The twin engines of economics are Supply and Demand. Demand refers to how much people wants something, and Supply refers to how much something is available. Adam Smith first came up with the Supply and Demand model, and when describing his model, he came up with the Water and Diamond paradox.
Water and Diamond Paradox
We can clearly see that water is much more essential to life than diamond, yet diamonds are worth so much more than water. The problem here is that even though there is great demand for water, the supply is much higher than the demand, hence its low price. On the other hand, even though there is much less demand for diamond than water, its supply is much lower than the demand, hence the high price.
Supply and Demand Equilibrium
We can visualize supply and demand on a graph. An example of a supply and demand curve is shown below.
Generic Supply and Demand Graph
The blue line represents the demand curve. The demand curve represents the consumers' willingness to pay for a certain good. As the price increases, the quantity the consumer obtains is likely to decrease.
On the other hand, the red line represents the supply curve. The supply curve represents the willingness of a producer to supply a good. As the price rises, the producers would be more willing to produce more.
When the two lines meet, we have a Supply and Demand Equilibrium. This is where both the suppliers and consumers will be happy.
Equilibrium Shift
Suppose that the graph represents the supply of chicken. Suppose that the supply of pork goes down due to a disease, leading to an increase in pork prices. Since pork and chicken are substitutes for each other, we can expect the demand for chicken to increase.
Increase in Demand
As the demand increases, the demand curve shifts upwards (or outwards). With the supply being fixed, this would mean that suppliers can start charging more as consumers are now more willing to pay for it.
On the other hand, if the supply for pork decreases with the demand being fixed, we can also end up with a higher price as shown in the following graph.
Decrease in Supply
Although prices increased in both cases, the quantity sold differs between them. In order to determine if it's a supply or demand shift, we need to be told the price, as well as the quantity.
Constraints
In certain countries, there is the concept of minimum wage. We can analyze employment using the Supply and Demand model as well.
Constraint with Excess Supply
In this case, the suppliers would the citizens (as they provide man-hours), while the consumers are the firms. In a country without minimum wage, we would expect the equilibrium to follow the supply and demand curves.
However, suppose that we add the constraint of minimum wage. When there is minimum wage, we would be in a state of disequilibrium. Due to the minimum wage, workers would be more willing to work. However, due to the higher costs, firms will be less willing to hire. This would lead to an excess in supply i.e. unemployment.
Notice that the new equilibrium e2 is actually on the demand curve instead of the supply curve. This is because even though there are more workers willing to work, the firms are the ones deciding how many they want to hire.
If, however, suppose that the minimum wage is below the equilibrium wage. In this case, the wages will actually stabilize at the equilibrium e1 instead of at the minimum wage.
In the above example, we talked about excess supply. There can also be a case where we have excess demand. Suppose that we try to model the Supply and Demand curves for oil.
Excess Demand
Initially, we are at the equilibrium point e1. Suppose that there is a worldwide shortage of oil. If the supply for oil decreases, prices are expected to increase. Shifting the supply curve upwards (to indicate the decrease of supply), we will end up at point e2. However, if the government decides to put a cap on the maximum price for gas (limiting it to the original price), the suppliers will now be unwilling to supply as much as before. We now end up with the equilibrium on the supply curve at e3.
Market Efficiency
In general, equilibrium points always results in the highest efficiency in the market. Constraints, therefore, lead to inefficiencies. The efficiency loss in the wage scenario is that even though workers are willing to work at a lower wage, they are now unemployed because of the minimum wage. Another example is where suppliers would be willing to supply more gas (and consumers will be willing to purchase them) but the gas price cap results in the shortage of gas.
A perfectly competitive market refers to a market where producers offer their goods to a wide range of consumers who bid up the price until the highest bidder gets it. An example of a perfectly competitive market is eBay auctions.
Without constraints, i.e. in a perfectly competitive market, the mechanism used for allocation is price. When prices are allowed to swing unconstrained, we will end up at the natural equilibrium. Looking at the gas example, price is no longer the allocation mechanism due to the constraint which leads to gas shortage. People will have to queue up for gas no matter how much money they are willing to pay. When price is not used as the allocation mechanism, there will be more inefficient mechanisms like the queue mechanism.
There is always a trade-off between efficiency and equity. Even though the market is most efficient at the equilibrium, but it may not be completely fair. For example, without a minimum wage, there are people who could be exploited. When equity comes into play, things become very complicated. For example, in order to shift the supply curve downwards, the government can provide subsidies to the oil companies. However, this would mean that people will be taxed more heavily on the other end.
Summary
In summary, the market is always going to attempt to reach equilibrium whenever they can. Whenever a constraint causes a disequilibrium, the component that is lacking (either supply or demand) will determine where the new equilibrium will be. Equilibrium points are points of highest market efficiency, and constraints, in general, lead to inefficiencies. However, inefficiency may not necessarily be bad as it leads to equity.
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