Let’s look at the market location where the three guys, Adam, Bob and Carl live. Their local deli is the Vienna. Because both supply and demand curves show the price on the vertical axis, and quantity on the horizontal axis, we can graph both demand and supply using the same chart to show what’s happening in the market, where a market is a place where buyers and sellers freely exchange goods.
Quantity demanded (red line) decreases with price and quantity supplied (blue line) increases with price. There is a unique point, and that’s where the two curves cross (yellow point). At this point, the price is $2/kg and the quantity demanded and supplied are both 14 kgs of sausage. This is the point we call market equilibrium. The two curves cross at this point, which means that demand is equal to supply (D = S)
Market equilibrium is considered efficient, and stable. Let’s look at why it’s efficient. Going back to the meaning of efficiency presented in Module 2, you will remember that it means a point where all resources are used in the best way (optimally) and that there is no waste. Revisiting the yellow point in Figure 6-6 you will see that the demand is 14kg. That is exactly the supply that is offered in the market. So there is no waste (no leftovers), and nobody goes without sausages at that price ($2/kg).
Let’s now look at why it’s stable. Why doesn’t the price rise above or below the equilibrium price of $2? If the Vienna sausage maker chose to make 20kg of sausage, he would need to get $3.50/kg to cover his costs. But at $3.50/kg, the consumers are willing to buy only 5kg. The only way Mr. Vienna sausage maker could sell that quantity would be to reduce the price, which is better than letting the sausage go to waste. This puts downward pressure on the price to the point where P = $2/kg.
Similarly, if the price were $1.50/kg demand would be 20kg, but the supply would only be 12kg. There would not be enough to satisfy all wants in the market. This is the invisible hand that Adam Smith talked about. There is pressure from consumers and producers to adjust quantity and price so that the market reaches equilibrium. This point is stable because both consumers and producers are satisfied as a result of satisfying themselves. Market forces are invisible and it is not necessary to centrally organize production or consumption.
We could look at a bigger market that includes all the consumers and all the producers, not just those in a certain neighbourhood. If we did this, the price might change a bit, but the total supply and total demand would both increase just because the size of the market increased.
Key point: You might have noticed that sometimes I will say, “quantity supplied” or “quantity demanded,” whereas in other instances I will say “supply” or “demand.” There is a distinct difference between the two (which is very well explained in the text on pages 47 and 48). When I use just the terms supply and demand I am referring to the entire curve: the supply curve or the demand curve. When I talk about quantity supplied or demanded, I’m referring to the amount on the x-axis (horizontal axis). It’s very important to refer to the correct one because we will be talking about changes in supply and demand (meaning a shifting of the entire curve), and changes in quantity traded in the market.