How does a market economy decide how much bread, how many apartments or how many concert tickets to produce, and who gets them? Mostly through prices, which are set by the interaction of supply and demand.
Demand
Demand describes how much of a good buyers are willing and able to purchase at each possible price. The law of demand states that, other things equal, when the price of a good rises, people buy less of it. Some buyers switch to substitutes, some do without, and some simply cannot afford as much.
A change in the good's own price causes a movement along the demand curve. Other changes shift the whole curve: changes in income, tastes, the prices of related goods, expectations or the number of buyers. If a study finds that blueberries are especially healthy, demand for blueberries shifts: people want more at every price.
Supply
Supply describes how much sellers are willing to offer at each price. The law of supply states that, other things equal, a higher price leads producers to offer more, because it covers higher costs and makes production more profitable. Supply shifts when the costs of inputs change, technology improves, weather affects harvests, or the number of sellers changes.
Equilibrium
Put the two together. At high prices, sellers want to sell more than buyers want to buy: a surplus. Unsold goods pile up and sellers cut prices. At low prices, buyers want more than sellers offer: a shortage. Lines form and sellers can raise prices. The price tends to move toward the point where the quantity demanded equals the quantity supplied. This is the equilibrium price.
Prices as signals
Prices do more than ration goods. They carry information. A rising price signals that a good has become scarcer or more wanted, and it gives buyers a reason to economize and producers a reason to supply more. No one needs to know why copper has become scarce; the higher price leads users to conserve and miners to dig more. Friedrich Hayek stressed this in a 1945 essay: prices coordinate the actions of millions of people who each know only a small part of the picture.
Price controls
Governments sometimes set prices by law. A price ceiling is a maximum price; if set below equilibrium, it tends to cause shortages, because buyers want more while sellers offer less. A price floor is a minimum price; if set above equilibrium, it tends to cause surpluses. Supporters of such controls usually aim at fairness, such as keeping necessities affordable; critics point to the shortages, queues and black markets that can follow. Whether the benefits outweigh the costs depends on the details and on values, a theme of Level 8.
Elasticity, simply
Price elasticity of demand measures how strongly the quantity demanded responds to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. Demand is elastic when buyers respond strongly, usually because good substitutes exist or the good is a luxury: if one brand of cereal raises its price, many shoppers switch. Demand is inelastic when buyers respond weakly, usually because the good is a necessity with few substitutes, such as insulin or, in the short run, gasoline. Elasticity matters for policy: a tax on a good with inelastic demand raises revenue but changes behavior little, while a tax on a good with elastic demand changes behavior more.
Worked example: a frost in orange country
Suppose a hard frost destroys a third of the orange crop in a major growing region.
Which curve shifts? The frost affects producers, not buyers' tastes or incomes, so supply shifts: at every price, fewer oranges are available. Demand has not changed.
What happens to price and quantity? At the old price, buyers now want more oranges than sellers have: a shortage. Sellers raise prices until the quantity demanded falls to match the smaller supply. The new equilibrium has a higher price and a lower quantity.
What signals does the price send? Juice makers look for oranges from other regions. Shoppers buy more apples or bananas. Growers elsewhere have a reason to ship more of their crop to this market. Nobody had to give orders; the price carried the message.
How big is the price change? That depends on elasticity. If shoppers easily switch to other fruit (elastic demand), a modest price rise is enough to cut purchases. If buyers feel they cannot do without (inelastic demand), the price must rise much more.
What if the government caps the price? Suppose officials, wanting to protect families, ban any price increase. Now the shortage persists: shelves empty early, lines form, and oranges go to whoever shows up first rather than whoever is willing to pay most. Supporters might reply that a cap shields poorer households from a sudden shock. Many economists suggest a different tool: let the price rise but give direct help to those who need it. Which approach is best is partly a question of values.