The interaction of demand and supply

In a market economy, prices allocate scarce resources through three functions: rationing, signalling and incentivising.

The rationing function operates when a good becomes scarcer. The reduced supply (or higher demand) drives the price up, which discourages some consumers from buying. In this way the limited supply is rationed among those who are most willing and able to pay, so the scarce good is shared out without queues or central direction.

The signalling function means that price changes act as signals to producers and consumers about where resources should flow. A rising price signals that consumers want more of a good (or that it has become scarcer), while a falling price signals the opposite. Prices therefore transmit consumers' preferences through the market, telling producers what to make.

The incentive function means that a higher price, by raising potential profit, gives producers an incentive to supply more and draws resources into that industry; a lower price gives the incentive to supply less and move resources elsewhere.

Together these functions reallocate resources automatically. For example, if demand for electric cars rises, the price rises (rationing current supply), the higher price signals strong demand, and the higher profit incentivises firms to expand production — so land, labour and capital move into making electric cars, all without any central planner. This is how the price mechanism answers the questions of what, how and for whom to produce.

Two changes occur simultaneously, one on each side of the market.

The disease destroying the crop reduces output and raises costs, so supply falls — the supply curve shifts left (S₁ → S₂). On its own this raises the equilibrium price and lowers the equilibrium quantity.

At the same time, rising demand for chocolate in fast-growing economies increases the demand for cocoa (a derived demand), so demand shifts right (D₁ → D₂). On its own this raises both the equilibrium price and quantity.

Combining the two effects: both the leftward supply shift and the rightward demand shift push the price upwards, so the equilibrium price of cocoa definitely rises, and probably rises sharply. The effect on quantity is indeterminate, however, because the fall in supply reduces quantity while the rise in demand increases it. The net change in quantity depends on the relative sizes of the two shifts: if the supply fall is larger, quantity falls; if the demand rise is larger, quantity rises.

So the diagram shows a clear, large rise in the price of cocoa, with an ambiguous change in quantity.

The price mechanism allocates resources through the rationing, signalling and incentive functions of price. The claim that it always does so efficiently is the foundation of free-market economics, but it has important exceptions.

The case that it allocates efficiently. Prices respond automatically to changes in demand and supply. A rise in demand raises price, which rations the scarce good, signals the change to producers, and incentivises them to supply more, drawing resources to where consumers value them most. This decentralised process uses the dispersed knowledge of millions of buyers and sellers, needs no costly bureaucracy, and tends to achieve allocative efficiency — resources flow to their most valued uses — and productive efficiency through competition.

The case against / where it fails. The mechanism does not always allocate efficiently, because of market failure:

• Public goods (e.g. defence) are not provided at all because of the free-rider problem.
• Externalities mean prices ignore costs/benefits to third parties (e.g. pollution is over-produced).
• Merit and demerit goods are mis-consumed because of imperfect information.
• Monopoly power lets firms restrict output and raise prices above the efficient level.
• The mechanism allocates by purchasing power, which may be efficient but is not equitable.

Judgement. The price mechanism allocates resources efficiently for most private goods in competitive markets, where its automatic signalling and incentives work well. But it does not allocate efficiently where market failures exist — public goods, externalities, information failures and monopoly. So the statement that it 'always' allocates efficiently is false as a general claim: the mechanism is an excellent allocator within its limits, which is precisely why real economies are mixed, using government intervention to correct the cases where the market fails. The most defensible conclusion is that the price mechanism is usually efficient but systematically fails in identifiable situations, so it allocates efficiently often, but not always.

Oil is linked to many markets through joint supply, derived demand, complements and substitutes, so a sustained rise in its price has wide effects.

Joint supply and complements. Petrol and diesel are produced from crude oil (joint supply) and are complements to cars. A higher oil price raises the price of petrol/diesel, which (as a complement) reduces the demand for petrol-powered cars — demand shifts left, lowering their price and quantity. Demand for fuel itself contracts (a movement along), though, as fuel demand is inelastic, by less than proportionately.

Derived demand. Transport firms use fuel as an input, so higher fuel costs raise their production costs, shifting the supply of transport services left and raising prices. Because demand for many goods relies on transport (a derived chain), costs rise across the economy, contributing to cost-push inflation.

Substitutes. Higher oil prices make substitutes relatively more attractive: demand for electric cars, public transport and renewable energy rises (their demand curves shift right), raising their prices and quantities and encouraging investment in them.

Judgement / qualifications. The size of these effects depends on elasticities and the time period. In the short run, demand for fuel and transport is very inelastic (few alternatives), so quantities change little and the main effect is higher prices and squeezed real incomes. In the long run, consumers and firms find substitutes (more fuel-efficient or electric vehicles, alternative energy), so the quantity effects grow and oil's dominance weakens. The effects also depend on whether the price rise is expected to persist: a sustained rise (as stated) triggers more substitution than a temporary one. The most defensible conclusion is that a sustained oil price rise raises costs and prices across complementary and derived markets in the short run, but its largest lasting effect is to accelerate substitution toward alternatives in the long run.