Demand, supply and market equilibrium
The laws of demand and supply, what shifts each curve, equilibrium prices, price floors and ceilings, and consumer and producer surplus.
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Why do onion prices crash after a bumper harvest and soar after a flood? Why does a government support price sometimes leave warehouses full of unsold grain? The answers come from the most basic model in economics: demand and supply. It explains how prices are set in markets, how they respond to weather, incomes, policies and trade, and who gains and loses when they change.
Demand, supply and equilibrium are foundational topics in agricultural economics, examined at every level.
Demand
Demand is the quantity of a good that buyers are willing and able to buy at each price, over a period of time.
The law of demand: other things being equal, as price rises, quantity demanded falls. The demand curve slopes downward, because at higher prices people buy less of the good, switch to substitutes and have less real income.
A change in the good's own price causes a movement along the demand curve. Other factors shift the whole curve:
- Income: for normal goods (meat, fruit, dairy) demand rises with income; for inferior goods (some coarse staples in some places) it falls.
- Prices of related goods: substitutes (wheat and rice; butter and margarine) and complements (tea and sugar).
- Tastes and preferences, health information and advertising.
- Population and its structure, and urbanisation.
- Expectations of future prices.
Supply
Supply is the quantity producers are willing and able to sell at each price.
The law of supply: other things being equal, as price rises, quantity supplied rises, because higher prices cover the higher costs of producing more and draw resources from other uses.
Factors that shift supply:
- Input prices (fertiliser, fuel, labour, feed).
- Technology and productivity, such as new varieties and irrigation.
- Weather, pests and diseases, which matter enormously in agriculture.
- Prices of competing products that use the same land.
- Government policies: taxes, subsidies and regulations.
- Number of producers and expectations.
Market supply is the sum of the quantities all producers offer at each price, so it also grows when more farmers enter, for example after irrigation reaches a new area.
Farm supply is often inelastic in the short run, because crops are planted months before harvest and perennial crops take years to change.
Market equilibrium
Equilibrium is the price at which quantity demanded equals quantity supplied. Above it there is a surplus, pushing price down; below it a shortage, pushing price up.
When a curve shifts, the equilibrium moves:
| Change | Price | Quantity |
|---|---|---|
| Demand increases (rising incomes) | rises | rises |
| Demand decreases | falls | falls |
| Supply increases (good harvest, new technology) | falls | rises |
| Supply decreases (drought, disease) | rises | falls |
Because food demand is usually price-inelastic, a good harvest can lower prices so much that farmers' total revenue falls, the "paradox of plenty" explained in the article on elasticity.
Interfering with the market
- Price floors, such as minimum support prices, set above equilibrium create a surplus, which the government must buy, store, export or destroy.
- Price ceilings, such as maximum retail prices, set below equilibrium create shortages, queues and black markets.
- Taxes and subsidies shift supply curves and change prices for both buyers and sellers; who bears a tax depends on the elasticities.
Consumer and producer surplus
- Consumer surplus: the difference between what buyers would be willing to pay and what they actually pay, the area below the demand curve and above the price.
- Producer surplus: the difference between the price received and the minimum producers would accept, the area above the supply curve and below the price.
Together they measure the welfare a market creates, and economists use them to estimate who gains and loses from policies and trade.
Finding equilibrium and the effect of a support price
For a crop in a local market, with price P per quintal and quantity Q in thousand quintals:
- Demand: Qd = 100 − 2P.
- Supply: Qs = −20 + 4P.
Equilibrium: 100 − 2P = −20 + 4P, so 6P = 120, P = 20 and Q = 60.
Surpluses at equilibrium. Demand reaches zero at P = 50, and supply starts at P = 5:
- Consumer surplus = ½ × 60 × (50 − 20) = 900.
- Producer surplus = ½ × 60 × (20 − 5) = 450.
A good harvest shifts supply to Qs = −2 + 4P: 100 − 2P = −2 + 4P gives P = 17, Q = 66. Price falls 15 per cent while quantity rises 10 per cent.
A support price of 22 under the original curves: Qd = 100 − 44 = 56, Qs = −20 + 88 = 68, leaving a surplus of 12 thousand quintals for the government to procure, costing 12,000 × 22 = 264,000 in purchases before storage costs.
Key points
- Law of demand: higher price, lower quantity demanded; law of supply: higher price, higher quantity supplied.
- Own-price changes move along a curve; income, related prices, tastes, technology, weather and policy shift curves.
- Equilibrium is where Qd = Qs; surpluses push prices down and shortages push them up.
- Supply increases lower price; demand increases raise it.
- Price floors above equilibrium create surpluses; ceilings below it create shortages.
- Consumer and producer surplus measure welfare from a market.
What the exams ask
- School-leaving and entrance papers: laws of demand and supply, determinants, and simple equilibrium diagrams.
- Degree and research-fellowship entrances: shifts versus movements, solving linear equilibrium equations, price controls, tax incidence, and consumer and producer surplus.
- Professional and policy examinations: effects of support prices, procurement and trade policies, and market interventions on farmers and consumers.
Described in general terms: the kind of examination, not a past paper. Laisha never reproduces exam questions.
Questions people ask
Why do farm prices fluctuate more than prices of manufactured goods?
Farm supply depends on weather and is fixed for months once crops are planted, while demand for food changes little with price. Small changes in supply therefore cause large price swings.
Is a support price always good for farmers?
It protects them from very low prices, but if set well above the market price it creates surpluses that are costly to store and can distort what farmers grow.
What is the difference between a change in demand and a change in quantity demanded?
A change in quantity demanded is a movement along the curve caused by the good's own price. A change in demand is a shift of the whole curve caused by something else, such as income or tastes.
Sources
- Mankiw, N. G. Principles of Economics, 9th edition. Cengage, 2020. Chapters 4–7.
- Tomek, W. G. and Kaiser, H. M. Agricultural Product Prices, 5th edition. Cornell University Press, 2014.
- Norwood, F. B. and Lusk, J. L. Agricultural Marketing and Price Analysis. Pearson, 2008.
- FAO. The State of Agricultural Commodity Markets 2022. FAO, Rome, 2022.
- Timmer, C. P., Falcon, W. P. and Pearson, S. R. Food Policy Analysis. Johns Hopkins University Press for the World Bank, 1983.
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