Chapter 10 : The interaction of demand and supply

• New market equilibriums

  When the demand or supply curves shift due to the PIRATES or PINTSWC reasons, new market equilibriums are established. For example, if there was an increase in the size of the population, demand would shift from D1 to D2. Price would increase to P2 and suppliers would supply a larger quantity of Q2. A new market equilibrium is established at P2 Q2
• Transmission of preferences

  Consumers can give producers information about what they want by making choices. A high price encourages firms to increase output, because they can make more profit. A low demand, such as in economic decline, means firms produce less
• Factors causing disequilibrium

  • Excess demand
  • Excess supply
• Equilibrium price and quantity


  This is when supply meets demand. On the diagram, this is shown by P1 and Q1
• Excess demand

  At Q2, price is at P2 which is below market equilibrium. Demand is now greater than supply, which can be calculated by Q3-Q2. This is a state of disequilibrium. The demand price does not equal the supply price, and the quantity demanded does not equal the quantity supplied. This is a shortage in the market. This pushes prices up and causes firms to supply more. Since prices increase, demand will contract. Once supply meets demand again, price will reach the market clearing price, P1
• Price mechanism

  • The price mechanism determines the market price. Adam Smith called this ‘the invisible hand of the market’. Resources are allocated through the price mechanism in a free market economy. The economic problem of scarce resources is solved through this mechanism. The price moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus. The price mechanism uses three main functions to allocate resources: Rationing, Transmission of preferences, Signalling
• Signalling

  The price acts as a signal to consumers and new firms entering the market. The price changes show where resources are needed in the market. A high price signals firms to enter the market because it is profitable. However, this encourages consumers to reduce demand and therefore leave the market. This shifts the demand and supply curves
• Alternative demand


  • Substitute goods, such as Samsung TVs over Panasonic TVs
• Rationing

  When there are scarce resources, price increases due to the excess of demand. The increase in price discourages demand and consequently rations resources. For example, plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets
• Excess supply

  This is when price is above P1. Supply is now at Q2 and demand is at Q1. There is a surplus of Q2- Q1. Price will fall back to P1 as firms lower their prices and try to sell their goods. The market will clear and return to equilibrium
• Market equilibrium

  At market equilibrium, price has no tendency to change, and it is known as the market clearing price