Price is dependent on the interaction between demand and supply components of a market. Demand and supply represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product takes place when buyers and sellers can agree upon a price. This section of the Agriculture Marketing Manual explains price in a competitive market. When imperfect competition exists, such as with a monopoly or single selling firm, price outcomes may not follow the same general rules. Equilibrium priceWhen a product exchange occurs, the agreed upon price is called an equilibrium price, or a market clearing price. Graphically, this price occurs at the intersection of demand and supply as presented in Image 1. In Image 1, both buyers and sellers are willing to exchange the quantity Q at the price P. At this point, supply and demand are in balance. Price determination depends equally on demand and supply. Image 1. Figure 1, Graph showing price equilibrium curves
It is truly a balance of the market components. To understand why the balance must occur, examine what happens when there is no balance, such as when market price is below that shown as P in Image 1. At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would clamour for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market. The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily, the market would be in surplus with too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases. Only when the price falls would balance be restored. A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically, some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business. Change in equilibrium priceWhen either demand or supply shifts, the equilibrium price will change. The section on understanding supply factors explains why a market component may move. The examples below show what happens to price when supply or demand shifts occur. Example 1: Unusually good weather increases output When a bumper crop develops, supply shifts outward and downward, shown as S2 in Image 2, more product is available over the full range of prices. With no immediate change in consumers' willingness to buy crops, there is a movement along the demand curve to a new equilibrium. Consumers will buy more but only at a lower price. How much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand. Image 2. Figure 2, Graph showing movement along demand curve
In Image 2, price falls from P1 to P2 if a bumper crop is produced. If the demand curve in this example was more vertical (more inelastic), the price-quantity adjustments needed to bring about a new equilibrium between demand and the new supply would be different. To understand how elasticity of demand affects the size of adjustment in prices and quantities when supply shifts, try drawing the demand curve (or line) with a slope more vertical than that depicted in Image 2. Then compare the size of price-quantity changes in this with the first situation. With the same shift in supply, equilibrium change in price is larger when demand is inelastic than when demand is more elastic. The opposite is true for quantity. A larger change in quantity will occur when demand is elastic compared with the quantity change required when demand is inelastic. Example 2: Consumers lower their preference for beef A decline in the preference for beef is one of the factors that could shift the demand curve inward or to the left, as seen in Image 3. Image 3. Figure 3. Graph showing movement along supply curve
With no immediate change in supply, the effect on price comes from a movement along the supply curve. An inward shift of demand causes price to fall and also the quantity exchanged to fall. The amount of change in price and quantity, from one equilibrium to another, is dependent upon the elasticity of supply. Imagine that supply is almost fixed over the time period being considered. That is, draw a more vertical supply curve for this shift in demand. When demand shifts from D1 to D2 on a more vertical supply curve (inelastic supply) almost all the adjustment to a new equilibrium takes place in the change in price. Price stabilityTwo forces contribute to the size of a price change: the amount of the shift and the elasticity of demand or supply. For example, a large shift of the supply curve can have a relatively small effect on price if the corresponding demand curve is elastic. That would show up in Example 1 above, if the demand curve is drawn flatter (more elastic). In fact, the elasticity of demand and supply for many agricultural products are relatively small when compared with those of many industrial products. This inelasticity of demand has led to problems of price instability in agriculture when either supply or demand shifts in the short-term. Price levelThe two examples above focus on factors that shift supply or demand in the short-term. However, longer-term forces are also at work, which shift demand and supply over time. One particular supply shifter is technology. A major effect of technology in agriculture has been to shift the supply curve rapidly outward by reducing the costs of production per unit of output. Technology has had a depressing effect on agricultural prices in the long-term since producers are able to produce more at a lower cost. At the same time, both population and income have been advancing, which both tend to shift demand to the right. The net effect is complex, but overall the rapidly shifting supply curve coupled with a slow moving demand has contributed to low prices in agriculture compared to prices for industrial products. At various levels of a market, from farm gate to retail, unique supply and demand relationships are likely to exist. However, prices at different market levels will bear some relationship to each other. For example, if hog prices decline, it can be expected that retail pork prices will decline as well. This price adjustment is more likely to happen in the long-term once all participants have had time to adjust their behaviour. In the short-term, price adjustments may not occur for a variety of reasons. For example, wholesalers may have long-term contracts that specify the old hog price, or retailers may have advertised or planned a feature to attract customers. SummaryMarket prices are dependent upon the interaction of demand and supply. An equilibrium price is a balance of demand and supply factors. There is a tendency for prices to return to this equilibrium unless some characteristics of demand or supply change. Changes in the equilibrium price occur when either demand or supply, or both, shift or move.
By the end of this section, you will be able to:
First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won’t buy it. While a consumer may be able to differentiate between a need and a want, but from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a homeless person probably has no effective demand for shelter. What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant. We can show an example from the market for gasoline in a table or a graph. Economist call a table that shows the quantity demanded at each price, such as (Figure), a demand schedule. In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like (Figure), with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is not math.) (Figure) shows the demand schedule and the graph in (Figure) shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded.
A Demand Curve for Gasoline The demand schedule shows that as price rises, quantity demanded decreases, and vice versa. We graph these points, and the line connecting them is the demand curve (D). The downward slope of the demand curve again illustrates the law of demand—the inverse relationship between prices and quantity demanded.
Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases. Confused about these different types of demand? Read the next Clear It Up feature.
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant. Still unsure about the different types of supply? See the following Clear It Up feature. (Figure) illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like (Figure), that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.
A Supply Curve for Gasoline The supply schedule is the table that shows quantity supplied of gasoline at each price. As price rises, quantity supplied also increases, and vice versa. The supply curve (S) is created by graphing the points from the supply schedule and then connecting them. The upward slope of the supply curve illustrates the law of supply—that a higher price leads to a higher quantity supplied, and vice versa.
The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.
Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market. (Figure) illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to (Figure). The supply curve (S) is identical to (Figure). (Figure) contains the same information in tabular form.
Demand and Supply for Gasoline The demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600. The equilibrium is the only price where quantity demanded is equal to quantity supplied. At a price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium such as $1.20, quantity demanded exceeds quantity supplied, so there is excess demand.
Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in (Figure), is called the equilibrium. The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price. In (Figure), the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal. The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity. Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in (Figure) illustrates this above equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline. Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus. With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium. Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in (Figure) shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550. When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model.
Review (Figure). Suppose the price of gasoline is $1.60 per gallon. Is the quantity demanded higher or lower than at the equilibrium price of $1.40 per gallon? What about the quantity supplied? Is there a shortage or a surplus in the market? If so, how much?
Since $1.60 per gallon is above the equilibrium price, the quantity demanded would be lower at 550 gallons and the quantity supplied would be higher at 640 gallons. (These results are due to the laws of demand and supply, respectively.) The outcome of lower Qd and higher Qs would be a surplus in the gasoline market of 640 – 550 = 90 gallons.
What determines the level of prices in a market?
What does a downward-sloping demand curve mean about how buyers in a market will react to a higher price?
Will demand curves have the same exact shape in all markets? If not, how will they differ?
Will supply curves have the same shape in all markets? If not, how will they differ?
What is the relationship between quantity demanded and quantity supplied at equilibrium? What is the relationship when there is a shortage? What is the relationship when there is a surplus?
How can you locate the equilibrium point on a demand and supply graph?
If the price is above the equilibrium level, would you predict a surplus or a shortage? If the price is below the equilibrium level, would you predict a surplus or a shortage? Why?
When the price is above the equilibrium, explain how market forces move the market price to equilibrium. Do the same when the price is below the equilibrium.
What is the difference between the demand and the quantity demanded of a product, say milk? Explain in words and show the difference on a graph with a demand curve for milk.
What is the difference between the supply and the quantity supplied of a product, say milk? Explain in words and show the difference on a graph with the supply curve for milk.
Review (Figure). Suppose the government decided that, since gasoline is a necessity, its price should be legally capped at $1.30 per gallon. What do you anticipate would be the outcome in the gasoline market?
Explain why the following statement is false: “In the goods market, no buyer would be willing to pay more than the equilibrium price.”
Explain why the following statement is false: “In the goods market, no seller would be willing to sell for less than the equilibrium price.”
Review (Figure) again. Suppose the price of gasoline is $1.00. Will the quantity demanded be lower or higher than at the equilibrium price of $1.40 per gallon? Will the quantity supplied be lower or higher? Is there a shortage or a surplus in the market? If so, of how much?
Costanza, Robert, and Lisa Wainger. “No Accounting For Nature: How Conventional Economics Distorts the Value of Things.” The Washington Post. September 2, 1990. European Commission: Agriculture and Rural Development. 2013. “Overview of the CAP Reform: 2014-2024.” Accessed April 13, 205. http://ec.europa.eu/agriculture/cap-post-2013/. Radford, R. A. “The Economic Organisation of a P.O.W. Camp.” Economica. no. 48 (1945): 189-201. http://www.jstor.org/stable/2550133. demand curve a graphic representation of the relationship between price and quantity demanded of a certain good or service, with quantity on the horizontal axis and the price on the vertical axis demand schedule a table that shows a range of prices for a certain good or service and the quantity demanded at each price demand the relationship between price and the quantity demanded of a certain good or service equilibrium price the price where quantity demanded is equal to quantity supplied equilibrium quantity the quantity at which quantity demanded and quantity supplied are equal for a certain price level equilibrium the situation where quantity demanded is equal to the quantity supplied; the combination of price and quantity where there is no economic pressure from surpluses or shortages that would cause price or quantity to change excess demand at the existing price, the quantity demanded exceeds the quantity supplied; also called a shortage excess supply at the existing price, quantity supplied exceeds the quantity demanded; also called a surplus law of demand the common relationship that a higher price leads to a lower quantity demanded of a certain good or service and a lower price leads to a higher quantity demanded, while all other variables are held constant law of supply the common relationship that a higher price leads to a greater quantity supplied and a lower price leads to a lower quantity supplied, while all other variables are held constant price what a buyer pays for a unit of the specific good or service quantity demanded the total number of units of a good or service consumers are willing to purchase at a given price quantity supplied the total number of units of a good or service producers are willing to sell at a given price shortage at the existing price, the quantity demanded exceeds the quantity supplied; also called excess demand supply curve a line that shows the relationship between price and quantity supplied on a graph, with quantity supplied on the horizontal axis and price on the vertical axis supply schedule a table that shows a range of prices for a good or service and the quantity supplied at each price supply the relationship between price and the quantity supplied of a certain good or service surplus at the existing price, quantity supplied exceeds the quantity demanded; also called excess supply |
Which answer best describes the relationship that normally exists between price and demand?
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