Supply and Demand Basics

A gas station in Phoenix charges $3.89 a gallon. One in rural Montana charges $4.45. A hurricane hits the Gulf Coast and both prices jump 30 cents in a week. No central authority set any of those numbers. Millions of individual decisions about buying and selling did.

Markets coordinate buyers and sellers through price. Buyers want lower prices, so they purchase more as prices fall; that's the demand curve sloping down. Sellers want higher prices, so they produce more as prices rise; that's the supply curve sloping up. The market-clearing price is the one price where the quantity buyers want exactly equals the quantity sellers offer. Above it, unsold surplus pushes price back down. Below it, shortages push it back up.

Setting up the scenario

Imagine a regional gasoline market. At $3.00/gallon, refiners supply 100 million gallons a week and drivers demand 130 million. Shortage: 30 million gallons short.

Finding equilibrium

What has to happen to close that 30-million-gallon gap?

Price rises. As it does, two things happen simultaneously: some drivers cut discretionary trips (demand falls), and refiners find it worth running idle capacity (supply rises). Say equilibrium lands at $3.50/gallon, where both sides want 115 million gallons. That's the market-clearing price. No surplus, no shortage.

The mechanism works in reverse too. If supply jumps (say a new pipeline opens), price falls until demand rises to absorb the extra supply.

How fast and cleanly this mechanism works depends on how competitive the market is. In electricity markets, the clearing mechanism runs every five minutes, and the structure has some unusual features worth examining separately.

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