Supply and demand is the model economists use to explain how prices and quantities are set in a market. Demand is the relationship between the price of something and how much buyers are willing and able to buy: as a rule, the lower the price, the more they want. Supply is the relationship between price and how much sellers are willing to offer: as a rule, the higher the price, the more they will produce. A market settles at the equilibrium price, the price where the quantity demanded equals the quantity supplied, so that everyone willing to trade at that price can do so. It is the foundation of how markets set prices, including the prices of financial assets, though those add their own dynamics.
Supply and Demand
Supply and demand is the basic model of how prices form in a market: the quantity sellers offer and the quantity buyers want to buy adjust until they meet at an equilibrium price. It underlies the pricing of nearly everything, from groceries to stocks.
Last reviewed by Steven Fox, CFP®, EA
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Quick Summary
- Demand describes how much buyers will purchase at each price; it generally rises as price falls. Supply describes how much sellers will offer; it generally rises as price rises.
- The market tends toward an equilibrium price where the quantity buyers want equals the quantity sellers offer.
- A shortage (price too low) pushes prices up; a surplus (price too high) pushes them down, moving the market back toward equilibrium.
- When something other than price changes, such as income, tastes, or costs, the whole curve shifts and the equilibrium moves.
Definition
Advanced Explanation
The two relationships pull in opposite directions, and that is what makes a single clearing price emerge. Buyers want to pay less and will buy more when prices drop; sellers want to charge more and will supply more when prices rise. Plotted against price, demand slopes down and supply slopes up, and they cross at one point: the equilibrium. At that price the amount buyers want to buy exactly matches the amount sellers want to sell.
The model earns its keep in explaining what happens when the market is not at equilibrium. If the price sits below equilibrium, buyers want more than sellers will provide, producing a shortage; competition among buyers bids the price up. If the price sits above equilibrium, sellers offer more than buyers will take, producing a surplus; sellers cut prices to move inventory. Either way the price is pushed back toward the level where the two quantities match. This self-correcting tendency is why economists treat the equilibrium as the price a free market gravitates toward.
A crucial distinction is between a movement along a curve and a shift of the whole curve. A change in the good's own price moves you along the existing demand or supply curve. A change in something else, buyers' incomes, tastes, the price of a substitute, or, on the supply side, the cost of materials, wages, or technology, shifts the entire curve to a new position, producing a new equilibrium price and quantity. Confusing the two ("higher prices reduced demand") is the most common error in using the model: a higher price reduces the quantity demanded along the curve; it does not shift demand.
How sharply quantity responds to price is captured by elasticity. Demand is elastic when a small price change causes a large change in quantity, as with a luxury that has close substitutes, and inelastic when quantity barely responds, as with a necessity like a life-saving medicine. Elasticity is why a bad harvest can send the price of an inelastic staple soaring while a glut of an elastic good barely moves its price. In financial markets the same forces set prices, more buyers than sellers push a stock up, more sellers than buyers push it down, but expectations, information, and speculation make those markets far more volatile than the textbook diagram suggests.
How to Remember
Demand slopes down (cheaper means people buy more); supply slopes up (pricier means sellers make more). Where the two lines cross is the price the market wants to find.
Used in a Sentence
“When a frost wiped out much of the orange crop, basic supply and demand took over: the reduced supply met unchanged demand, and the price of orange juice climbed sharply.”
How It Works
In a market, buyers and sellers react to price until the quantity demanded and the quantity supplied line up. A price above that point leaves goods unsold and gets cut; a price below it leaves buyers unsatisfied and gets bid up; the market converges on the equilibrium.
A hypothetical shows a shift. Suppose a neighborhood has a stable market for weekend house cleaning at an equilibrium of about $120 per visit, where the number of households wanting a cleaner matches the number of cleaners available. Then a large employer opens nearby and raises local incomes. Higher incomes increase how many households want the service at every price, shifting the demand curve outward. At the old $120 price there are now more would-be customers than cleaners, a shortage, so prices are bid up until a new equilibrium forms at, say, $150, where the larger quantity demanded again meets the quantity supplied. Nothing about the cost of cleaning changed; a shift in demand alone moved the price.
Pros and Cons
What the model explains well
- Why prices rise when something becomes scarcer or more wanted, and fall when it becomes abundant or less wanted.
- Why free markets tend to clear, eliminating persistent shortages and surpluses through price.
- Why necessities and luxuries respond so differently to price changes, through the idea of elasticity.
Its limits
- It assumes competitive markets; monopolies, regulation, and price controls can prevent the equilibrium from forming.
- It describes tendencies, not precise predictions, and real markets adjust with lags and frictions.
- In financial markets, expectations and speculation add volatility the simple diagram does not capture.
People Also Asked
Answers to the most frequently asked questions.
What is the equilibrium price?
The equilibrium price is the price at which the quantity buyers want to buy exactly equals the quantity sellers want to sell, so the market clears with no shortage or surplus. If the price is below it, competition among buyers pushes it up; if above it, sellers cut prices to move goods. A free market tends to converge on this price.
What is the difference between a shift in demand and a movement along the demand curve?
A movement along the demand curve happens when the good's own price changes: a higher price reduces the quantity demanded, a lower price increases it. A shift of the whole demand curve happens when something else changes, such as buyers' incomes, tastes, or the price of a substitute, so buyers want more or less at every price. Confusing the two is the most common mistake in using the model.
What does elasticity mean in supply and demand?
Elasticity measures how much the quantity bought or sold responds to a change in price. Demand is elastic when a small price change causes a large change in quantity, as with a luxury that has substitutes, and inelastic when quantity barely moves, as with a necessity. Elasticity explains why a shortage of an essential good can send its price soaring while the same shortage of an easily substituted good barely moves it.
Does supply and demand set stock prices?
Yes, at the most basic level: a stock's price rises when there are more buyers than sellers at the current price and falls when there are more sellers than buyers. But financial markets add layers the simple model does not, expectations about the future, new information, and speculation, which make asset prices far more volatile than the price of an everyday good.
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