Supply and demand in markets

Now you understand how demand and supply behave individually, it’s time to combine them to create a market. Watch the video showing how we can combine supply and demand curves to explain a simple market’s behaviour.

When you bring both demand and supply curves together on one graph, and bring in the effects of a shifting demand or supply and changes in price along the curve, you can explain a simple market’s behaviour.

Remember, ‘simple’ models like this only work if you make some assumptions, which are:

• It’s a market of many producers (who supply) and buyers (who demand)
• The market has no barriers to entry or exit
• Everyone knows what their competitors are doing

This is known as perfect knowledge.

Equilibrium of supply and demand

The concept described in the video is explained below as well, if you’d like to follow it at your own pace.

The point where demand satisfies supply at a specific price and quantity is known as the equilibrium of demand and supply and is represented by the following graph:

Where the two curves intersect is the point of equilibrium. In this example, £2 buys seven journeys of transport. If the price increases from £2 to £2.50, a movement along the demand curve, consumers buy fewer transport journeys: they were buying seven, now they only want four journeys.

The problem is that the supplier has produced 10 transport journeys because the price is higher and there is more profit to be made. This has now caused a surplus.

Conversely, if the price falls from £2 to £1.50, this increases demand to 10 transport journeys because they’re now cheaper. Unfortunately, supply has fallen to only four transport journeys, because there is no profit in the lower price. This causes a shortage.

Both surplus and shortages are caused by changes in price, which move along the curves.