We know that prices influence the choices made by consumers and producers.  But how does the market determine prices?

By bringing buyers and sellers together to exchange goods, services, and resources.

Let’s use the supply and demand for sunglasses to illustrate.  You know that sunglasses could sell at various prices.  But only one price perfectly balances consumption and production.

We find that price where the demand and supply curves intersect.  It equals $80 in our example.  This is the equilibrium price.  In competitive markets, the equilibrium price develops through the natural interaction of buyers and sellers.

Suppose, for example, that we arbitrarily set the price of sunglasses at $120.  At this price, consumers are willing and able to purchase 4,400 pairs of sunglasses.  Producers, however, are willing to provide 6,000 pairs.  So, at a price of $120, 1,600 pairs of sunglasses remain unsold in the marketplace.

That’s the difference between the 6,000 pairs supplied and the 4,400 demanded.

The market has too many sunglasses!  This excess production creates downward pressure on prices.  Producers who want to eliminate unsold inventory lower their prices, incentivizing consumers to buy more.  At lower prices, firms also reduce production, because they can’t sell sunglasses for the price they wanted.

Do you see the competing forces? As prices fall, more consumers will want to consume the good.  But producers will decrease production because the lower price does less to cover their costs.

Eventually, price falls to a point where the quantity demanded exactly equals the quantity supplied.

At this price, no excess production means no pressure to change prices.  When the quantity demanded equals the quantity supplied, we say that the market has “cleared.”

This is why in economics we sometimes refer to the equilibrium price as the market clearing price.

Now, suppose that the price of a pair of sunglasses is $60.  At that price, the quantity supplied equals 4,800 pairs.  However, the quantity demanded is 5,600 pairs.  Quantity demanded exceeds quantity supplied by 800 pairs of sunglasses. That’s the difference between the 5,600 pairs demanded and the 4,800 supplied.

Now there are too few sunglasses in the market!

Excess demand drives prices higher as consumers buy all the sunglasses available in the marketplace.  This upward pressure on price incentivizes producers to increase production.  And as prices rise, excess demand begins to fall.

For some consumers, the marginal benefit associated with buying a pair of sunglasses does not justify paying the higher price.  Prices will rise until the quantity demanded equals the quantity supplied.


At this price, no excess demand means no pressure to change prices.  Again, a market reaches equilibrium when it clears: when the quantities supplied and demanded equalize at a single price—the equilibrium price.

A key feature of competitive markets is that the equilibrium price results from interaction between buyers and sellers and requires no outside coordination.


Was there ever a time when you were willing and able to pay for something that you really wanted but all the stores were sold out?

We call that a shortage.  A shortage occurs when producers provide too little of a good at the prevailing price.  For a market in equilibrium, the quantity supplied equals the quantity demanded, and so no shortage exists.

However, if for some reason the price of a good lies below the equilibrium price, the quantity demanded exceeds the quantity supplied, and a shortage results.

The size of a shortage is the difference between quantity supplied and quantity demanded.  Let’s look at our graph with numbers.

At a price of $6, 70 units are demanded, but only 30 are supplied, which results in a shortage of 40 units.  When we subtract quantity demanded from quantity supplied, we get a negative number.

That negative sign tells us that too little was supplied.  The only way to eliminate a shortage is for prices to rise.  When too little is produced, the market puts upward pressure on price, eventually restoring the market to equilibrium.

So, if you observe a shortage that won’t go away, it’s because prices are not allowed to adjust, such as when the government artificially sets prices.  On the other hand, sometimes prices are set above the equilibrium price, such as when a vendor initially sets the price of a product too high.

When that occurs, the quantity supplied exceeds the quantity demanded.  When producers make more than people want to buy at the prevailing price, we call that a surplus.

The size of a surplus is the difference between the quantity supplied and the quantity demanded.  So at a price of $16 suppliers produce 80 units, but consumers demand only 20.  The difference between 80 and 20 is a surplus of 60 units.  Eighty minus 20 is a positive 60, indicating that too much was produced.

When too much is produced, the market puts downward pressure on price, which eventually returns the market to equilibrium.  If you see a surplus that won’t go away, it’s because prices aren’t allowed to fall.  A good example is empty seats at a baseball stadium, where ticket prices are set at the beginning of the season.  For attendance to increase, prices would have to fall, but they don’t.






Markets dynamically adjust when prices are not in equilibrium.  Let’s see how changes in demand can move the market for strawberries to a new equilibrium, changing the prices and quantities traded in the process.

We begin at price P1 and quantity Q1.  Suppose it’s summer and everyone wants strawberry ice cream,  increasing the demand for strawberries.  We represent that increase as a rightward shift of the demand curve, from D1 to D2.

At the prevailing price, P1, the new quantity demanded, Qd, is greater than the quantity supplied, Qs, causing a shortage in the market for strawberries.

As you’ve seen, when quantity demanded is greater than quantity supplied, there is upward pressure on price.  As prices rise, farmers decide to produce more strawberries.  As a result, quantity supplied increases.

And as prices rise, some consumers will be discouraged from buying strawberries, so quantity demanded falls, until quantity supplied equals quantity demanded at the new equilibrium price, P2, and equilibrium quantity, Q2.

Let’s use numbers to review the effect of an increase in demand.  We begin in equilibrium at a price of $5 and a quantity of 10,000 pounds.  First, demand shifts to the right.  Prices rise from $5 to $6 a pound, and output increases from 10,000 to 12,000 pounds.  The market enters a new, stable equilibrium in which more strawberries are traded at higher prices.

Let’s go back to the beginning and suppose instead that demand for strawberries falls.  Say it’s winter, and people want hot chocolate instead of strawberry ice cream.  As before, we begin in equilibrium at price P1 and quantity Q1.

We represent a decrease in demand as a leftward shift of the demand curve, from D1 to D3.  At the prevailing price, P1, the quantity supplied, Qs, is greater than the quantity demanded, Qd, creating a surplus.

A surplus places downward pressure on price.  As prices fall, consumers buy more, and producers decide to produce less.  Eventually, the market reaches a new equilibrium at price P3 and quantity Q3.

Using numbers to review the effect of a decrease in demand, let’s start in equilibrium at a price of $5 per pound and a quantity of 10,000 pounds.  When the demand for strawberries decreases, price falls from $5 to $4 and quantity traded falls from 10,000 to 8,000 pounds.











It’s relatively simple to show changes in supply and demand while holding one or the other constant.

But market dynamics are often more complex than that.  Say the market for strawberries is in equilibrium at price P1 and quantity traded Q1.  What happens if both demand and supply increase at the same time?  We know without a doubt that quantity traded will rise.

However, as for price, we can only say, “It depends.”  In this graph, demand and supply increase by the same amount.  Although quantity increases, price remains the same, at P1.

Suppose instead that demand increases more than supply—as shown by the shifts from D1 to D2 and from S1 to S2.  Prices rise, and so does quantity.

Why does price change now and not earlier?  The upward pressure on price caused by the increase in demand exceeds the downward pressure on price caused by the increase in supply. Overall, quantity traded, and price rise.

Now suppose that supply increases more than demand.  Here we see supply increase from S1 to S2 and demand increase from D1 to D2.  When both demand and supply increase, quantity rises, from Q1 to Q2.  Yet here price falls, from P1 to P2.

Why? The downward pressure on price caused by the increase in supply exceeds the upward pressure on price caused by the increase in demand. What about when both demand and supply fall at the same time?

The results are exactly the opposite of what we’ve shown so far: Quantity falls, but price may rise, fall, or remain the same.  Now let’s see what happens when demand and supply move in opposite directions.

Say supply decreases from S1 to S2 and demand increases from D1 to D2.  We know for sure that price is going to rise.  That’s because increases in demand and decreases in supply on their own both tend to cause prices to rise.

Together, the effect is magnified.  What we don’t know for sure, without more information, is how quantity will change.  In the case of identical absolute changes, quantity remains fixed, at Q1.

If demand increases by more than the decrease in supply, price will rise but so will quantity traded.  Should supply decrease by more than demand increases, price rises, from P1 to P2, but quantity traded falls, from Q1 to Q2.

What about when demand decreases and supply increases at the same time?  The results are exactly the opposite of what we’ve shown so far.  Price will fall, but a change in quantity, if any, depends on the absolute sizes of the shifts.  This table summarizes how complex changes affect price and quantity in the marketplace.

When demand and supply move in the same direction, we can know for sure how quantity changes, but not necessarily price.  When demand and supply move in opposite directions, we can know for sure how price will change, but not necessarily the quantity.



Price ceilings are maximum legal prices.  Governments typically impose and enforce such ceilings when they believe that prices are unfairly high—or want to make specific goods more accessible to low-income consumers.

For example, in New York and other cities, some landlords can’t rent apartments at the market-clearing price.

Let’s use our economic toolkit to analyze the effect of a price ceiling on the market for rental housing.  We begin with a basic demand and supply graph that is in equilibrium at price Pe and quantity Qe.

Suppose the city council decides that this equilibrium price is too high for a rental unit and passes a law mandating that the maximum legal price for rent is Pc, a price ceiling below the equilibrium price.  At the new, lower price, the quantity demanded for apartments will rise since more people will be willing and able to pay for an apartment.  At the same time, the quantity supplied will fall as producers become less willing and able to offer apartments for rent.

As a result, the market for apartments does not clear, causing a housing shortage.  More units are demanded than supplied.  We’ll analyze the welfare effects of price ceilings later on.

While many people think price ceilings are good because they lower prices, they often ignore the important role that firms play in supplying output to the market. At a lower price, firms will produce fewer goods.

In the case of rent control, some landlords will sell their buildings or turn apartments into condominiums or even commercial structures.  This shortage is one of the ironies of rent control policies—fewer apartments are made available, not more.

This is true for all price ceilings set below the equilibrium price, regardless of the good or service being traded.




Have you ever wanted a job, any job, but just couldn’t find one?  It may be because of a market distortion called a price floor.  A price floor is a minimum legal price for a good or service.

The federal minimum wage is an example of a price floor with which you are probably familiar.

In the market for labor, the price for labor is the wage, so we’ll revise our graph using We to indicate the equilibrium wage.  In other markets—such as the market for sunglasses—we think of firms as suppliers and consumers as demanders.

But when it comes to labor markets, those roles are reversed: The workers are the suppliers of labor, and the firms are the demanders of labor.  A price floor, or minimum wage, is designed to provide a higher wage than the equilibrium wage.  Graphically, the minimum wage, Wf, is higher than the equilibrium wage, We.


At the higher wage the quantity of labor supplied will increase.  For example, at the higher wage college students may want to take a part-time job or work more hours.  However, since firms now have to pay more for labor, the quantity of labor demanded will fall, signifying that firms will hire fewer employees.

Any time the quantity supplied exceeds the quantity demanded, there is a surplus in the market.  However, instead of a surplus of sunglasses, this is a surplus of labor.  That means that some people who are looking for work will be unable to find any.

In economics we call a surplus of labor unemployment.  Markets respond to surpluses by placing downward pressure on prices, so we would normally expect to see the wage fall, and the market would work toward the equilibrium wage.

But with a price floor set above the equilibrium, wages can’t fall since it’s against the law to hire at a lower wage.  As a result, the surplus persists.  This is one of the great ironies of price floors and all other market distortions: They can have significant unintended consequences.

The effect of the minimum wage is hotly debated and controversial. What is clear, however, is that economics can help inform that debate.






Have you ever been excited about buying a car until you realized how much sales tax you would have to pay?

Taxes change the price you have to pay when you buy a good or service, and as a result taxes affect the quantities demanded, supplied, and traded.  Let’s use our model of supply and demand to examine the impact of a tax on the market for wine.  In our example, in the absence of a tax the market for wine would rapidly move to an equilibrium where the price per bottle would be $10 and the quantity demanded and supplied would be 50,000 bottles.

What happens when we impose an excise tax of $4 per bottle on suppliers, meaning that suppliers pay the tax?  An excise tax is a tax on a good or service that depends on the units sold, not the price.

From the seller’s point of view, the cost of producing each bottle just increased by $4.  We represent this increase as a $4 vertical shift of the supply curve, signifying that marginal costs have gone up by $4.  With the new supply curve, St, the market moves to a new equilibrium, where the market price is now $12 and the quantity of wine traded is 40,000 bottles.  The new price paid by consumers is $12.

Remember, however, that producers have to pay $4 of that new price to the government as tax revenue, so the sellers actually receive only $8 for each bottle of wine sold.  What is the net effect of the tax?

The tax increases the price paid by consumers, reduces the price received by producers, and decreases the quantity traded.


Notice that the tax is actually paid by both buyers and sellers.  From an equilibrium price of $10, buyers are now paying $12, which amounts to $2 of the tax.  The price received by producers has fallen to $8, the other $2 of the tax.

For the government, tax revenue is the orange area in our graph and is equal to the amount of the tax times the quantity traded, Qt, or $4 times 40,000 bottles, a total of $160,000.

When it comes to taxes, it doesn’t matter who pays them since most of the time both buyers and sellers will generally wind up paying a share.




Most of the time, both buyers and sellers wind up sharing the cost of a tax.  To illustrate, let’s see what happens when buyers have to pay a $4 tax on each bottle of wine purchased.

In the absence of a tax, the equilibrium price and quantity are $10 a bottle and 50,000 bottles.  Having the buyer pay the tax results in a $4 vertical shift of the demand curve, from D to Dt.

With the new demand curve, the market reaches a new equilibrium price of $8 per bottle and 40,000 bottles traded.

The price producers receive is $8.  Buyers pay the retail price of $8 plus the $4 tax, for a total of $12 per bottle.  Let’s take a moment and summarize the effect of the tax on the market for wine.

The price received by sellers falls, from $10 to $8 per bottle.  The price paid by buyers rises, from $10 to $12 a bottle.  And the quantity traded declines, from 50,000 to 40,000 bottles.  The tax revenue the government collects is equal to the amount of the tax times the quantity traded, Qt, or $4, times the new quantity traded, 40,000, which equals $160,000.

Graphically, tax revenue is represented by the orange area. In addition to raising revenue for the government, taxes generally raise prices paid by consumers, reduce prices received by producers, and reduce the quantity traded in a market.