Price determination and market shifts

How supply and demand set the equilibrium price, how shortages and surpluses push the price there, what happens when one or both curves shift, and the three functions of price.

In November 2022, supermarkets rationed eggs.

Bird flu had forced farmers to cull millions of hens, and feed and energy costs had soared, so many egg farmers cut back. Supermarkets did not raise shelf prices quickly enough to match, and shelves emptied. Several chains limited each shopper to a few boxes of eggs.

Why did shelves empty, and what normally stops that happening?

Equilibrium.

The equilibrium (market-clearing) price is where quantity demanded equals quantity supplied. There is no pressure for the price to change.

Below it, there is excess demand (a shortage). Above it, there is excess supply (a surplus).

The model assumes a competitive market where the price is free to move, and that buyers and sellers respond to prices.

The three functions of the price mechanism.

1. Signalling: a rising price tells producers that consumers want more, and tells consumers the good has become scarcer.
2. Incentive: a higher price makes producing more profitable, encouraging firms to expand and new firms to enter.
3. Rationing: a higher price discourages some buyers, so the scarce good goes to those willing and able to pay most.

Together they reallocate resources without anyone planning it. When egg prices were held down in 2022, the rationing function was replaced by purchase limits, and farmers had less incentive to expand.

Think first

Supermarkets keep the price of eggs the same, but fewer eggs arrive.

Shoppers still want as many eggs as before at that price.

What happens in the shops?

At the old price, more eggs are demanded than supplied: excess demand. If the price cannot rise to clear the market, something else has to ration the eggs, such as purchase limits. This happened in UK supermarkets in late 2022.

Step by step

1. Supply and demand cross at £8: buyers want 12 thousand and sellers offer 12 thousand. The market clears.

2. Suppose the price is £6, below equilibrium. Buyers want 16 thousand but sellers offer only 8: excess demand of 8 thousand. Buyers compete for the scarce goods and sellers see they can charge more, so the price is pushed up, demand contracts and supply extends, until the shortage disappears at £8.

   Check: At a price of £6, quantity demanded is 16 thousand and quantity supplied is 8 thousand. What is there?

   16 − 8 = 8 thousand more wanted than offered: a shortage.

3. Above equilibrium, at £10, it is the other way round. Sellers offer 16 thousand, buyers want only 8: excess supply of 8. Unsold stock builds up, so sellers cut prices: demand extends, supply contracts and the price falls back to £8.

4. Now shifts. Demand increases to D2. At the old price of £8 there is excess demand, so the price rises to P2 and supply extends. New equilibrium: higher price and higher quantity. Notice: demand shifted, supply extended. Supply did not shift.

   Check: Demand increases from D to D2, with supply unchanged. What happens?

   At the old price there is excess demand, so price rises and supply extends to a higher quantity.

5. Now the supply curve shifts instead, with demand unchanged.

   Check: Supply decreases and demand does not change. At the old price of £8, what is there, and what happens to the price?

   Less is supplied at £8 but buyers want the same amount, so there is a shortage. Buyers compete for the goods and the price is bid up.

6. Supply decreases to S2, as with the eggs. At £8 there is now excess demand, so the price rises and demand contracts. New equilibrium: higher price, lower quantity. If the price is held at £8, the shortage stays, and shops ration instead.

7. Sometimes both curves shift at once.

   Check: Demand and supply both increase. Which result is certain?

   Both shifts raise quantity. Their effects on price pull in opposite directions, so the price depends on which shift is bigger.

8. When both curves shift, one result is certain and one depends on the sizes. Here demand and supply both increase: quantity definitely rises, but the price could rise, fall or, as here, stay the same. It depends on which shift is bigger.

What your diagram must show

• Demand and supply with P1 and Q1 marked
• Supply shifted to the left, labelled S2
• New equilibrium where S2 meets D
• P2 above P1 and Q2 below Q1
• All curves, prices and quantities labelled

A common mistake

Below equilibrium, quantity demanded (16 thousand) is greater than quantity supplied (8 thousand): that is excess demand, a shortage, not excess supply.

Exam question

Explain how the price mechanism removes a shortage in a market.

Model answer

A shortage, or excess demand, exists when the price is below the equilibrium, so the quantity demanded is greater than the quantity supplied.

[Diagram: D and S with a price below equilibrium, the gap between quantity supplied and quantity demanded labelled excess demand, and an arrow showing the price rising.]

Buyers compete for the limited goods and sellers see they can charge more, so the price rises. As it rises, some buyers decide the good is no longer worth it, so demand contracts, and producing the good becomes more profitable, so supply extends. The price keeps rising until quantity demanded equals quantity supplied at the equilibrium price, where the shortage disappears.

In doing this, the price signals that the good is scarce, gives producers an incentive to supply more and rations the good to those most willing and able to pay.

How quickly the shortage disappears depends on how price elastic supply is: if producers cannot raise output quickly, the price has to rise further. However, if the price is held down, the shortage remains and the good is rationed by queues or purchase limits instead.