We’re going to start with a circular flow diagram, which pictures the economy in terms of flows of goods, services, and payments between two groups, households and firms, through three markets: goods, labor, and financial capital.

The goods market includes all the items that households buy: food, clothes, furniture, haircuts, phone service, computers, and so on. In the goods market, goods flow from the firms, which produce the goods, to the households. Households make payments for the goods, which flow back to the firms. In the jargon of economists, firms are the suppliers of goods and households are the demanders of goods.

In the labor market, labor flows from households—that is, from people who work—to the firms who hire those workers. For example, the Target Corporation has about 350,000 employees. Payments flow from the company to the workers and their households in the form of wages and benefits. In this market, the roles of supply and demand are reversed from the goods market; firms demand labor, while households supply labor.

In the financial markets, households invest money—either directly by buying shares of stock or indirectly by putting their savings in a bank, which in turn invests in or lends to firms. The households are paid for those investments by the firms in the form of interest and dividends. Thus, households are suppliers of financial capital and firms are demanders. (It should be noted that firms may also supply capital, but they invest on behalf of their owners and shareholders—that is, households again.)

The circular flow diagram shows how all three circles run through households and firms, and thus, how all three markets are part of a larger, integrated macroeconomic whole. Later on we’ll look at how government and other nations interact with these three loops, but for starters, let’s focus on these two sets of actors and three markets in which they interact.

In the first of three markets—the goods market—where do prices come from? When many noneconomists talk about prices, they talk about prices being “too high” or “too low,” which is best understood as a way of comparing the world as it is to the world as they think it ought to be. You’ll hear statements such as “nurses are paid too little” or “gasoline costs too much.” To an economist, this sort of judgment is like saying the weather today is “too cold” or “too hot.” It tells you something about the preferences of the person, but nothing about why things are as they are.

To noneconomists, prices are typically value-laden. Economists try to avoid those sorts of value judgments, which we call the diamond water paradox. This paradox goes back to the forefather of all economists, Adam Smith (1776 [1994], pp. 31–32), and The Wealth of Nations , in which he draws a distinction between “value in exchange” and “value in use.” Diamonds have great value in exchange. If you have one to trade, you can get a lot for it. But diamonds don’t have much value in use—you can’t eat them, they don’t trim your hedges for you, and they make lousy paperweights. They’re basically frivolous, a luxury. Water, on the other hand, is one of the basic necessities of life, not to mention water’s not-so-basic uses, such as transport and steam power. It has very high value in use. But water is also extremely cheap. In most places, it falls out of the sky for free, and in normal circumstances its value in exchange is correspondingly low.

Clearly, value in exchange and value in use don’t always line up. So when we look at the price of an item, which of these values are we talking about? When economists talk about price, we’re talking about the exchange value. The exchange value of a good is tied to its scarcity—how much of the good there is relative to how many people want it. Diamonds have a high price because, compared with how many diamonds there are, lots of people want them enough to pay a high price. Water has a low price because, compared with how much is available, people aren’t willing to pay much for it. You can imagine a situation in which someone dying of thirst would be willing to trade diamonds for water, but that’s not the norm!

The dramatist Oscar Wilde (1891) once defined a cynic as “a man who knows the price of everything and the value of nothing.” That’s also a good description of economists, who focus on the price of everything and the intrinsic value in use of nothing. To think about price like an economist, you need to purge your mind of preconceptions about a good’s value in use. When you get used to it, separating prices from judgments about value is emotionally liberating. You don’t have to think about whether a price is “right” or whether it’s an accurate reflection of your personal values. Price is what happens out in the world from the interaction of supply and demand, from what’s available and what people want.

I’ve been tossing the terms “supply” and “demand” around rather loosely, but they actually have quite specific meanings. When economists talk about demand for a good, they’re referring to the relationship between the price of a good and the quantity of that good that’s demanded. For most goods, most of the time, as the price of the good goes up, the quantity demanded tends to drop.

This is easy to visualize with a graph. The quantity of the good is on the horizontal axis, and the price of the good is on the vertical axis. The curve representing demand slopes downward. That downward slope tells you that as the price drops further and further, the quantity demanded gets bigger and bigger.

At the gut level, this pattern makes sense, but what’s the actual cause? Economists have offered two specific reasons. One is the “substitution effect.” As the price of a good goes up and up, people tend to substitute other goods for it. For example, as the price of orange juice goes up, people substitute other drinks, or perhaps vitamin C pills. As the price of gasoline goes up, people might drive less, they might join carpools, or they might buy cars that have higher gas mileage.

The other reason is called an “income effect.” As the price of a good rises, your income has less buying power, so you can’t buy everything you did before—you buy either fewer things or less of the same things. For example, if you’re someone who likes to buy fancy coffee every morning on your way to work, and the price of your favorite beverage goes up to $100 a cup, you probably can’t buy that cup of coffee every morning. The buying power of your income in terms of coffee is reduced. Even if the price rises only a little bit, the buying power of your income is diminished, and the income effect forces you to buy less of that good or other goods.

It’s important not to confuse the terms “demand” and “quantity demanded” as economists use them. “Quantity demanded” refers to the specific amount of a good that is desired at each given price. In 2009, about 120 million bags of coffee were sold at a price of $1.15 per pound. “Demand” refers to the relationship between price and quantity demanded. It refers to how much is desired at any possible price or at every price. As the price of coffee rises, the quantity of coffee demanded will decline. In terms of our graph, quantity demanded is a point, but demand is the curve.

So here’s a trick question: What makes demand rise or fall? The answer is not price; price affects the quantity demanded, but it doesn’t cause the demand relationship itself to move. When economists talk about “demand” shifting, we’re not talking about one point moving up or down; we’re talking about the whole demand curve shifting up or down by the same amount. We’re talking about a situation in which, at every given price on the axis, the same larger or smaller quantity is demanded. What could cause such a change?

Now let’s turn to supply. Supply refers to the relationship between the quantity of a good supplied and the price of a good. As the price of the good goes up, the quantity supplied tends to rise, too, because as the good’s price rises, firms become more willing to supply that good. So whereas our demand curve sloped downward, the supply curve slopes upward.

Once again, this probably makes some intuitive sense, but economists have tried to spell out specific reasons behind the pattern. First, existing firms want to produce more as the price rises because they can earn higher profits. Second, new firms decide to enter the market and start producing the good if the price rises enough.

Just as there’s often confusion between “demand” and “quantity demanded,” there’s a parallel confusion between “supply” and “quantity supplied.” Quantity supplied refers to the specific amount produced at a given price. Supply refers to how much is produced at every price. Quantity supplied is a point, and supply is a curve.

Here’s that trick question again, this time from the supply perspective: What makes supply rise or fall? Again, it’s not price. Price causes the quantity supplied to change, but it doesn’t shift the entire supply curve. For supply to increase, the whole supply relationship has to move, so that at every given price, a larger quantity will be supplied. Conversely, for supply to fall, at every given price, a smaller quantity must be supplied. What are some examples of factors that could move supply in this way?

Now we’re ready to look at how supply and demand interact. Let’s start off by thinking about a basic good, such as pizza. Let’s first consider the situation with a low price. At a low price, the quantity supplied is correspondingly low because nobody wants to produce the good, but the quantity demanded is likely to be relatively high because many people want to buy lots of pizza at that low price. As the price of pizza rises a little, the quantity supplied increases; restaurants want to produce more of the good. But when the price rises, the quantity demanded drops off; people are less willing to buy the pies. As quantity supplied rises and quantity demanded falls, at some point the quantity of pizza demanded is equal to the quantity supplied. That point is called the equilibrium.

What does equilibrium mean in practical terms? If a good’s price is higher than the equilibrium, then the quantity supplied of that good will exceed the quantity demanded. Stuff starts piling up on the shelves. To get rid of it, the seller has to start cutting prices until people are willing to buy. The price starts to drop toward that equilibrium point, where the quantity supplied and the quantity demanded meet. Equilibrium is the point at which price and quantity are efficient in the specific economic sense that nothing is being wasted. Just as an efficient machine has no wasted motion, or no extra parts, an efficient market has no extra products sitting around, or no extra demand for products that are not there.

If the price of a good falls below the equilibrium, then quantity demanded will exceed quantity supplied. In that situation, people are practically lining up to buy that good before supplies at the local store run out. Suppliers notice this, and they begin to raise prices. As a result, quantity demanded begins to fall and quantity supplied starts to rise, until again, the two quantities are equal and the price reaches equilibrium.

Equilibrium is the point toward which a market economy tends—but that’s not to say that markets are always at equilibrium. There are long-standing disputes over how long it takes markets to reach equilibrium, how close they usually are to equilibrium, and when or whether market prices will overshoot equilibrium and need to bounce back. In the mid-2000s, housing prices in the United States clearly veered well above equilibrium for a period of several years before the pendulum began to swing the other way. But over time, markets typically tend in the direction of equilibrium.

Any change in demand or supply—remember, that’s a change in the whole curve—will cause the equilibrium point to shift. Consider, for example, the market for beef. If income rises, then the demand for beef rises. The result would be a situation in which the new equilibrium has a higher price and quantity sold in the market. Now imagine the opposite situation. Let’s say there’s an outbreak of cattle disease, and the supply of beef drops as a result. The outcome would be a lower quantity and a higher price sold at equilibrium. A lot of an introductory economics class is devoted to thinking through the consequences of these demand and supply shifts. The specific goods and examples change, but the basic pattern is the same: Think about demand, think about supply. Start at equilibrium; think about what would happen if demand or supply shifted. Think about what new price and quantity would result at the new equilibrium. Supply and demand is a framework for discussing how prices and quantities are determined in markets and why those market prices and quantities are going to change. Understand this, and you’re on your way to a solid grasp of the basics of economics.

In the real world, equilibrium means only that quantity demanded and quantity supplied are in balance; it doesn’t mean that people feel content with the result. Some buyers will always say, “I think I’m paying too much.” Some sellers will always say, “I can’t believe it’s selling for so little.” Sometimes buyers or sellers will go to the government and lobby for a change in the price of a good, even when the market for that good is at or near equilibrium. In the next chapter, we’ll talk about some consequences that arise when this happens.

One common complaint about the supply-and-demand model is that “real people don’t think that way.” At one level, this is obviously true: most people don’t use these terms or draw graphs in their heads. But as long as buyers search for what they prefer at the lowest possible price, taking their desires, their finances, and their possibilities for substitution into account, and as long as firms adjust their production in response to changes in price, the supply-and-demand approach will work reasonably well. The reality of supply and demand may not always be likable, or morally attractive, or desirable in any deep philosophical sense, but it is a useful tool—a powerful and accurate way of describing and understanding why prices are at the levels they are and why prices might be rising or falling. It works as a way of describing markets all over the world, at all different times in history, and for all sorts of products—from pencils to pizza.