrium quantity to increase from Q1 to Q2. Note that if the supply curve shifts leftward, from S2 to S1, then the equilibrium price moves from P2 to P1 and the equilibrium quantity moves from Q2 to Q1; likewise, when the demand curve shifts from D2 to D1.

If non-price determinants change both supply and demand, then how the market equilibrium will change will depend on how much the supply changes compared to the demand changes. If the change in supply exceeds the change in demand, then the same analysis applied to shifts in the supply curve while the demand remained constant applies here also. If the change in demand exceeds the change in supply, then the market equilibrium changes in the same direction as when the supply was held constant.

Example: Ticket Prices and Scalping

A good example of the economics of supply and demand can be found in how tickets are sold. When promoters of big events want to sell tickets, they price their tickets so that they can sell enough to fill the available seats. However, there are always some people willing to pay more, especially after the tickets have been sold out. Ticket scalpers seek to satisfy the needs of these people by providing tickets at higher prices. Like the big event promoters, ticket scalpers want to be able to sell all that they have — otherwise, they will have unsold tickets that will reduce their profits by the amount paid for the unsold tickets. Although some people consider scalping unethical, and in some places, it is even illegal, the ticket scalpers are simply providing a service to people who really want to see the event but were unable to get tickets for one reason or another. Although the late buyers are paying higher prices, they are willing to pay the higher prices to see the event. If ticket scalpers did not earn a profit, then they would not provide the service. Profit, after all, is the objective of most businesses.