3.4: The Basics of Supply and Demand

To appreciate how perfect competition works, we need to understand how buyers and sellers interact in a market to set prices. In a market characterized by perfect competition, price is determined through the mechanisms of supply and demand. Prices are influenced both by the supply of products from sellers and by the demand for products by buyers. When supply is greater than demand, prices fall, and when demand is greater than supply, prices rise.

To illustrate this concept, let us create a supply and demand schedule for one particular good sold at one point in time. Then we’ll define demand and create a demand curve, and define supply and create a supply curve. Finally, we’ll see how supply and demand interact to create an equilibrium price—the price at which buyers are willing to purchase the quantity that sellers are willing to sell.

Demand and the Demand Curve

Demand is the quantity of a product that buyers are willing to purchase at various prices. The quantity of a product that people are willing to buy depends on its price. Consumers are typically willing to buy less of a product when prices rise and more of a product when prices fall. Generally speaking, we find products more attractive at lower prices, and we buy more at lower prices because our income goes further.

Using this logic, we can construct a demand curve that shows the quantity of a product that will be demanded at different prices. Let’s assume that Figure 3.4, “The Demand Curve,” represents the daily price and quantity of apples sold by farmers at a local market. Note that as the price of apples goes down, buyers’ demand goes up. Thus, if a pound of apples sells for $0.80, buyers will be willing to purchase only fifteen hundred pounds per day. But if apples cost only $0.60 a pound, buyers will be willing to purchase two thousand pounds. At $0.40 a pound, buyers will be willing to purchase twenty-five hundred pounds.

Factors that can affect demand include changes in income levels, population changes, consumer preferences, complementary goods, and substitute goods.

Supply and the Supply Curve

Supply is the quantity of a product that sellers are willing to sell at various prices. The quantity of a product that a business is willing to sell depends on its price. Businesses are more willing to sell a product when the price rises and less willing to sell it when prices fall. Again, this fact makes sense: businesses are set up to make profits, and there are larger profits to be made when prices are high.

Now we can construct a supply curve that shows the quantity of apples that farmers would be willing to sell at different prices, regardless of demand. As shown in Figure 3.5, “The Supply Curve”, the supply curve goes in the opposite direction from the demand curve: as prices rise, the quantity of apples that farmers are willing to sell also goes up. The supply curve shows that farmers are willing to sell only a thousand pounds of apples when the price is $0.40 a pound, two thousand pounds when the price is $0.60, and three thousand pounds when the price is $0.80.

Factors that affect supply include technological changes, changes in resource prices, price expectations, the number of suppliers, and the price of substitute goods.

Equilibrium Price

We can now see how the market mechanism works under perfect competition. We do this by plotting both the supply curve and the demand curve on one graph, as we have done in Figure 3.6. "The Equilibrium Price” is the state in which market supply and demand balance each other; the point at which the two curves intersect.

“The Equilibrium Price”, where the supply and demand curves intersect, is at the price of $0.60 and quantity of two thousand pounds. Thus, $0.60 is the equilibrium price. At this price, the quantity of apples demanded by buyers equals the quantity of apples that farmers are willing to supply. If a single farmer tries to charge more than $0.60 for a pound of apples, they won’t sell very many because other suppliers are making apples available for less. As a result, their profits will go down. If, on the other hand, a farmer tries to charge less than the equilibrium price of $0.60 a pound, they will sell more apples, but their profit per pound will be less than at the equilibrium price. With profit being the motive, there is no incentive to drop the price.

What have you learned in this discussion? Without outside influences, markets in an environment of perfect competition will arrive at an equilibrium point at which both buyers and sellers are satisfied. But you must be aware that this is a very simplistic example. Things are much more complex in the real world. For one thing, markets rarely operate without outside influences. Sometimes, sellers supply more of a product than buyers are willing to purchase; in that case, there’s a surplus. Sometimes, they don’t produce enough of a product to satisfy demand; then we have a shortage.

Circumstances also have a habit of changing. What would happen, for example, if incomes rose and buyers were willing to pay more for apples? The demand curve would change, resulting in an increase in the equilibrium price. This outcome makes intuitive sense: as demand increases, prices will go up. What would happen if apple crops were larger than expected because of favourable weather conditions? Farmers might be willing to sell apples at lower prices rather than letting part of the crop spoil. If so, the supply curve would shift, resulting in another change in equilibrium price: the increase in supply would bring down prices.

Media Attributions

“Figure 3.4: The demand curve” is reused from Demand curve, © 2022 by Kindred Grey, licensed CC BY 4.0 and includes simple red apple from Openclipart.

“Figure 3.5: The supply curve” is reused from Supply curve, © 2022 by Kindred Grey, licensed CC BY 4.0 and includes simple red apple from Openclipart.

“Figure 3.6: The equilibrium price” is reused from Equilibrium price, © 2022 by Kindred Grey, licensed CC BY 4.0 and includes simple red apple from Openclipart.

Image Descriptions

Figure 3.4

In the background is an apple. In the foreground is a graph of the demand curve for apples. The x-axis, representing apples (pounds per day) extends from 0 to 5,000 in 1,000 increments. The y-axis, price (dollars per pound) extends from 0 to 1.00 in 0.20 increments. The curve is a straight, negative line. Three lines show points of intersection from the y-axis to the x-axis. The first line set extends from 0.80 on the y-axis to the curve, and down from the curve to a point between 1,000 and 2,000 on the x-axis. The second line set extends from 0.60 to the curve, then from the curve to 2,000 on the x-axis. The third line set extends from 0.40 on the y-axis to the curve, then from the curve to a point between 2,000 and 3,000 on the x-axis.

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Figure 3.5

In the background is an apple. In the foreground is a graph of the supply curve for apples. The curve is a straight, positive line. The graph plots “Price” in dollars per pound on the vertical axis and “Apples per day” in pounds on the horizontal axis. The vertical axis ranges from 0 to 1.00 dollars per pound, marked at intervals of 0.20. The horizontal axis ranges from 0 to 5000 pounds, marked at 1000-pound intervals. A red line labelled “Supply” extends diagonally from the origin, rising to the right, indicating an increase in price per pound with the supply of apples per day. Three line sets show points of intersection from the y-axis to the x-axis. The first dashed line set extends from 0.80 on the y-axis to the curve, then from the curve to 3,000 on the x-axis. The second line set extends from 0.60 on the y-axis to the curve, then from the curve to 2,000 on the x-axis. The third line set extends from 0.40 on the y-axis to the curve, then from the curve to 1,000 on the x-axis.

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Figure 3.6

In the background is an apple. In the foreground is a graph displaying both the supply and demand for apples. The X-axis represents “Apples per day (pounds)” ranging from 0 to 5,000, and the Y-axis shows “Price (dollars per pound)” from 0.00 to 0.80. A black dot marks the equilibrium point where the two lines intersect. The demand curve, labelled in red and sloping downwards from left to right, crosses the supply curve, labelled also in red but sloping upwards from left to right, at the equilibrium. The intersection occurs at approximately 2,500 pounds and $0.60 per pound.

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