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Supply, Demand and Prices
Why do concert tickets for a famous artist sell out instantly at high prices? Why are strawberries cheaper in summer? Why do flights cost more during school holidays? The answers lie in supply and demand, one of the most powerful tools in economics. In this lesson you will learn how markets set prices and why those prices change.
Demand
Demand is how much of a product consumers are willing and able to buy at different prices.
The law of demand
When the price of a product rises, people generally buy less of it; when the price falls, they buy more, if other things stay the same. This is the law of demand. Higher prices encourage people to buy less or switch to alternatives, called substitutes.
What shifts demand?
Demand can increase or decrease at every price because of:
- Income: rising incomes usually increase demand for many goods
- Tastes and trends: a viral video can suddenly boost demand
- Prices of related goods: if coffee becomes expensive, demand for tea may rise
- Expectations: if people expect prices to rise, they may buy now
- Number of buyers: a growing population increases demand
Supply
Supply is how much of a product producers are willing and able to sell at different prices.
The law of supply
When the price of a product rises, producers generally want to supply more of it, because it becomes more profitable. When the price falls, they supply less.
What shifts supply?
- Production costs: if ingredients or wages become more expensive, supply falls
- Technology: better technology usually increases supply
- Weather and natural events: a drought can reduce crop supply
- Number of sellers: more businesses entering a market increases supply
- Government policies: taxes can reduce supply; subsidies can increase it
Equilibrium: where supply meets demand
The equilibrium price is the price at which the quantity buyers want equals the quantity sellers offer. Markets tend to move toward this price.
Example: a school bake sale
| Price per cupcake | Cupcakes students want | Cupcakes bakers will make |
|---|---|---|
| 1 dollar | 120 | 40 |
| 2 dollars | 80 | 80 |
| 3 dollars | 50 | 110 |
At 1 dollar, demand (120) is greater than supply (40): there is a shortage, and cupcakes sell out fast. At 3 dollars, supply (110) is greater than demand (50): there is a surplus, and many cupcakes go unsold. At 2 dollars, quantity demanded equals quantity supplied (80): this is the equilibrium.
Shortages and surpluses push prices
- In a shortage, sellers can raise prices, and buyers compete for limited goods.
- In a surplus, sellers cut prices to clear unsold stock, which is why shops hold sales.
Why prices change: real examples
| Situation | What changes | Effect on price |
|---|---|---|
| Strawberries in summer | supply increases (harvest season) | price falls |
| Flights during holidays | demand increases | price rises |
| A frost damages orange crops | supply decreases | price rises |
| New technology makes TVs cheaper to produce | supply increases | price falls |
Prices as signals
Prices send signals. A high price signals scarcity and encourages consumers to buy less and producers to make more. Over time, this can help markets adjust.
When markets are not left alone
Governments sometimes set price controls. A price ceiling (maximum price), such as some rent controls, aims to keep goods affordable but can create shortages. A price floor (minimum price), such as a minimum wage, aims to raise incomes. Economists study and debate the effects of such policies, which can vary depending on how they are designed.
Elasticity: how much do people react?
Price elasticity of demand measures how strongly buyers respond to a price change. Demand is inelastic when people keep buying roughly the same amount even if the price rises, which is common for necessities with few substitutes, such as essential medicines or fuel for getting to work in the short term. Demand is elastic when people cut back sharply, which is common for luxuries or goods with many substitutes, such as one brand of crisps. Businesses and governments use elasticity to predict how price changes or taxes will affect sales. For example, a government taxing a product with inelastic demand will raise revenue but may not reduce consumption much.
Key takeaways
- The law of demand: higher prices usually mean people buy less.
- The law of supply: higher prices usually mean producers offer more.
- The equilibrium price is where quantity demanded equals quantity supplied.
- Shifts in supply or demand change prices; prices act as signals.
Practice
Predict the effect on price: 1. a popular celebrity is seen wearing a particular brand of jacket; 2. a new factory makes solar panels more cheaply; 3. a hurricane damages sugar cane crops.
Answers: 1 demand increases, so the price tends to rise. 2 supply increases, so the price tends to fall. 3 supply decreases, so the price of sugar tends to rise.