Introduction

We have looked independently at how demand and supply works, and we will now examine how they interact to determine equilibrium price and output in a free market.

The demand and supply curves for a particular good / service slope in opposite directions due to their relationship with price, as discussed in previous articles.

Due to this, if we model the demand and supply of a good on one set of axes, the demand and supply curves will intersect. This point of intersection is the price at which the quantities demanded and quantities supplied will be equal, and is the market price of the good; this point is called free market equilibrium. See P1 and Q1 in figure 5 below.

If the price were any higher than this point, there would be a surplus of supply because producers would be willing to produce more than consumers were willing to buy - see PX.

Due to this, producers would be forced to compete on price to get rid of their stock, bringing the price down and increasing demand to the level it equals supply.

If the price were lower, there would be a shortage of goods supplied because consumers would be willing to buy more of a good than suppliers were willing to supply at this price - see PY.

As consumers would be unable to obtain all they want, they would be happy to pay more for a good, pushing the price up and increasing supply to the level it equals demand.

Changes in Equilibrium

In the Supply and Demand articles, we discussed shifts in the supply and demand curves due to changes in their determinants (other than price). We will now look at how this affects free market equilibrium.

Changes in demand

Figure 6 below shows the current demand curve, D1, and supply curve S1, for a good; the equilibrium price and quantity are P1 and Q1 respectively.

Assume there was an overall increase in the amount of demand for the relevant good. For example, if the number of substitute goods in the market decreased, or if overall income levels increased. This would result in an outward shift of the demand curve - from D1 to D2. At any given price level along D2, there would be more demand for a product than along D1.

D2 would intersect S1 at a new point, resulting in a higher market equilibrium price and quantity - P2 and Q2.

However, if the overall demand for a particular good decreased, D1 would shift inward to D3, resulting in a lower market equilibrium price and quantity - P3 and Q3. An example of why demand might decrease could include a change in consumer tastes, or an increase in substitute goods (e.g. if figure 6 related to older generations of smart phone, newer models being released could result in the reduced demand for older models).

Go back to the article on Demand to remind yourself of other reasons the demand curve might shift.

Changes in supply

Figure 7 below shows the current demand curve, D1, and supply curve S1, for a good; the equilibrium price and quantity are P1 and Q1 respectively.

Assume there was an overall increase in the supply for the relevant good. For example, if the availability of inputs increased (meaning the cost of inputs decreased). Or if the government had given out subsidies to produce the good. This would cause the supply curve to shift outwards to S2. At any given price level along S2, there would be more supply for a product than along S1.

S2 would intersect D1 at a new point, resulting in a lower market equilibrium price and quantity - P2 and Q2.

However, if the overall supply for a particular good decreased, S1 would shift inward to S3, resulting in a higher market equilibrium price and quantity - P3 and Q3. This could happen, for example, if there was a market shock which caused the availability of inputs to decrease (thereby increasing their cost).

Go back to the article on Supply to remind yourself of other reasons the supply curve might shift.

Conclusion

We have now looked at demand, supply and the interaction between them in a free market:

• Demand is downward sloping; as prices increase, demand decreases;
• Supply is upward sloping; as prices increase, supply increases;
• The point at which supply and demand for a particular good intersect results in the equilibrium price and quantity for that good;
• Changes to the determinants of demand and supply can cause the curves to shift, resulting in a new equilibrium price and quantity.

Have a look at the news, particularly the markets section, for an article discussing the increased or decreased price of a commodity. Read this and think about why there has been a change in terms of supply and demand.

Draw your own demand and supply curves on a set of axes and experiment with their movement, noting what happens to the equilibrium price and quantity each time.

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