This episode of our Economic Lowdown Podcast Series answers a crucial economic question: Where do prices come from? Listeners discover that supply and demand work together like the two blades of a scissors to determine the market equilibrium - and the prices of the things you buy.
Where do prices come from? Are they the result of government planning? Are they random? Do they happen spontaneously? Or are they set by some invisible hand?
In a market economy like the United States, the choices that individual consumers and producers make every day determine how society's scarce resources will be used. Consumer and producer choices determine what and how much will be produced and at what price. These choices create the market forces of supply and demand. Let's review the basics of supply and demand and then we will discuss market equilibrium.
Lesson 1: Law of Demand
Quantity demanded is the amount of a good that buyers are willing and able to purchase at a particular price. Many things determine demand, but only price can determine the quantity demanded of a specific good. If you have the money and are willing to buy 2 ice cream cones a week, at $2 per cone, the quantity demanded would be 2 cones a week. Now, what happens if the price increases to $4 a cone? If you are like most people, the quantity of ice cream cones you demand will decrease as the price rises. In this case, assume your quantity demanded is now only 1 cone a week, which is what you are willing and able to buy. Notice that as the price of the cones increases, the quantity of ice cream cones demanded decreases. This means quantity demanded is negatively related to price-which means they have an inverse relationship. Economists refer to this relationship as the law of demand. The law of demand states that, other things being equal, when the price of a good rises, the quantity demanded of that good falls. The reverse is also true-when the price of a good falls, the quantity demanded of that good rises. The combination of the quantities people are willing and able to buy of a good or service at various prices constitutes a demand schedule. When the demand schedule is graphed, the demand curve is downward sloping.
Lesson 2: Law of Supply
Now we need to look at the other side of the market and examine the sellers or producers. The quantity supplied of any good or service is the amount of a good that sellers are willing and able to sell at a particular price. Many factors affect supply, but only price can determine the quantity supplied. When the price of ice cream cones increases from $2 to $4, sellers respond by offering more cones for sale to earn additional profit. The result is an increase in the quantity of ice cream cones supplied. If the price of ice cream cones falls from $4 to $1, sellers will decrease their quantity supplied. At this low price, they will maximize their profits-or minimize their losses-by offering fewer cones for sale. The relationship between price and quantity supplied is a direct relationship. Economists refer to this relationship as the law of supply. When the price of a good rises, the quantity supplied of that good will increase. The reverse is also true: If the price of a good decreases, the quantity supplied of that good will decrease. The combination of the quantities producers are willing to produce and sell at various prices constitutes a supply schedule. When the supply schedule is graphed, the supply curve is upward sloping.
Lesson 3: Equilibrium
So, is it supply or demand that determines the market price? The answer is "both." Like the two blades of a scissors, supply and demand work together to determine price. When you combine the supply and demand curves, there is a point where they intersect; this point is called the market equilibrium. The price at this intersection is the equilibrium price, and the quantity is the equilibrium quantity. At the equilibrium price, there is no shortage or surplus: The quantity of the good that buyers are willing to buy equals the quantity that sellers are willing to sell. Buyers can buy the quantity they want to buy at the market price, and sellers can sell the quantity they want to sell at the market price.
So, is equilibrium a constant, unchanging point? No. Markets do have a natural tendency to settle at the equilibrium price, but the price may bounce around a bit in the process. Think of a deep bowl with steep sides. Now, put a marble in the bowl and turn the bowl in circles. The marble in the bowl will roll around the sides of the bowl, but as it rolls, gravity will pull it toward the bottom. As you slow the turning motion, the marble will drop to the bottom. In a similar way, prices also roll around as the forces of supply and demand change, but they tend toward and eventually settle at equilibrium.
Imagine a market in transition, where the demand for ice cream cones has suddenly decreased, but market price has not yet settled to the new equilibrium. Suppliers will continue to respond to the market price-which is now too high-while consumers have decreased the quantity they demand. This means that suppliers will produce a greater quantity than consumers are willing to purchase, resulting in a surplus. The surplus puts downward pressure on the market price, which causes it to drop back toward the equilibrium price.
Now imagine the demand for ice cream cones has increased, but the market price has not yet risen to the new, higher, equilibrium price. Suppliers will continue to respond to the market price-which is now too low-while consumers have increased the quantity they demand. This means that sellers will supply a smaller quantity of goods than buyers are willing to purchase, resulting in a shortage. Buyers will respond by bidding up the price, and before you know it, the price is rising toward the equilibrium point.
Markets tend toward equilibrium unless there are barriers, called price controls, that prevent reaching equilibrium. One price control is called a price floor, which is a barrier that holds prices above the equilibrium price. It is called a floor because it sets the lowest legal price that can be charged-but to be effective, it must be above the equilibrium price. Minimum wage laws passed by state and federal governments are one example of a price floor. Remember that a wage is a price in a labor market. So, a minimum wage is an attempt to hold wages above the equilibrium price to benefit workers. The price control on the other end of the market is a price ceiling, and it attempts to hold prices below the equilibrium price. It is called a ceiling because it sets the highest legal price that can be charged-and to be effective, it must be set below the equilibrium price. One example of a price ceiling is rent control, where local governments attempt to help those in poverty by restricting landlords to charging rent at a level below the equilibrium price.
Of course, both of these policies are meant to benefit certain segments of the market, but they also have negative effects; remember, there is no free lunch. Price floors cause surpluses in the market. In the case of the minimum wage, a surplus means that workers will seek to supply a greater number of labor hours than employers will demand, resulting in an increase in unemployment. Price ceilings cause shortages in the market. In the case of rent-controlled apartments, this means fewer available apartments than the number of people wanting them, which means some people have to double up or move farther away. Economists generally prefer to allow prices to settle at equilibrium and choose other methods, such as subsidies, to help people who need extra income or affordable housing.
To recap, buyers make up the demand side of the market. Sellers make up the supply side of the market. As buyers and sellers interact, the market will tend toward an equilibrium price.
It's as if an invisible hand pushes and pulls markets toward their equilibrium level.