Supply and demand
The "law" of supply and demand states that in a market with perfect competition, prices of goods tend to rise when supply is low or consumer demand is high, and conversely that prices tend to fall when supply is high or demand is low. This causes the market to approach the equilibrium point. Price is thus seen as a function of supply curves and demand curves.
The model of supply and demand assumes that buyers and sellers can enter and exit the market. If supply exceeds demand, sellers will leave the market, buyers will enter the market and the price will be forced downward. If demand exceeds supply, buyers will leave the market, sellers will enter the market and the price will be forced upward.
This model will not work if there is an monopoly with one supplier which can adjust the price of a good at all. In this situation, it is predicted that the monopolist will attempt to maximize his profit, which will result in a price higher than the equilibrium price of a good.
The law of supply and demand is important in the functioning of a market economy in that it is the mechanism by which most resource allocation decisions are made, therefore avoiding the disequilbriums and resource misallocations of a command economy.
Simple Supply and Demand curves
This can be illistrated with the following graph:
File:Simple supply and demand.png
The demand curve is the amount that will be bought at a given price. The supply curve is the quantity that producers are willing to make at a given price. As you can see, more will be purchased when the price is lower (the quantity goes up.). On the other hand, as the price goes up, producers are willing to produce more goods. Where these cross is the equilibrium. This will create a price of P and a quantity of Q since that is where the two lines cross.
Demand curve shifts
When more people want something the demand curve will shift right. An example of this would be more people suddenly wanting more coffee. This will cause the demand curve to shift from the initial curve D0 to the new curve D1. This raises the equilibrium price from P0 to the higher P1. This raises the equilibrium quantity from Q0 to the higher Q1.
Conversely, if the demand decreases, the opposite happens. If the demand starts at D1, and then shifts to D0, the price will decrease and the quantity will decrease.
Supply curve shifts
When the suppliers costs change the supply curve will shift. For example, if someone invents a better way of growing wheat, then the amount of wheat that can be grown for a given price will increase. This creates a shift from a original supply curve S0 to a new lower supply curve S1. This causes the equilibrium price to decrease from P0 to P1. The equilibrium quantity increases from Q0 to Q1. Notice that the price and the quantity move in opposite directions in a supply curve shift.
Conversely, if the supply decreases, the opposite happens. If the supply curve starts at S1, and then shifts to S0, the price will increase and the quantity will decrease.
Effects of being away from the Equilibrium Point
If the price is too high, then the quantity produced will be greater than the demand at that price. This will cause a oversupply problem. If the price is too low, then too little will be produced. This will cause a undersupply problem. Businesses responses to both these problems restores the quantity and the price to the equilibrium.