The interaction of demand and supply

Economics AS · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

A market is in equilibrium at the price where quantity demanded equals quantity supplied. At a higher price there is excess supply, so sellers cut the price. At a lower price there is excess demand, so the price is bid up. The price moves until the market clears.

A shift in demand or supply creates a new equilibrium. Work out which curve shifts and in which direction, then read off the new price and quantity. If both curves shift, one of the two results is certain and the other depends on the size of each shift.

Markets are linked through complements, substitutes, derived demand and joint supply. Prices do three jobs: rationing, signalling and incentivising.

Rules to remember

Equilibrium: quantity demanded = quantity supplied. Disequilibrium: excess demand (shortage) or excess supply (surplus).
Demand rises: price and quantity both rise. Demand falls: both fall.
Supply rises: price falls and quantity rises. Supply falls: price rises and quantity falls.
Both rise: quantity rises, price uncertain. Demand rises and supply falls: price rises, quantity uncertain.
Joint demand (complements): used together, such as cars and petrol. Alternative demand (substitutes): one replaces the other.
Derived demand: a factor or input is wanted for what it helps to produce. Joint supply: making one good also produces another, such as beef and leather.
Rationing: a higher price limits a good to those most willing and able to pay. Signalling: price changes show producers what consumers want. Incentivising: higher prices and profits encourage firms to supply more.

Common mistake

Students say the curves shift to remove a surplus or shortage. In disequilibrium the price changes and there are movements along both curves; the curves stay where they are.

Worked example

Demand and supply are Qd = 100 − 2P and Qs = 4P − 20, where P is the price in dollars. Supply then falls by 30 units at every price. Find the equilibrium price and quantity before and after.

Before: 100 − 2P = 4P − 20, so 120 = 6P and P = $20. Quantity = 100 − (2 × 20) = 60 units.
New supply: Qs = 4P − 20 − 30 = 4P − 50.
After: 100 − 2P = 4P − 50, so 150 = 6P and P = $25. Quantity = 100 − (2 × 25) = 50 units.

Answer: Price rises from $20 to $25 and quantity falls from 60 to 50 units.

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