The Market: Supply and Demand

Have you ever wondered why things cost what they do? How does the apple farmer decide on the number of apples to produce? Do you think about the decision you make when you go to the store and see apples for sale? The decision by the farmer of how much to supply and the decision by you and every other consumer on how much you will demand work together in what economists call the market. The market (or the “invisible hand” as Adam Smith put it) will determine the price of apples as well as the amount of apples produced.  

First we look at the farmer’s decision. When the farmer decides how many trees to plant and how many apples to take to the market he looks at the price of apples. If the price is high then he will make a lot of money off of his apples and so will plant more. Every apple farmer will do the same, so there is a relationship between the price of a good and how much is supplied. As the price of apples goes up, the number of apples supplied increases. This can be illustrated with a supply curve.

Figure 1 - Supply Curve

Higher price (going up the y axis), more quantity (going to the right on the x axis)

Now think of you the consumer. If apples are expensive, you may just decide to buy plums instead. If apples are cheap, you might buy apples instead of plums. Once again there is a relationship between the price of apples and how many apples are demanded.  The higher the prices of apples, the fewer apples are demanded. This is illustrated using a demand curve.

Figure 2 - Demand Curve

The higher the price (moving up the y axis) the fewer apples demanded (moving left on the x axis).

The farmer and you interact in the market for apples. When demand for apples equals the supply of apples the market is in equilibrium. The most efficient amount of apples is produced and the price is determined.  Combining the demand curve with the supply curve illustrates the market equilibrium.

Figure 3 - Supply and demand: market equilibrium

This price and quantity is found very quickly by the market. This is best explained by describing what happens when the market is not in equilibrium. Assume the price is momentarily higher than the market equilibrium. Well the farmers see the higher price and decide to send more apples to the market. When the farmers get to the market they will find that there are not enough people that want all the apples they brought. The farmers’ apples start to go bad so in order to sell them all they lower the price. It works in the opposite direction too. If the price is below the equilibrium price, the farmers see the low price and send fewer apples to the market. Once they get to the market they notice that they are quickly running out of apples. In order to not run out of apples they raise the price. This back and forth insures that the price will eventually come to equilibrium: the point at which all the apples the farmers wants to sell at that price equals all the apples that consumers want to buy at that price.

The price of apples does not always stay the same. Changes in price can come from changes in supply and/or demand at a given price level.

For example, assume a medical journal shows that eating apples significantly reduces the chances of heart disease.  As a result, more people will go to the store and buy apples (the key here is that something changed the demand for apples other than the price of apples). This is illustrated by shifting the demand curve to the right.

Figure 4 - Shifting the demand curve to the right

The farmers do two things, they see that the apples they brought to the market are not going to be enough and so they raise the price. At the same time they send their helpers back to the apple storage shed and have them bring more apples to sell. Eventually market equilibrium is found and there is a new higher equilibrium price of apples with more apples being bought and sold.

On your own:

Use the graph and come up with an explanation of what will happen to the price of apples and the quantity sold if demand falls.  What will happen if supply decreases for some reason (say there is a big flood across Wisconsin where most of the apples are grown)?

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