Lesson 12 of 14 · free to read
Prices are determined by the interaction of demand and supply, with equilibrium occurring where quantity demanded equals quantity supplied, and shifts in either curve change the equilibrium.
You've seen how the circular flow connects households and businesses through markets. But what actually decides the price you pay for a snowboard jacket or a gallon of gas?
The idea
Prices emerge where the quantity buyers want equals the quantity sellers offer, and shifts in demand or supply move that balance.
In a free market, consumers and businesses constantly make choices based on prices. Consumers want the best quality at the lowest price; businesses want to keep costs down and revenues high. These choices determine what gets produced and at what price.
For example, if Mexican food becomes popular, high demand attracts entrepreneurs who open more Mexican restaurants, competing on price, quality, or features.
Vocabulary· 2 terms
Notice the line slopes downward from left to right: as price falls from $200 to $0, the quantity demanded rises from near 0 to over 1,200 jackets. At $100, trace up to the curve and read across to 600 jackets.
Vocabulary· 2 terms
Notice this line slopes upward from left to right: as price rises from $0 to $200, quantity supplied climbs past 1,200 jackets. At $100, trace up to the curve and read across to 800 jackets.
When demand and supply are plotted together, they cross at the equilibrium point. For snowboard jackets, that's $80 and 700 jackets.
If the price rises to $160, suppliers produce more than buyers want, creating a surplus that pushes the price down. If the price falls to $60, buyers want more than suppliers offer, creating a shortage that pushes the price up. These automatic adjustments bring the market back to equilibrium.
Definition
equilibrium
The point at which the quantity demanded equals the quantity supplied, establishing the price and quantity at which the market clears.
The price where buyers want exactly what sellers offer.
Find where the demand curve (D) and supply curve (S) cross—that's point E. At $160, the supply curve sits to the right of demand (surplus); at $60, demand sits to the right of supply (shortage).
Equilibrium holds steady unless demand or supply shifts. A shift means buyers or sellers change how much they want at every price, moving the whole curve.
For example, if snowboarders' incomes rise, they may buy a second jacket, shifting demand to the right. If incomes fall, demand shifts left. Other demand shifters include tastes, prices of related products, expectations about future prices, and the number of buyers.
Supply also shifts. New technology that lowers production cost—like North Face's laser-guided cutting equipment—makes each jacket cheaper to produce, so more jackets are supplied at every price.
If resource prices (labor, fabric) rise, profit per jacket falls and supply decreases. Other supply shifters include the prices of other goods that use the same resources, the number of suppliers, and taxes.
Factors that shift demand and supply curves: Shift Demand
| Factor | To the Right If | To the Left If |
| Buyers' incomes | Increase | Decrease |
| Buyers' preferences/tastes | Increase | Decrease |
| Prices of substitute products | Increase | Decrease |
| Expectations about future prices | Will rise | Will fall |
| Number of buyers | Increases | Decreases |
Each row names a factor and tells which direction it pushes the curve. For demand, read the left column; for supply, read the right. For example, a rise in buyers' incomes shifts demand right, while a rise in resource prices shifts supply left.
Factors that shift demand and supply curves: Shift Supply
| Factor | To the Right If | To the Left If |
| Technology | Lowers cost | Increases cost |
| Resource prices | Fall | Rise |
| Changes in prices of other products that can be produced with the same resources | Profit of other product falls | Profit of other product rises |
| Number of suppliers | Increases | Decreases |
| Taxes | Decreases | Increases |
Each row names a factor and tells which direction it pushes the curve. For demand, read the left column; for supply, read the right. For example, a rise in buyers' incomes shifts demand right, while a rise in resource prices shifts supply left.
Hurricane Katrina in 2005 shows these shifts in action. The storm disrupted Gulf Coast oil production and refining, cutting the supply of gasoline while demand stayed the same. The supply curve shifted left, and prices rose. This illustrates how a supply decrease raises the equilibrium price.
Equilibrium
Market structure is the number of suppliers in a market. Economists identify four types: perfect competition, pure monopoly, monopolistic competition, and oligopoly.
Definition
market structure
The number of suppliers in a market, which defines the competitive environment.
How many sellers are in a market, which shapes how they compete.
The four types of market structure are covered in the Market Structures unit.
The shift factors
Recap
Say each point to yourself, then tap it to check.
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Adapted from Introduction to Business, © 2018 OpenStax, Rice University
Lawrence J. Gitman, Carl McDaniel, Amit Shah, Monique Reece, Linda Koffel, Bethann Talsma, and James C. Hyatt
Licensed under CC BY 4.0. This course is an adaptation, not the original work.
Access for free at openstax.org/details/books/introduction-business