No other diagram is as important to understand economics as the image below. None, bar none.
No other diagram is as misunderstood either, and therein lies a tale.
Here’s a useful tip whenever you’re looking at a diagram, plot or chart for the first time. Don’t look at it.
The brain is looking for a story, a plot, a narrative with which to understand what is going on, and we take a look at the story that is being told to us. We might take a look at the content of the chart, the title of the chart – but very rarely do we take the time to take a look at the axes of the chart. Economists and statisticians learn this the hard way, by being fooled more often they should be – but you needn’t make that mistake. Remember, whenever you’re taking a look at a visualization for the first time, always take a look at the axes.
And in this case, the vertical axis shows you the price (they don’t mention this, but it is the per unit price), and the horizontal axis shows you the quantity demanded, measured in units. That is, if in this diagram you pick the intersection of the red line and the blue line to analyze, and assume that P* is 10 and Q* is 100…
… what that would mean is that the market is willing to demand 100 units of a good (say, standard size packets of Parle-G) when the price is 10 rupees per standard size packet of Parle-G. The reason we can say this is because that point of intersection lies on the red line, which is the demand curve.
Of course, since the point of intersection lies on blue curve as well, it also means that the market is willing to supply 100 units of standard size packets of Parle-G when the price is 10 rupees per standard size packet of Parle-G.
That is, we are in a happy instance of the suppliers in the market being willing to supply exactly the amount that consumers in the market are willing to buy – at that particular price of 10 rupees, per standard size packet of Parle-G. The amount that is being produced is exactly the amount that is being demanded, and we economists therefore call this the market clearing price.
We need to be aware of a couple of things that are often left unsaid. One, we really ought to be speaking about the quantity demanded and supplied per time unit. This could be per hour, per minute, per year – but it needs to be per something. It isn’t much use to say that markets clear, because how long they take to clear also matters.
Second, this equilibrium isn’t a magical things that simply happens – it is the outcome of a process that involves buyers and sellers transacting with each other repeatedly, over time. It is this process that economics studies. In other words, the diagram you are taking a look at is the outcome of a process – and it is the process that is the most interesting.
So interesting, in fact, that we’re going to be devoting an entire post to it.