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Supply and demand in markets
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Supply and demand in markets

How do demand and supply combine to create a market? Find out and explore the equilibrium of demand and supply.
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This graph compares price and quantity of transport journeys, with quantity on the X axis and price on the Y axis. The supply curve slopes diagonally up from left to right, while the demand curve slopes diagonally down. Where the two curves intersect is the point where demand satisfies supply at a specific price and quantity. This is known as the equilibrium of demand and supply. In this example, £2 will buy seven transport journeys. If the price is increased from £2 to £2.50, there is a movement along the demand curve and consumers buy fewer transport journeys. They were buying seven, now they only want four.
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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 caused a surplus.
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Conversely, if the price falls from £2 to £1.50, this increases demand to 10 transport journeys because they are now cheaper. However, 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.

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:

This equilibrium of demand and supply graph compares price and quantity, with quantity on the x-axis and price on the y-axis. The supply curve slopes diagonally up and to the right, while the demand line slopes diagonally down and to the right, so the two curves create an X-shape. Where they intersect is marked as the point of equilibrium. There is a dotted line going horizontally from the equilibrium, marking its location on the y-axis at £2. There is a dotted line going vertically down from the point of equilibrium, marking its location on the x-axis at 7.

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.

This graph builds on the one above, with additional features indicated. There is a new dotted line marked on the graph indicating a price of £2.50, which intersects the supply and demand lines. The place where the £2.50 line meets the demand line corresponds to four quantities of transport. The place where the £2.50 price line meets the supply line corresponds to 10 quantities of transport journeys. The difference in the number of journeys demanded and the number of journeys supplied is marked as surplus, with six journeys more supplied than are demanded (10 minus 4).

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.

The graph builds on the original equilibrium of demand and supply graph with additional features indicated. There is a new dotted line marked on the graph indicating a price of £1.50, which intersects the supply and demand lines. The place where the £1.50 line meets the supply line corresponds to four quantities of transport. The place where the £1.50 price line meets the demand line corresponds to 10 quantities of transport journeys. The difference in the number of journeys demanded and the number of journeys supplied is marked as shortage, with six journeys more demanded than are supplied (10 minus 4).

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

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