Welcome to the Heart of Economics!
Hey everyone! Get ready to explore one of the most important topics in Economics: how demand, supply, and price all work together. Think of it like a dance where buyers and sellers are the partners, and the price is the music they dance to. Understanding this dance is key to understanding how markets work, from the price of your bubble tea to the cost of a new smartphone.
In these notes, we'll break it all down step-by-step. Don't worry if it seems tricky at first – we'll use simple examples and clear explanations to make sure you get it. You've got this!
Quick Recap: The Building Blocks
Before we see how demand and supply interact, let's do a super quick review of what they are. Think of them as the two main characters in our story.
Character 1: Demand
• What is it? Demand shows the relationship between the price of a good and the quantity consumers are willing and able to buy at that price, over a certain period.
• The Law of Demand: This is a fundamental rule! When the price of a good goes up, the quantity demanded goes down. When the price goes down, the quantity demanded goes up. (Example: You'll buy more ice cream cones when they're $10 than when they're $30!)
• The Curve: Because of this, the demand curve is always downward-sloping.
Character 2: Supply
• What is it? Supply shows the relationship between the price of a good and the quantity producers are willing and able to sell at that price, over a certain period.
• The Law of Supply: This is the producer's side of the story. When the price of a good goes up, the quantity supplied goes up. When the price goes down, the quantity supplied goes down. (Example: A bakery will make more cakes if they can sell them for a high price.)
• The Curve: This means the supply curve is always upward-sloping.
Finding the "Sweet Spot": Market Equilibrium
So, what happens when these two characters meet?
Imagine a marketplace. Buyers (demand) want the lowest price possible. Sellers (supply) want the highest price possible. They have to agree on a price for a sale to happen. The point where they agree is called equilibrium.
Equilibrium is a state of balance where there is no tendency for the price or quantity to change. It's the point where the quantity that buyers want to buy is exactly equal to the quantity that sellers want to sell.
• Equilibrium Price (P*): The price at which quantity demanded equals quantity supplied. This is also known as the "market-clearing price".
• Equilibrium Quantity (Q*): The quantity bought and sold at the equilibrium price.
Finding Equilibrium with a Schedule (A Table)
Let's look at the market for face masks. We can see demand and supply at different prices in a table.
Price per box
$80
$60
$40
$20
Quantity Demanded (boxes)
100
200
300
400
Quantity Supplied (boxes)
500
400
300
200
Market Situation
Surplus (Qs > Qd)
Surplus (Qs > Qd)
Equilibrium (Qd = Qs)
Shortage (Qd > Qs)
Look for the price where the numbers match! At $40, the quantity demanded (300 boxes) is exactly the same as the quantity supplied (300 boxes). That's our sweet spot!
• The Equilibrium Price (P*) is $40.
• The Equilibrium Quantity (Q*) is 300 boxes.
Finding Equilibrium with a Graph
A graph is just a picture of the schedule. When we draw the demand curve (D) and the supply curve (S) on the same diagram, the point where they cross is the equilibrium.
(Imagine a downward-sloping line labeled 'D' and an upward-sloping line labeled 'S'. The point where they intersect is 'E'. A dotted line from 'E' to the vertical Price axis gives you P*, and a dotted line from 'E' to the horizontal Quantity axis gives you Q*.)
Key Takeaway
Market equilibrium occurs at the price and quantity where the demand and supply curves intersect. At this point, the market is "cleared" – every unit a seller wants to sell at that price is bought by a consumer.
When the Market is Out of Balance
The market is not always at equilibrium. What happens if the price is too high or too low?
Too Low: A Shortage (Excess Demand)
A shortage happens when the market price is below the equilibrium price. At this low price, consumers want to buy a lot, but producers don't want to supply much.
Quantity Demanded > Quantity Supplied (Qd > Qs)
Real-world example: When a new limited-edition sneaker is released at a low official price. Everyone rushes to buy it, but there aren't enough pairs to go around, creating a shortage.
How does the market fix it?
Buyers who really want the item will be willing to pay more. Sellers see this and raise their prices. As the price rises, quantity supplied increases and quantity demanded decreases until the shortage disappears and the market reaches equilibrium again.
Too High: A Surplus (Excess Supply)
A surplus happens when the market price is above the equilibrium price. At this high price, producers are eager to sell, but consumers are not willing to buy much.
Quantity Supplied > Quantity Demanded (Qs > Qd)
Real-world example: Shops with lots of unsold mooncakes after the Mid-Autumn Festival. They have a surplus and need to get rid of them.
How does the market fix it?
Sellers with unsold goods will start lowering their prices to attract customers. As the price falls, quantity supplied decreases and quantity demanded increases until the surplus is gone and the market reaches equilibrium.
Did you know?
This self-correcting nature of markets is what the famous economist Adam Smith called the "invisible hand". Without any central planner, the market guides itself back to equilibrium through the actions of individual buyers and sellers.
Key Takeaway
When the price is not at equilibrium, shortages or surpluses occur. These situations create pressure on the price to either rise (in a shortage) or fall (in a surplus) until it returns to the equilibrium level.
Let's Get Moving! Changes in Equilibrium
Equilibrium isn't permanent. It can change if something causes the entire demand or supply curve to shift. Let's learn how to analyse these changes. It's the most common type of question you'll see on this topic!
The Golden 3-Step Rule for Analysis
Whenever you hear about an event affecting a market, use these three steps. This will make your analysis clear and logical!
Step 1: Decide. Does the event shift the Demand curve or the Supply curve?
Step 2: Direction. Which way does the curve shift? (Right for an increase, Left for a decrease).
Step 3: Determine. Compare the new equilibrium point with the old one. What happened to the equilibrium price (P*) and quantity (Q*)?
Scenario 1: A Change in Demand
(a) An INCREASE in Demand (Demand curve shifts to the RIGHT)
Example: A heatwave hits Hong Kong. What happens to the market for air conditioners?
Step 1: Decide. Hot weather affects buyers' desire for air conditioners. It's a change in Demand.
Step 2: Direction. People want more air conditioners at every price. Demand increases, so the demand curve shifts to the right (from D1 to D2).
Step 3: Determine. The new intersection point (E2) is higher and further to the right than the old one (E1). Therefore, the equilibrium price increases (P*↑) and the equilibrium quantity increases (Q*↑).
(b) A DECREASE in Demand (Demand curve shifts to the LEFT)
Example: People become more health-conscious and decide to drink less sugary soda. What happens to the market for soda?
Step 1: Decide. A change in tastes affects buyers. It's a change in Demand.
Step 2: Direction. People want less soda at every price. Demand decreases, so the demand curve shifts to the left (from D1 to D2).
Step 3: Determine. The new intersection point is lower and further to the left. Therefore, the equilibrium price decreases (P*↓) and the equilibrium quantity decreases (Q*↓).
Scenario 2: A Change in Supply
(a) An INCREASE in Supply (Supply curve shifts to the RIGHT)
Example: A new technology allows factories to produce electric cars more cheaply. What happens to the market for electric cars?
Step 1: Decide. A change in production cost affects sellers. It's a change in Supply.
Step 2: Direction. It's cheaper to produce, so firms supply more cars at every price. Supply increases, so the supply curve shifts to the right (from S1 to S2).
Step 3: Determine. The new intersection point is lower and further to the right. Therefore, the equilibrium price decreases (P*↓) and the equilibrium quantity increases (Q*↑).
(b) A DECREASE in Supply (Supply curve shifts to the LEFT)
Example: The price of coffee beans (an input) increases significantly. What happens to the market for coffee sold in cafes?
Step 1: Decide. The cost of an input affects sellers. It's a change in Supply.
Step 2: Direction. It's more expensive to make coffee, so cafes supply less at every price. Supply decreases, so the supply curve shifts to the left (from S1 to S2).
Step 3: Determine. The new intersection point is higher and further to the left. Therefore, the equilibrium price increases (P*↑) and the equilibrium quantity decreases (Q*↓).
Memory Aid: Summary of Shifts
• Demand ↑ (shifts right) → P* ↑, Q* ↑
• Demand ↓ (shifts left) → P* ↓, Q* ↓
• Supply ↑ (shifts right) → P* ↓, Q* ↑
• Supply ↓ (shifts left) → P* ↑, Q* ↓
What about when BOTH curves shift? (A quick look)
Sometimes, two events happen at once. For example, during Chinese New Year, the demand for flowers increases (shift D right), AND some flower sellers go on holiday, decreasing supply (shift S left).
In this case, both shifts push the price up, so we know for sure that price will increase. However, one shift increases quantity while the other decreases it. Without knowing which shift is bigger, the final effect on quantity is uncertain.
Key idea: When both curves shift, the change in ONE variable (either P* or Q*) will be certain, but the change in the OTHER will be uncertain or ambiguous.
Common Mistakes to Avoid
1. Mixing up shifts vs. movements. Remember: A change in the good's own price causes a movement along the curve. A change in any other factor (like income, tastes, technology, input costs) causes a shift of the entire curve.
2. Forgetting to label your diagrams! Always label your axes (Price and Quantity), your curves (D1, S1, D2, S2), and your equilibrium points (E1, E2, P1, Q1, P2, Q2). Marks are lost for poor labeling!
3. Shifting the wrong way. Just remember: Increase = Right, Decrease = Left. Say it over and over!
Key Takeaway
The 3-Step Rule is your best friend for analysing changes in markets. By identifying the curve that shifts, the direction of the shift, and the resulting change in P* and Q*, you can predict the outcome of almost any market event.
Congratulations!
You've just mastered the core mechanism of how markets work! The interaction of demand and supply is a powerful tool that helps us understand price changes all around us. Keep practicing the 3-Step Rule, and you'll be an economics expert in no time. Keep up the great work!