Overview

This is the most famous diagram in economics: two intersecting lines that explain why diamonds are expensive and water is cheap (usually). It describes how buyers and sellers interact to determine prices.

Core Idea

Equilibrium: The point where the Supply curve (sellers) and Demand curve (buyers) cross. At this price, everyone who wants to buy can buy, and everyone who wants to sell can sell.

Formal Definition (if applicable)

Law of Demand: As price increases, quantity demanded decreases. Law of Supply: As price increases, quantity supplied increases.

Intuition

Imagine a concert. If tickets are $1, everyone wants one (high demand), but the band won’t play (low supply). If tickets are $10,000, the band will play all night (high supply), but no one will buy (low demand). Somewhere in the middle ($100), the arena is full.

Examples

  • Gas Prices: When oil supply drops (war, disaster), gas prices rise to ration the limited supply.
  • Clearance Sales: When a store has too much inventory (surplus), they lower the price to increase demand.
  • Uber Surge Pricing: Increasing price during high demand to encourage more drivers (supply) to get on the road.

Common Misconceptions

  • “Price is set by costs.” (Price is set by what people are willing to pay, not just what it cost to make.)
  • “Demand is a fixed number.” (Demand is a curve; it changes depending on price.)
  • Elasticity: How sensitive demand is to price changes (e.g., insulin is inelastic; luxury cars are elastic).
  • Shortage: When price is too low ($Q_d > Q_s$).
  • Surplus: When price is too high ($Q_s > Q_d$).

Applications

  • Business Strategy: Setting the right price for a product.
  • Public Policy: Understanding the impact of taxes or price controls (minimum wage, rent control).
  • Investing: Predicting commodity price movements.

Criticism / Limitations

The model assumes “perfect competition” (many buyers/sellers, identical products), which rarely exists in the real world (monopolies, branding).

Further Reading

  • Marshall, Principles of Economics
  • Mankiw, Principles of Economics