Explaining Supply and Demand

Supply and demand are a fundamental basis of economics, they help explain the determination of price and output in different markets. The laws of supply and demand suggest that a free market will respond to changes in demand and supply to overcome shortages and surplus and maintain an ‘equilibrium price’. For example, a shortage of diamonds leads to a higher price. If demand for diamonds increased, this would put upward pressure on prices to prevent a shortage.

increase supply

Readers Question Could you explain the above diagram.

The above diagram shows a fundamental aspect of economics – supply and demand.

The supply of petroleum is the quantity produced and sold on to the open market. The initial price of petrol is at P0 where Supply equals demand.

However, if the supply of petrol increased to S1 there would be a surplus of petrol at the price p0. Basically there would be more petrol than people want to consume. It is no good for firms to have excess supply because they are not getting anything for it.

Therefore, to encourage demand firms reduce price; as the price falls more people are encouraged to buy it. Thus the price will fall to P1 where the market regains equilibrium (supply = demand). As long as supply does not equal demand there is always a tendency for prices to change.

In recent months the supply of oil has been falling, causing oil prices to rise.

Note: the one criticism of the diagram is that I don’t believe the demand for petrol is so elastic. I think the demand for petrol is inelastic – which means an increase in supply would cause a big fall in price.


By on December 31st, 2007

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