Explain how the forces of demand and supply establish equilibrium price and quantity, and how shifts in the curves change that equilibrium.

What this dot point is asking

A market is any arrangement that brings buyers and sellers together to exchange a good or service. In TCE Economics we usually assume a competitive market with many buyers and sellers, where price is free to move.

Demand

Demand is the quantity of a good buyers are willing and able to purchase at each price over a period. The law of demand says that, all else equal, as price falls quantity demanded rises, so the demand curve slopes downward from top-left to bottom-right. This happens because of the income effect (a lower price leaves buyers with more real purchasing power) and the substitution effect (the good becomes cheaper relative to alternatives).

A change in price causes a movement along the demand curve. A change in a non-price factor shifts the whole curve. The main demand shifters are:

• Income (for normal goods, higher income shifts demand right).
• Prices of substitutes and complements.
• Tastes and preferences.
• Population and demographics.
• Expectations about future prices.

Supply

Supply is the quantity sellers are willing and able to produce at each price. The law of supply says that, all else equal, a higher price encourages more production, so the supply curve slopes upward. The main non-price supply shifters are input or resource costs, technology, the number of producers, government taxes and subsidies, and producer expectations. Lower input costs or new technology shift supply right (more is supplied at every price).

Equilibrium

Equilibrium is where the demand and supply curves intersect. At the equilibrium price the quantity demanded equals the quantity supplied, so there is no pressure for price to change.

• If price is above equilibrium there is a surplus (excess supply); sellers cut prices and price falls back.
• If price is below equilibrium there is a shortage (excess demand); buyers bid prices up and price rises.

We can write the conditions simply. Equilibrium requires $Q_d = Q_s$. A surplus occurs when $Q_s > Q_d$ and a shortage when $Q_d > Q_s$.

Shifts and the new equilibrium

When a curve shifts, follow these steps in the exam: state which curve shifts and in which direction, redraw it, then read off the new equilibrium and compare price and quantity with the original.

For example, a poor season for Australian wheat raises the input cost of flour. The supply of bread shifts left, the equilibrium price rises and the equilibrium quantity falls. By contrast, if the ABS reports rising household incomes, demand for a normal good such as restaurant meals shifts right, raising both equilibrium price and quantity.

When both curves shift, you can usually predict the direction of either price or quantity but not always both; the result depends on the relative size of the two shifts.

When you draw these diagrams, always put price on the vertical axis and quantity on the horizontal axis, label both curves, and clearly mark the original and new equilibrium points and the direction of any shift.