The theory of supply and demand is simple. But do you really understand how it works? This explorable explainer hopes to bring the theory to life, visually, one step at a time.
We'll be looking at a market where precious stones 💎 are traded, but the same applies to most regular goods. To keep things simple, we'll assume that buyers and sellers are seeking to purchase or sell a single unit of 💎.
Sellers obtain 💎 by manufacturing, finding, extracting, or purchasing it in a secondary market. They will then attempt to sell it to one of the buyers in our market.
Sellers won't just sell at any old price. Every seller has a price limit: the minimum price that they are willing to sell for.
This price limit is usually determined by how much it cost them to obtain it, or how much personal benefit they would lose by selling. Perhaps they spent lots of valuable time finding it, or it was dug out of the ground using expensive machinery or labour.
Different sellers will have different price limits. Some can obtain 💎 at a lower cost than others. For example, the cost of labour can vary significantly between different countries, or perhaps 💎 is more difficult to extract in places with rocky or mountainous terrain. Some sellers can earn more selling something else, so will only bother to sell 💎 if the price is sufficiently high.
The number of sellers who will trade in our market is determined by the prevailing market price there. Sellers will participate if the market price is greater or equal to their price limit. As we increase the price, more and more sellers will enter* the market as they are able to sell 💎 for more than their price limit, allowing them to trade.
Buyers are intending to purchase 💎 in the market. They may do so because they plan to resell it elsewhere at a profit, or because they derive some value from ownership.
Buyers also have a price limit, which for them is the maximum price they are willing to buy 💎 for.
As with sellers, different buyers will have different price limits. It may be determined by what price they can resell it at, or how much benefit or enjoyment they derive from ownership.
Let's have a closer look at an individual seller. Her price limit is $4, so she should be willing to sell for any price at or above $4. Higher is obviously better; if she sells it for $5, she is now better off by $1. This is known as a surplus.
If we look at the same thing for all sellers, arranged in order of their price limits, we can see how many of them will participate as the price changes.
This gives rise to a supply curve: it tells us what quantity of 💎 sellers are willing to part with at a range of different prices.
Supply curves slope upwards, because as the price increases, more sellers enter the market, and a higher quantity is offered for sale.
Similarly, the demand curve tells us what quantity buyers are willing to buy at a range of different prices. A buyer with a price limit of $6 will be willing to pay any price less than $6. Buying for $5 means that he can capture $1 of surplus for himself.
If we arrange our buyers in order of their price limits, we can produce the demand curve, which shows the quantity of 💎 buyers are willing to buy at each price.
Let's take a close look at what happens when our seller meets our buyer:
This pair will trade if they are able to arrive at a mutually agreeable price, which is anywhere between $4 and $6. There is $2 of total surplus value available, to be divided between them. Exactly where they end up may depend on bargaining power or negotiation prowess. But if we don't expect buyers or sellers to have any persistent advantage over the other, it would be reasonable to assume that they are most likely to land somewhere in the middle, around $5.
But what does this tell us about what will actually happen when all participants are allowed to trade freely? And can we predict what prices will be agreed?
Similar to the 1-on-1 example above, we can expect that the prevailing market price will be one that divides the surplus evenly between buyers and sellers.
Traders are incentivised to meet their counterparties in the middle, as surpluses are only made when participants trade; sellers want high prices and buyers low ones, but if they're too high or too low, there won't be anyone willing to trade with them.
So let's take a closer look at the surplus. In the chart below, can you find the price that balances the total surplus made by buyers and sellers?
The point at which the two curves cross over or intersect (between $5 and $6) is the price that will not only balance the surplus values of buyers and sellers, but will also maximise the total surplus value generated ($20)
This is known as the equilibrium price. It is the price that should prevail in this market when participants are left to trade freely. Simply by trading goods at this price, they are collectively better off by $20.
Luckily, we've prepared a simulation. Press the button below to conduct a real-time trading session** with some very simple robots who have only been given a single instruction: maximise their surplus by trading.
The average price should end up at the equilibrium: between $5 and $6, maximising and balancing the surplus value captured by buyers and sellers. The spread of observed prices around the equilibrium can be large or small, depending on the structure of the market. For example, if trading occurs privately between pairs of participants, it would involve more effort to find the best available deal, so inferior offers may be accepted, leading to more variation.
Do you want to run these experiments in your class, with your students as buyers and sellers? If so, you may be interested in Breakeven, our real-time trading game designed for teaching a wide variety of concepts in Economics. Free for single classes of up to 30 students, Breakeven comes with access to a range of market-based activities with companion lecture slides and interactive explainers like this one. To find out more, we'd love to hear from you at firstname.lastname@example.org.
I hope you found this explainer useful! Subsequent explainers will explore what happens when price limits change, when prices are set or restricted by law, the role of price sensitivity, and how taxes distort markets.
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*: In reality, changing prices will produce two effects: more participants will enter/leave the market, and existing participants may also adjust their quantity supplied and demanded. For example, if prices are high enough, a manufacturing business may elect to produce more items and pay workers overtime.
**: The mechanism is a public double auction market. Each robot trader makes offers, starting off with unrealistically high surplus expectations and lowering them gradually until they manage to transact. They are not allowed to sell at a loss (negative surplus).
Many thanks to Chris Makler (econgraphs.org) for his invaluable feedback on an early draft.