Definitions and Basics

Efficiency, Supply and Demand, and Market Clearing, by Arnold Kling

Supply and Demand: Prices play a central role in the efficiency story. Producers and consumers rely on prices as signals of the cost of making substitution decisions at the margin. How are prices determined?

Economic theory says that the price of something will tend toward a point where the quantity demanded is equal to the quantity supplied. This price is known as the market-clearing price, because it “clears away” any excess supply or excess demand.

Market clearing is based on the famous law of supply and demand. As the price of a good goes up, consumers demand less of it and more supply enters the market. If the price is too high, the supply will be greater than demand, and producers will be stuck with the excess. Conversely, as the price of a good goes down, consumers demand more of it and less supply enters the market. If the price is too low, demand will exceed supply, and some consumers will be unable to obtain as much as they would like at that price—we say that supply is rationed….

The Wheat Activity, a lesson plan from the Foundation for Teaching Economics

In this simulation students are workers producing wheat.  The students will use their available capital (pencils) to produce wheat by writing the word “w-h-e-a-t” as many times on the piece of paper (land) as possible in a given time period.  Each round more students are added to each team which will slow down production and show how even as total product increases the marginal productivity of workers does not increase at that same rate.  Students will use this activity and marginal decision making to understand how companies make decisions to hire based on marginal productivity.

Where Do Prices Come From?” by Russ Roberts at Econlib, June 4, 2007.

Prices adjust to equate how much people want to buy with how much they want to sell.

And if people want to buy more than they did before, prices rise. If people want to sell more than they did before, prices fall.

Supply and demand. Buyers are competing with each other. Sellers are competing with each other.

A Price is a Signal Wrapped up in an Incentive, video at Marginal Revolution University

Donald Boudreaux, Information and Prices, in the Concise Encyclopedia of Economics

Market prices are vital because they condense, in as objective a form as possible, information on the value of alternative uses of each parcel of property. Nearly every parcel of property has alternative uses. For example, a plot of land can be used to site a pumpkin patch, a restaurant, a suite of physicians’ offices, or any of many other things.

Everything Has Its Price (And That’s a Good Thing) at LearnLiberty.

In the News and Examples

Michael L. David, Price Gouging is Fine but Humans Are Better, Econlib, November 2017.

Price controls in the aftermath of a disaster will make things worse, not better. And there’s nothing wrong with saying so—especially if saying so can help stop publicity-seeking politicians from getting in the way.

Paul Mueller and Jan Gerber, What is a Just Price? Econlib, May 2020.

This essay explores the historic debate about what makes prices just and why economists by and large no longer ask that question. To be sure, much has been written on this topic over thousands of years. Here we simply highlight a few of the most important contributions to just price theory; those of Aristotle and Aquinas, the Spanish Scholastics of Salamanca, John Locke, and Etienne Condillac.

Munger on Shortages, Prices, and Competition. EconTalk podcast, October 19, 2009.

Mike Munger of Duke University talks with EconTalk host Russ Roberts about the limits of prices and markets, especially in the area of health. They talk about vaccines, organ transplants, the ethics of triage and what role price should play in allocating. The discussion concludes with a discussion of how markets respond to price controls, particularly minimum wages.

Richard B. McKenzie, How Free-Market Kidney Sales Can Save Lives- And Lower the Total Cost of Kidney Transplants, Econlib, March 2012.

“Suppose that plumbers were given valuable pipes and fittings free of charge, on the condition that they could not resell what they had been given. What would we expect plumbers to do next?”

A Little History: Primary Sources and References

Alfred Marshall, biography from the Concise Encyclopedia of Economics

Alfred Marshall was the dominant figure in British economics (itself dominant in world economics) from about 1890 until his death in 1924. His specialty was microeconomics—the study of individual markets and industries, as opposed to the study of the whole economy. His most important book was Principles of Economics. In it Marshall emphasized that the price and output of a good are determined by both supply and demand: the two curves are like scissor blades that intersect at equilibrium. Modern economists trying to understand why the price of a good changes still start by looking for factors that may have shifted demand or supply. They owe this approach to Marshall….

Equilibrium of Normal Demand and Supply, by Alfred Marshall. Book V, Chapter 3 in Principles of Economics

We have next to inquire what causes govern supply prices, that is prices which dealers are willing to accept for different amounts….

When demand and supply are in stable equilibrium, if any accident should move the scale of production from its equilibrium position, there will be instantly brought into play forces tending to push it back to that position; just as, if a stone hanging by a string is displaced from its equilibrium position, the force of gravity will at once tend to bring it back to its equilibrium position. The movements of the scale of production about its position of equilibrium will be of a somewhat similar kind*19. [par. V.III.21. See footnote 19 for the original diagram of supply and demand.]

Advanced Resources

Classroom experiments with supply, demand, and equilibrium.

Vernon Smith on Markets and Experimental Economics. EconTalk podcast episode, May 21, 2007. Includes printable Listening Guide.

Vernon Smith, Professor of Economics at George Mason University and the 2002 Nobel Laureate in Economics, talks about experimental economics, markets, risk, behavioral economics and the evolution of his career.

Related Topics



Competition and Market Structures

Market Failures

Price Ceilings and Floors

Economic Institutions