Supply and demand together determine the prices and quantities of goods bought and sold. Neither factor alone is sufficient to determine price and quantity. It is through their interaction that supply and demand do their work, just as two blades of a scissors are required to cut paper.

A market will determine the price at which the quantity of a product demanded is equal to the quantity supplied. At this price, the market is said to be cleared or to be in equilibrium, meaning that the amount of the product that consumers are willing and able to purchase is matched exactly by the amount that producers are willing and able to sell. This is the equilibrium price and the equilibrium quantity. The equilibrium price is also called the market-clearing price.

Figure 9 puts together Figures 2 and 5, showing the market supply and demand for gaming apps. It illustrates how supply and demand interact to determine equilibrium price and quantity. Clearly, the quantities demanded and supplied equal one another only where the supply and demand curves cross, at point e. From the table in Figure 9, you can see that quantity demanded and quantity supplied are the same at only one price. At $6 per app, sellers are willing to provide exactly the same quantity as consumers would like to purchase. Hence, at this price, the market clears, since buyers and sellers both want to transact the same number of units.

The beauty of a market is that it automatically works to establish the equilibrium price and quantity, without any guidance from anyone. To see how this happens, let us assume that gaming apps are initially priced at $8, a price above their equilibrium price. As we can see by comparing points a and b, sellers are willing to supply more apps at this price than consumers are willing to buy. Economists characterize such a situation as one of excess supply, or surplus. In this case, at $8, sellers supply 40 apps to the market (point b), yet buyers want to purchase only 20 (point a). This leaves an excess of 20 apps overhanging the market; these unsold apps ultimately become surplus inventories.

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Here is where the market kicks in to restore equilibrium. As inventories rise, most firms cut production. Some firms, moreover, start reducing their prices to increase sales. Other firms must then cut their own prices to remain competitive. This process continues, with firms cutting their prices and production, until most firms have managed to exhaust their surplus inventories. This happens when prices reach $6 and quantity supplied equals 30, because consumers are once again willing to buy up the entire quantity supplied at this price, and the market is restored to equilibrium.

In general, therefore, when prices are set too high, surpluses result, which drive prices back down to their equilibrium levels. If, conversely, a price is initially set too low, say, at $4, a shortage results. In this case, buyers want to purchase 40 apps (point d), but sellers are only providing 20 (point c), creating a shortage of 20 apps. Because consumers are willing to pay more than $4 to obtain the few apps available on the market, they will start bidding up the price of gaming apps. Sensing an opportunity to make some money, firms will start raising their prices and increasing production once again until equilibrium is restored. Hence, in general, excess demand causes firms to raise prices and increase production.

When there is a shortage in a market, economists speak of a tight market or a seller’s market. Under these conditions, producers have no difficulty selling off all their output. On the other hand, when a surplus of goods floods the market, this gives rise to a buyer’s market, because buyers can buy all the goods they want at attractive prices.

We have now seen how changing prices naturally works to clear up shortages and surpluses, thereby returning markets to equilibrium. Some markets, once disturbed, will return to equilibrium quickly. Examples include the stock, bond, and money markets, where trading is nearly instantaneous and extensive information abounds. Other markets react very slowly. Consider the labor market, for instance. When workers lose their jobs due to a plant closing, most will search for new jobs that pay at least as much as the salary at their previous jobs. Some will be successful, while others might struggle, having to settle for a lower-paying position after a long job search. Similarly, real estate markets can be slow to adjust because sellers will often refuse to accept a price below what they are asking, until the lack of sales over time convinces sellers to adjust the price downward.

These automatic market adjustments can make some buyers and sellers feel uncomfortable: It seems as if prices and quantities are being set by forces beyond anyone’s control. In fact, this phenomenon is precisely what makes market economies function so efficiently. Without anyone needing to be in control, prices and quantities naturally gravitate toward equilibrium levels. Adam Smith was so impressed by the workings of the market that he suggested that it is almost as if an “invisible hand” guides the market to equilibrium.

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Given the self-correcting nature of the market, long-term shortages or surpluses are almost always the result of government intervention, as we will see in the next chapter. First, however, we turn to a discussion of how the market responds to changes in supply and demand, or to shifts of the supply and demand curves.

Once a market is in equilibrium and the forces of supply and demand balance one another out, the market will remain there unless an external factor changes. But when the supply curve or demand curve shifts (some determinant changes), equilibrium also shifts, resulting in a new equilibrium price and/or output. The ability to predict new equilibrium points is one of the most useful aspects of supply and demand analysis.

Predicting the New Equilibrium When One Curve Shifts When only supply or only demand changes, the change in equilibrium price and equilibrium output can be predicted. We begin with changes in supply.

Changes in Supply Figure 10 shows what happens when supply changes. Equilibrium initially is at point e, with equilibrium price and quantity at $9 and 30, respectively. But let us assume that a rise in wages or the bankruptcy of a key business in the market (the number of sellers falls) causes a decrease in supply. When supply declines (the supply curve shifts from S₀ to S₂), equilibrium price rises to $12, while equilibrium output falls to 20 (point a).

If, on the other hand, supply increases (the supply curve shifts from S₀ to S₁), equilibrium price falls to $6, while equilibrium output rises to 40 (point b). This is what has happened in the electronics industry: Falling production costs have resulted in more electronic products being sold at lower prices.

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We have seen how equilibrium price and quantity will change when supply changes. When supply increases, equilibrium price will fall and output will rise; when supply decreases, equilibrium price will rise and output will fall.

Changes in Demand The effects of demand changes are shown in Figure 11. Again, equilibrium is initially at point e, with equilibrium price and quantity at $9 and 30, respectively. But let us assume that the economy then enters a recession and incomes sink, or perhaps the price of some complementary good soars; in either case, demand falls. As demand decreases (the demand curve shifts from D₀ to D₂), equilibrium price falls to $6, while equilibrium output falls to 20 (point a).

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During the same recession just described, the demand for inferior goods (beans and bologna) will rise, as falling incomes force people to switch to less expensive substitutes. For these products, as demand increases (shifting the demand curve from D₀ to D₁), equilibrium price rises to $12, and equilibrium output grows to 40 (point b).

Like changes in supply, we can predict how equilibrium price and quantity will change when demand changes. When demand increases, both equilibrium price and output will rise; when demand decreases, both equilibrium price and output will fall.

Predicting the New Equilibrium When Both Curves Shift When both supply and demand change, things get tricky. We can predict what will happen with price in some cases and output in other cases, but not what will happen with both.

Figure 12 portrays an increase in both demand and supply. Consider the market for corn. Suppose that an increase in corn-based ethanol production causes demand for corn to increase. Meanwhile, suppose that bioengineering results in a new corn hybrid that uses less fertilizer and generates 50% higher yields, causing supply to also increase. When demand increases from D₀ to D₁ and supply increases from S₀ to S₁, output grows to Q₁ as shown in the left panel.

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But what happens to the price of corn is not so clear. If demand and supply grow the same, output increases, but price remains at P₀ (also captured in the middle panel to the right). If demand grows relatively more than supply, the new equilibrium price will be higher (top panel on the right). Conversely, if demand grows relatively less than supply, the new equilibrium price will be lower (bottom panel on the right). Figure 12 is just one of the four possibilities when both supply and demand change. The other three possibilities are shown in Table 1 along with the four possibilities when just one curve shifts. When only one curve shifts, the direction of change in equilibrium price and quantity is certain. But when both curves shift, the direction of change in either the equilibrium price or quantity will be indeterminate.

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