Markets, Competition, and Personal Choices

How Markets Work: Scarcity, Supply, and Demand

Everyday economic life begins with a fundamental condition: scarcity. Scarcity exists because human wants exceed the limited resources available to satisfy them. Because there are never enough resources to fulfill every desire, individuals and societies must continually decide how to allocate what is available. In a market, these decisions occur through the interaction of buyers and sellers, who determine the prices and quantities of the goods and services exchanged.

The behavior of buyers is described by the law of demand. The law of demand states that as the price of a good increases, the quantity demanded decreases, assuming all else remains equal. When prices fall, buyers purchase more. On the other side of the transaction, the behavior of sellers is explained by the law of supply. The law of supply states that as the price of a good increases, the quantity supplied increases, assuming all else remains equal. Higher prices give producers a stronger incentive to bring a larger quantity of goods to market.

Market equilibrium is the price and quantity at which quantity demanded equals quantity supplied; actual markets do not always reach or remain at equilibrium. Market equilibrium occurs at the price where the quantity demanded equals the quantity supplied. The equilibrium price is also known as the market-clearing price because it leaves neither an unsold excess nor unmet demand. When the price is not at equilibrium, market imbalances occur. A surplus occurs when the quantity supplied is greater than the quantity demanded, usually because the price is above equilibrium. In contrast, a shortage occurs when the quantity demanded is greater than the quantity supplied, usually because the price is below equilibrium.

Supply and demand are constantly influenced by outside conditions called determinants. Determinants that can shift demand include changes in consumer income, consumer tastes, population, and the prices of related goods. An increase in consumer demand shifts the demand curve to the right, which increases both equilibrium price and equilibrium quantity. A decrease in consumer demand shifts the demand curve to the left, which lowers both equilibrium price and equilibrium quantity. On the supply side, determinants that can shift supply include changes in production costs, technology, taxes, subsidies, and the number of sellers. An increase in supply shifts the supply curve to the right, which lowers the equilibrium price and increases the equilibrium quantity. Conversely, a decrease in supply shifts the supply curve to the left, which raises the equilibrium price and decreases the equilibrium quantity.

How strongly consumers react to changes in price is described by price elasticity of demand. Price elasticity of demand measures how sensitive consumer purchases are to a change in price. Goods that are necessities with few substitutes typically have inelastic demand, meaning price changes cause small changes in quantity demanded. Because consumers must have these items, they continue buying similar amounts even if prices rise. On the other hand, goods with many substitutes or luxury items typically have elastic demand, meaning price changes cause large changes in quantity demanded. When prices rise on items with easy alternatives or luxury goods, consumers quickly decrease their purchases.