How do supply and demand work?

Definition

Supply and demand are fundamental economic concepts that describe how prices and quantities of goods are determined in a market.

• Demand is the quantity of a good that consumers are willing and able to buy at various prices.
• Supply is the quantity that producers are willing and able to sell at various prices.

The law of demand states that, all else equal, as the price of a good increases, the quantity demanded decreases. The law of supply states that as the price increases, the quantity supplied increases.

The equilibrium is the point where supply equals demand.

Worked Example

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

• Demand: $Q_D = 20 - 2P$
• Supply: $Q_S = 4 + 3P$

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

$$ 20 - 2P = 4 + 3P $$

Step 2: Solve for $P$

$$ 20 - 4 = 3P + 2P \\ 16 = 5P \\ P^* = \frac{16}{5} = 3.2 $$

Step 3: Find equilibrium quantity

Plug $P^* = 3.2$ into either equation:

$$ Q^* = 20 - 2(3.2) = 20 - 6.4 = 13.6 $$

Takeaways

• Prices in a market are determined by the interaction of supply and demand.
• The equilibrium price and quantity occur where supply equals demand.
• Changes in supply or demand shift the equilibrium, affecting both price and quantity.