Consumers demand, producers supply. Supply reflects producers’ changing willingness and ability to make or sell at the various prices that occur in the market. If you were selling cookies or crude oil, which would entice you to produce more, a low price or a high price? If you said low price, you would quickly find yourself broke. However, if you said high price, you just might have a chance to make a profit. The law of supply states that producers are able and willing to sell more as the price increases. The reason for the law of supply is the simple fact that as production increases, so do the marginal costs. As rational, self-interested individuals, suppliers are only willing to produce if they are able to cover their cost.
Elasticity of supply is the producers’ sensitivity to changes in price on the quantity they are willing to produce. The key factor in supply elasticity is the amount of time it takes to produce the good or service. If producers can respond to price changes rapidly, supply is relatively elastic. However, if producers need considerable time to respond to changes in the market price of their product, supply is relatively inelastic. Compare corn tortillas and wine. Corn tortillas are easily produced with readily available materials. If the market price of corn tortillas were to suddenly increase, producers would have little difficulty in producing more tortillas in response to the price change. Now, if the market price of Pinot Noir were to suddenly increase, winemakers would have much more difficulty responding to the price change. Vines take years to develop, grapes take time to ripen, and wine needs time to age. All of these factors give wine a relatively inelastic supply.
When supply meets demand, something interesting happens. A price is born. In an efficient market, prices are a function of the supply and demand for the good or service. Instead of central planners, government officials, or oligarchs dictating artificial prices or rationing who gets what, the market relies on the impersonal forces of supply and demand to determine prices and to serve the rationing function. The pitting of consumers trying to maximize their utility against producers trying to maximize their profits is what determines the price of goods in the market and also the quantity that is bought and sold.
Supply and demand ration goods and services efficiently and fairly. Prices are efficient because they are understood by most participants in the market. If you give a child $5 and send her into a candy shop, she could figure out what she can afford without having to ask anyone for help. A price conveys much information. The price of a good communicates to consumers whether or not to purchase and to the producer whether or not to produce it. Prices are fair because they are neutral; they favor neither buyer nor seller.
A market is said to be in equilibrium when at the prevailing price there is neither a surplus nor shortage of the good or service. When this condition is present, then the price is called the equilibrium or market-clearing price. Market equilibrium is the most desirable outcome because it allows for consumers to maximize utility while also allowing producers to maximize profits.
There are times when the market is not in equilibrium. Sometimes, the market price is greater than the equilibrium price.
When this happens, a surplus results. The amount producers supply is greater than the amount consumers demand. If you have ever walked past a clearance rack full of sweaters and wondered to yourself, “Who would wear that?” you are not alone. Countless others had walked past those now-surplus sweaters before they were placed on the clearance rack. They walked past because the marginal cost of the sweater to the consumer was greater than the marginal utility. The purpose of the clearance rack is to offer these sweaters at a price low enough to induce some hapless, utility-maximizing individual to purchase them.
If the market price is too low, then a shortage might result. Shortages occur when the quantity demanded is greater than the quantity supplied. When shortages occur in the market, buyers compete against each other to purchase an item and bid up the price until equilibrium is reached. Auctions take advantage of this phenomenon, and the consumer who wants the good the most gets it. How do you know he wanted it the most? He offered the most money. Prices are fair, efficient, and effective at rationing most goods and services.