Price changes

Nobody sets the price of coffee. No committee meets to decide it. Yet a price exists, it changes, and it somehow rations a limited supply among everyone who wants some. Understanding how that happens without anyone arranging it is the single most useful thing economics teaches, and it starts with two curves.

A single consumer's demand for a good is individual demand. Adding up the quantities demanded by every consumer at each price gives market demand, so the market demand curve is the sum of all the individual demand curves. Market supply is built in the same way from the supply of every firm. A movement along a demand curve caused by a change in the good's own price is called an extension of demand when quantity demanded rises and a contraction when it falls; the same words are used for supply.

The demand curve slopes downward because as price falls, buyers who were previously priced out enter the market, and existing buyers find the good more attractive relative to substitutes. The supply curve slopes upward because higher prices make production more profitable, so firms devote more resources to that good and higher-cost producers find it worth entering.

Shifts versus movements

This distinction separates strong answers from weak ones, and it comes down to a single question: what changed? If the price of the good itself changed, you move along the existing curve, and that is called a change in quantity demanded or quantity supplied. If anything else changed, the whole curve shifts, and that is called a change in demand or supply. Income, tastes, the price of substitutes and complements, and population all shift demand. Production costs, technology, taxes, subsidies, weather and the number of firms all shift supply.

Each cause of a shift works for a reason worth stating. Demand shifts right when incomes rise, for normal goods, because buyers can afford more at every price; for inferior goods, such as the cheapest own-brand foods, it shifts left, as buyers switch to better alternatives. A rise in the price of a substitute shifts demand right, and a rise in the price of a complement shifts it left. Advertising and changes in fashion or tastes shift demand in the direction the change favours. A larger population, or a change in its age structure, changes how many buyers there are for particular goods. Expectations matter too: if buyers expect prices to rise next month they buy more now.

Supply shifts for the same kind of reasons on the producer's side. A rise in the cost of raw materials, wages or energy makes each unit dearer to produce, so supply shifts left. Better technology lowers costs and shifts supply right. An indirect tax is like an extra cost and shifts supply left; a subsidy works the other way. More firms entering the market shift supply right. Weather and disease shift the supply of farm goods, sometimes sharply. And goods produced together, such as beef and leather, are in joint supply, so a rise in the output of one raises the supply of the other.

Away from equilibrium the market corrects itself. Above the equilibrium price, supply exceeds demand and the resulting surplus pushes sellers to cut prices. Below it, demand exceeds supply and the shortage lets sellers raise prices. Neither adjustment requires anyone to plan it, which is the central insight of the price mechanism.