When buyers purchase exactly as much as sellers are willing to sell what is the condition that has been reached?

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 have to 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.

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.

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.

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.

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.

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This episode of our Economic Lowdown Podcast Series answers a crucial economic question: Where do prices come from? Listeners discover that supply and demand work together like the two blades of a scissors to determine the market equilibrium - and the prices of the things you buy.

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Transcript

Where do prices come from? Are they the result of government planning? Are they random? Do they happen spontaneously? Or are they set by some invisible hand?

In a market economy like the United States, the choices that individual consumers and producers make every day determine how society's scarce resources will be used. Consumer and producer choices determine what and how much will be produced and at what price. These choices create the market forces of supply and demand. Let's review the basics of supply and demand and then we will discuss market equilibrium.

Lesson 1: Law of Demand

Quantity demanded is the amount of a good that buyers are willing and able to purchase at a particular price. Many things determine demand, but only price can determine the quantity demanded of a specific good. If you have the money and are willing to buy 2 ice cream cones a week, at $2 per cone, the quantity demanded would be 2 cones a week. Now, what happens if the price increases to $4 a cone? If you are like most people, the quantity of ice cream cones you demand will decrease as the price rises. In this case, assume your quantity demanded is now only 1 cone a week, which is what you are willing and able to buy. Notice that as the price of the cones increases, the quantity of ice cream cones demanded decreases. This means quantity demanded is negatively related to price-which means they have an inverse relationship. Economists refer to this relationship as the law of demand. The law of demand states that, other things being equal, when the price of a good rises, the quantity demanded of that good falls. The reverse is also true-when the price of a good falls, the quantity demanded of that good rises. The combination of the quantities people are willing and able to buy of a good or service at various prices constitutes a demand schedule. When the demand schedule is graphed, the demand curve is downward sloping.

Lesson 2: Law of Supply

Now we need to look at the other side of the market and examine the sellers or producers. The quantity supplied of any good or service is the amount of a good that sellers are willing and able to sell at a particular price. Many factors affect supply, but only price can determine the quantity supplied. When the price of ice cream cones increases from $2 to $4, sellers respond by offering more cones for sale to earn additional profit. The result is an increase in the quantity of ice cream cones supplied. If the price of ice cream cones falls from $4 to $1, sellers will decrease their quantity supplied. At this low price, they will maximize their profits-or minimize their losses-by offering fewer cones for sale. The relationship between price and quantity supplied is a direct relationship. Economists refer to this relationship as the law of supply. When the price of a good rises, the quantity supplied of that good will increase. The reverse is also true: If the price of a good decreases, the quantity supplied of that good will decrease. The combination of the quantities producers are willing to produce and sell at various prices constitutes a supply schedule. When the supply schedule is graphed, the supply curve is upward sloping.

Lesson 3: Equilibrium

So, is it supply or demand that determines the market price? The answer is "both." Like the two blades of a scissors, supply and demand work together to determine price. When you combine the supply and demand curves, there is a point where they intersect; this point is called the market equilibrium. The price at this intersection is the equilibrium price, and the quantity is the equilibrium quantity. At the equilibrium price, there is no shortage or surplus: The quantity of the good that buyers are willing to buy equals the quantity that sellers are willing to sell. Buyers can buy the quantity they want to buy at the market price, and sellers can sell the quantity they want to sell at the market price.

So, is equilibrium a constant, unchanging point? No. Markets do have a natural tendency to settle at the equilibrium price, but the price may bounce around a bit in the process. Think of a deep bowl with steep sides. Now, put a marble in the bowl and turn the bowl in circles. The marble in the bowl will roll around the sides of the bowl, but as it rolls, gravity will pull it toward the bottom. As you slow the turning motion, the marble will drop to the bottom. In a similar way, prices also roll around as the forces of supply and demand change, but they tend toward and eventually settle at equilibrium.

Imagine a market in transition, where the demand for ice cream cones has suddenly decreased, but market price has not yet settled to the new equilibrium. Suppliers will continue to respond to the market price-which is now too high-while consumers have decreased the quantity they demand. This means that suppliers will produce a greater quantity than consumers are willing to purchase, resulting in a surplus. The surplus puts downward pressure on the market price, which causes it to drop back toward the equilibrium price.

Now imagine the demand for ice cream cones has increased, but the market price has not yet risen to the new, higher, equilibrium price. Suppliers will continue to respond to the market price-which is now too low-while consumers have increased the quantity they demand. This means that sellers will supply a smaller quantity of goods than buyers are willing to purchase, resulting in a shortage. Buyers will respond by bidding up the price, and before you know it, the price is rising toward the equilibrium point.

Markets tend toward equilibrium unless there are barriers, called price controls, that prevent reaching equilibrium. One price control is called a price floor, which is a barrier that holds prices above the equilibrium price. It is called a floor because it sets the lowest legal price that can be charged-but to be effective, it must be above the equilibrium price. Minimum wage laws passed by state and federal governments are one example of a price floor. Remember that a wage is a price in a labor market. So, a minimum wage is an attempt to hold wages above the equilibrium price to benefit workers. The price control on the other end of the market is a price ceiling, and it attempts to hold prices below the equilibrium price. It is called a ceiling because it sets the highest legal price that can be charged-and to be effective, it must be set below the equilibrium price. One example of a price ceiling is rent control, where local governments attempt to help those in poverty by restricting landlords to charging rent at a level below the equilibrium price.

Of course, both of these policies are meant to benefit certain segments of the market, but they also have negative effects; remember, there is no free lunch. Price floors cause surpluses in the market. In the case of the minimum wage, a surplus means that workers will seek to supply a greater number of labor hours than employers will demand, resulting in an increase in unemployment. Price ceilings cause shortages in the market. In the case of rent-controlled apartments, this means fewer available apartments than the number of people wanting them, which means some people have to double up or move farther away. Economists generally prefer to allow prices to settle at equilibrium and choose other methods, such as subsidies, to help people who need extra income or affordable housing.

To recap, buyers make up the demand side of the market. Sellers make up the supply side of the market. As buyers and sellers interact, the market will tend toward an equilibrium price.

It's as if an invisible hand pushes and pulls markets toward their equilibrium level.

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