Price Determination: Demand and Supply

This section focuses on how prices are determined in a market through the interaction of supply and demand. We will explore the concepts of equilibrium, surplus, and shortage, and how these are represented graphically using demand and supply curves.

Understanding Demand

Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a specific period. The law of demand states that generally, as the price of a good increases, the quantity demanded decreases, and vice versa. This inverse relationship is depicted by the downward-sloping demand curve.

• Factors influencing demand (other than price):
• Consumer income
• Consumer tastes and preferences
• Prices of substitute goods
• Prices of complementary goods
• Consumer expectations about future prices
• Population size

Understanding Supply

Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at various prices during a specific period. The law of supply states that generally, as the price of a good increases, the quantity supplied increases, and vice versa. This direct relationship is depicted by the upward-sloping supply curve.

• Factors influencing supply (other than price):
• Cost of production (including wages, materials, and technology)
• Producer expectations about future prices
• Number of sellers in the market
• Government policies (e.g., taxes, subsidies)
• Technological changes

The Equilibrium Price

Equilibrium occurs when the quantity demanded equals the quantity supplied. This point is where the demand and supply curves intersect. At the equilibrium price, there is no pressure for the price to change.

The equilibrium price is also known as the market-clearing price because it eliminates both surplus and shortage.

Surplus and Shortage

Surplus occurs when the quantity supplied exceeds the quantity demanded at a given price. This leads to downward pressure on prices as producers try to sell off excess stock.

Shortage occurs when the quantity demanded exceeds the quantity supplied at a given price. This leads to upward pressure on prices as consumers compete for limited goods.

Drawing and Interpreting the Demand and Supply Curves

A standard demand and supply diagram is used to illustrate the relationship between price, quantity demanded, and quantity supplied. The demand curve slopes downwards from left to right, and the supply curve slopes upwards from left to right. The intersection of these two curves determines the equilibrium price and quantity.

Changes in Demand and Supply

Changes in factors other than price will shift the demand or supply curves, leading to a new equilibrium price and quantity.

Change	Curve Shift	New Equilibrium
Increase in demand	Demand curve shifts right	Higher equilibrium price and higher equilibrium quantity
Decrease in demand	Demand curve shifts left	Lower equilibrium price and lower equilibrium quantity
Increase in supply	Supply curve shifts right	Lower equilibrium price and higher equilibrium quantity
Decrease in supply	Supply curve shifts left	Higher equilibrium price and lower equilibrium quantity

Price Controls

Governments sometimes intervene in markets through price controls, such as price ceilings (maximum prices) and price floors (minimum prices). These controls can lead to unintended consequences, such as shortages (with price ceilings) or surpluses (with price floors).

Price Ceiling: A legal maximum price that can be charged for a good or service. If the price ceiling is set below the equilibrium price, it will create a shortage.

Price Floor: A legal minimum price that can be charged for a good or service. If the price floor is set above the equilibrium price, it will create a surplus.