There is a joke that goes like so. Teach a parrot to say supply and demand, and you have an economist. Economics is all about supply and demand. To understand the market economy, you should know the law of supply and demand. Not surprisingly, this is one of the most important laws in economics, even though this law is often wrong. This law states that the price is where supply and demand are equal. An example of the coffee market can clarify that.

If coffee is free, people might like to drink lots of coffee. But producers cannot make coffee for free. They go bankrupt if coffee is free because they have costs, for instance, employees and equipment. A price of € 3 per kilogramme may not cover all their expenses. Some producers can produce cheaper than others because they have more efficient production facilities. When the price is € 5, a few producers might make a profit and start making coffee.

That may not be enough to satisfy the demand that is out there. The low-cost producers have a limited production capacity. They may come up with 650 kilogrammes of coffee. Consumers might want to gobble up 1,700 kilogrammes if the price is only € 5 per kilogramme. In that case, there would be a shortage of 1,050 kilogrammes. Consumers who fear that they get nothing might offer more money, so the price of coffee rises.

When coffee becomes more expensive, some consumers might not be able to afford coffee. Others may buy less because they have other expenses like beer and milk. On the other hand, some producers can make a profit at this price and start producing. So when the price increases, supply goes up, and demand goes down.

At € 10 per kilogramme, every producer may make a profit, even those with high costs, and producers may come up with 2,000 kilogrammes. Consumers may only buy 600 kilogrammes because it is too expensive, resulting in a surplus of 1,400 kilogrammes. Producers may try to sell their surplus at lower prices before it gets spoiled to recover some of their costs. When prices are lower, consumers are willing to buy more. High-cost producers cannot make a profit and stop making coffee. So when the price decreases, demand goes up, and supply goes down.

The price may settle where supply equals demand. When the price is € 7, producers may make 1,200 kilogrammes, and consumers may gobble up 1,200 kilogrammes. So € 7 per kilogramme could be the price of coffee according to the law of supply and demand. The law often does not work as more issues play a role, but the law suffices for a basic understanding of markets. A graph can illuminate the discussion so far:

The graph shows the quantities of coffee demanded and supplied at different prices. When the price increases, demand goes down, and supply goes up. The downward-sloping black dashed line represents demand. The upward-sloping black line represents supply. If the price is low, the supply is small, and demand is high, leading to a shortage. At € 5, there will be a shortage of 1,050 kilogrammes as demand is 1,700 kilograms while supply is only 650 kilogrammes.

If the price is high, there is little demand and plenty of supply, leading to a surplus. If the price is € 10, there will be a surplus of 1,400 kilograms as supply is 2,000 kilograms and demand is only 600 kilograms. The lines of demand and supply cross at 1,200 kilograms and a price of € 7. Supply and demand match 1,200 kilograms, and € 7 is the price according to the law of supply and demand.

In reality, things often differ a lot from this simple model. There may be different qualities of coffee at their own price. In some markets, there is a lot of competition, and corporations hardly make a profit. Other markets lack competition, and corporations make huge profits. And there hardly ever is an equilibrium as the factors that influence supply, demand, and price constantly change. Nevertheless, simple examples like this one help to explain how a market economy works.

Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.