Chapter 2 · Competitive markets: Demand and supply
Supply & demand
Find equilibrium price and quantity where demand meets supply. Read the axes and curves, then explain how buyers’ and sellers’ decisions interact.
The economic idea
A market is any arrangement that brings buyers and sellers together to exchange goods, services or resources. In a competitive market, there are many buyers and sellers and no single participant has sufficient market power to determine the market price. Market outcomes emerge from their interaction.
Demand is the quantity of a good or service that consumers are willing and able to buy at different prices during a given time period, ceteris paribus. The downward-sloping demand curve shows the law of demand: as price falls, quantity demanded increases; as price rises, quantity demanded decreases. Market demand is the horizontal sum of individual demand.
Supply is the quantity of a good or service that producers are willing and able to offer for sale at different prices during a given time period, ceteris paribus. The upward-sloping supply curve shows the law of supply: as price rises, quantity supplied increases; as price falls, quantity supplied decreases. Market supply is the horizontal sum of individual supply.
Market equilibrium occurs at the price at which quantity demanded equals quantity supplied. This is a market-clearing position: the plans of buyers and sellers are compatible, so there is no shortage or surplus and no pressure for price to change.
The price mechanism performs signalling, incentive and rationing functions. A changing price communicates information about relative scarcity, gives consumers and producers incentives to alter their behaviour, and rations the available output among competing buyers.
A change in the good’s own price causes movement along an existing curve, changing quantity demanded or quantity supplied. An increase may be called an extension of demand or supply, and a decrease a contraction: these are movements, not shifts. A non-price determinant changes the whole curve. In your answer, state which quantity changes and why.
In the basic competitive-market model, equilibrium can be allocatively efficient when there are no externalities, no market power and no other market failures. At the efficient quantity, marginal benefit equals marginal cost and total surplus is maximised. This efficiency conclusion does not mean that the outcome is necessarily equitable.
How a competitive market reaches equilibrium
“Quantity” is measured on the horizontal axis. Moving to the right represents a greater quantity exchanged in the market.
“Price” is measured on the vertical axis. Moving upward represents a higher price per unit.
“D” is a market demand curve. Each point shows the total quantity consumers are willing and able to buy at the corresponding price during the stated time period, ceteris paribus.
“S” is a market supply curve. Each point shows the total quantity producers are willing and able to offer for sale at the corresponding price during the stated time period, ceteris paribus.
The market-clearing point: E
“D” and “S” meet at “E”. The guide lines connect this point to “Pₑ” on the price axis and “Qₑ” on the quantity axis. At that price, the quantity consumers plan to buy is exactly the quantity producers plan to sell.
A price below Pₑ
Below “Pₑ”, the quantity demanded on “D” is greater than the quantity supplied on “S”. The market has excess demand—a shortage—so some buyers cannot purchase what they planned to buy.
A price above Pₑ
Above “Pₑ”, the quantity supplied on “S” is greater than the quantity demanded on “D”. The market has excess supply—a surplus—so some output remains unsold.
Read consumer and producer surplus as gains from trade
Consumer surplus is the area below “D” and above “Pₑ”, up to “Qₑ”. It is the difference between what buyers are willing to pay and what they pay. Producer surplus is the area above “S” and below “Pₑ” over the same quantity. It is receipts above the minimum producers would accept.
These welfare areas measure benefits from exchange. They are different from a market surplus, which means excess supply at a particular price. A market can clear with no excess supply while consumers and producers both receive surplus.
How the price mechanism removes the imbalance
Begin at the price being tested and compare quantity demanded with quantity supplied horizontally across the diagram.
A shortage gives sellers an incentive to raise price; a surplus gives sellers an incentive to lower it. The changing price signals the relative scarcity of the good.
As price changes, consumers move along “D” and producers move along “S”. These are changes in quantity demanded and quantity supplied—not shifts of either curve.
Adjustment ends at “E”, where the shortage or surplus has disappeared and there is no further pressure for price to change.
What the current state establishes
“Pₑ” is the equilibrium price and “Qₑ” is the equilibrium quantity currently shown. The dashed guides allow each value to be read from the appropriate axis.
Under the assumptions of the competitive model, “E” is allocatively efficient because the marginal benefit represented by “D” equals the marginal cost represented by “S”.
Common mistakes to avoid
- Write “quantity demanded equals quantity supplied”, not “demand equals supply”. Demand and supply are entire curves; quantities are compared at a particular price.
- The return to “E” is movement along “D” and “S”. Neither curve shifts merely because the market price changes.
- A market-clearing outcome is not automatically fair or affordable. Allocative efficiency and equity are different criteria.
How to draw this diagram
- Title the diagram “Supply & demand”. Label the horizontal axis “Quantity” and the vertical axis “Price”.
- Draw D first and label it clearly.
- Draw S next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model applies ceteris paribus and separates the effect of the variable being studied from simultaneous changes in other determinants.
- It simplifies adjustment by assuming that buyers and sellers respond to price signals and that prices can move towards equilibrium.
- It does not by itself show the speed or size of adjustment, which depend on price elasticities, the time period and the size of the initial imbalance.
- Competitive equilibrium is not necessarily socially efficient when externalities, asymmetric information, market power, public goods or other market failures are present.
- Allocative efficiency does not determine whether the distribution of income, output or welfare is equitable.