Demand and Supply
Putting them together

Demand and supply completely characterize the basic neoclassical market model. In this model, equilibrium is obtained at the point of intersection of the associated demand and supply curves. The market price is endogenously determined when quantity demanded equals quantity supplied.

At a given price, if the sellers of a good find that they are not supplying all of the quantity demanded by would-be buyers, they will raise the price to the point where the excess demand has been eliminated ("priced out of the market"). Such rationing by price is a more profitable way to "ration" the available supply among the buyers than other rationing methods (one-to-a-customer or first-come-first-served, for example).

Similarly, if the buyers of a good find that the amount supplied to them exceeds what they are willing to purchase at a given price, they will bargain down ("haggle") the price until the excess supply has shrunk to zero. Paying more than necessary would be irrational.

This reasoning leads us to the Law of Market Clearing: The equilibrium market price is such that there are no buyers who desire to buy more, even paying a higher price if necessary (i.e., no shortages), and no sellers desiring to sell more, accepting a lower price if required (i.e., no surpluses).

The price at which quantity demanded equals quantity supplied is called the market clearing price. Equilibrium in neoclassical markets free of government intervention occurs at this price.

A change in any economic variable other than own price can have one of five effects on the market for a particular good:

  1. A rise in demand.
  2. A fall in demand.
  3. A rise in supply.
  4. A fall in supply.
  5. No effect.
The changes in quantity exchanged and market price that are induced by each of these effects are described by a particular "law of supply and demand". A technique known as comparative statics is employed to illustrate these laws. This technique involves changing one of the variables previously held constant and comparing the new equilibrium position of the market to the original one.

Equilibrium quantity and price in a free market are given by the intersection of the associated demand and supply curves.

One of the laws of supply and demand says that a decrease in supply causes a rise in market price and a fall in quantity exchanged. Such a shift in the supply curve could be the result of an increase in the price of labour, for example.

Another of the laws of supply and demand says that an increase in demand causes a rise in both market price and quantity exchanged. Such a shift in the demand curve could be the result of an aggressive advertizing campaign which succeeds in changing people's preferences.

Continue to Price Elasticity Go to Exercise 1.1