How does supply and demand determine prices?

Explanation: How Supply and Demand Determine Prices

Supply and demand is a fundamental economic model that explains how prices are set in a competitive market.

• Demand refers to how much of a good consumers are willing and able to buy at various prices.
• Supply refers to how much producers are willing and able to sell at various prices.

The market price is determined at the point where the quantity demanded equals the quantity supplied. This point is called the equilibrium.

Worked Example

Suppose the demand and supply for a product are given by the following equations:

• Demand: $Q_D = 100 - 2P$
• Supply: $Q_S = 20 + 4P$

where $Q_D$ is the quantity demanded, $Q_S$ is the quantity supplied, and $P$ is the price.

Step 1: Set $Q_D = Q_S$ to find equilibrium

$$ 100 - 2P = 20 + 4P $$

Step 2: Solve for $P$

$$ 100 - 20 = 4P + 2P \\ 80 = 6P \\ P = \frac{80}{6} = \frac{40}{3} \approx 13.33 $$

Step 3: Find equilibrium quantity

Plug $P$ back into either equation (use demand):

$$ Q_D = 100 - 2 \left( \frac{40}{3} \right) = 100 - \frac{80}{3} = \frac{220}{3} \approx 73.33 $$

Equilibrium price: $P^* \approx 13.33$
Equilibrium quantity: $Q^* \approx 73.33$

Takeaways

• Prices are determined where supply equals demand (the equilibrium).
• If price is above equilibrium, surplus occurs; if below, shortage occurs.
• Changes in supply or demand shift the equilibrium price and quantity.