Law of Supply and Demand in Economics: How It Works (original) (raw)

What Is the Law of Supply and Demand?

The law of supply and demand combines two fundamental economic principles that describe how changes in the price of a resource, commodity, or product affect its supply and demand. Supply rises while demand declines as the price increases. Supply constricts while demand grows as the price drops.

Levels of supply and demand for varying prices can be plotted on a graph as curves. The intersection of these curves marks the equilibrium or market-clearing price at which demand equals supply and represents the process of price discovery in the marketplace.

Key Takeaways

• The law of demand holds that the demand level for a product or a resource will decline as its price rises and rise as the price drops.
• The law of supply says that higher prices boost the supply of an economic good and lower ones tend to diminish it.
• A market-clearing price balances supply and demand and can be graphically represented as the intersection of the supply and demand curves.
• The degree to which changes in price translate into changes in demand and supply is known as the product's price elasticity.
• Demand for basic necessities is relatively inelastic. It's less responsive to changes in their price.

Investopedia / Alex Dos Diaz

Understanding the Law of Supply and Demand

It may seem obvious that the price satisfies both the buyer and the seller in any sale transaction, matching supply with demand. The interactions between supply, demand, and price in a free marketplace have been observed for thousands of years.

Many medieval thinkers distinguished between a "just" price based on costs and equitable returns and one at which the sale was transacted, just like modern-day critics of market pricing for select commodities.

Our understanding of price as a signaling mechanism matching supply and demand is rooted in the work of Enlightenment economists who studied and summarized the relationship.

Supply and demand don't necessarily respond to price movements proportionally. The degree to which price changes affect the product's demand or supply is known as its price elasticity.

Note

Price discovery based on supply and demand curves assumes a marketplace in which buyers and sellers are free to transact or not depending on the price.

Products with a high price elasticity of demand will see wider fluctuations in demand based on the price. Basic necessities will be relatively inelastic in price because people can't easily do without them so demand will change less relative to changes in the price.

Factors such as taxes and government regulation, the market power of suppliers, the availability of substitute goods, and economic cycles can all shift the supply or demand curves or alter their shapes. However, the commodities affected by these external factors remain subject to the fundamental forces of supply and demand as long as buyers and sellers retain agency.

The Law of Demand

The law of demand holds that demand for a product changes inversely to its price when all else is equal. The higher the price, the lower the level of demand.

Buyers have finite resources so their spending on a given product or commodity is limited as well. Higher prices reduce the quantity demanded as a result. Demand rises as the product becomes more affordable.

Changes in demand levels as a function of a product's price relative to buyers' income or resources are known as the income effect.

But some exceptions exist. One is Giffen Goods. These are typically low-priced staples also known as inferior goods. They're those who see a drop in demand when incomes rise because consumers trade up for higher-quality products.

The substitution effect turns the product into a Giffen good when the price of an inferior good rises and demand goes up because consumers use more of it in place of costlier alternatives.

Veblen goods are at the opposite end of the income and wealth spectrum. They're luxury goods that gain in value and consequently generate higher demand levels as they rise in price because the price of these luxury goods signals and may even increase the owner's status.

Veblen goods are named for economist and sociologist Thorstein Veblen who developed the concept and coined the term "conspicuous consumption" to describe it.

The Law of Supply

The law of supply relates price changes for a product to the quantity supplied. The law of supply relationship is direct, not inverse. The higher the price, the higher the quantity supplied. Lower prices mean reduced supply all else being equal.

Higher prices give suppliers an incentive to supply more of the product or commodity, assuming their costs aren't increasing as much. Lower prices result in a cost squeeze that curbs supply. Supply slopes are upwardly sloping as a result.

As with demand, supply constraints may limit the price elasticity of supply for a product. Supply shocks can cause a disproportionate price change for an essential commodity.

Equilibrium Price

Also called a market-clearing price, the equilibrium price is that at which demand matches supply, producing a market equilibrium that's acceptable to buyers and sellers.

Supply and demand in terms of the quantity of the goods are balanced at the point where an upward-sloping supply curve and a downward-sloping demand curve intersect leaving no surplus supply or unmet demand.

The level of the market-clearing price depends on the shape and position of the respective supply and demand curves, which are influenced by numerous factors.

Factors Affecting Supply

Supply will tend to decline toward zero at product prices below production costs in industries where suppliers aren't willing to lose money.

Price elasticity will also depend on the number of sellers, their aggregate productive capacity, how easily it can be lowered or increased, and the industry's competitive dynamics. Taxes and regulations may matter as well.

Factors Affecting Demand

Consumer income, preferences, and willingness to substitute one product for another are among the most important determinants of demand.

Consumer preferences will depend in part on a product's market penetration because the marginal utility of goods diminishes as the quantity owned increases. The first car is more life-altering than the fifth addition to the fleet. The living room TV is more useful than the fourth one for the garage.

What Is a Simple Explanation of the Law of Supply and Demand?

Higher prices cause supply to increase as demand drops. Lower prices boost demand while limiting supply. The market-clearing price is one at which supply and demand are balanced.

Why Is the Law of Supply and Demand Important?

The law of supply and demand is essential because it helps investors, entrepreneurs, and economists understand and predict market conditions. A company that's considering a price hike on a product will typically expect demand for it to decline as a result and will attempt to estimate the price elasticity and substitution effect to determine whether to proceed.

What Is an Example of the Law of Supply and Demand?

Gasoline consumption plunged with the onset of the COVID-19 pandemic in 2020 and prices quickly followed because the industry ran out of storage space. The price decline in turn served as a powerful signal to suppliers to curb gasoline production. Crude oil prices in 2022 then provided producers with additional incentive to boost output.

The Bottom Line

The law of supply and demand reflects two central economic principles that describe the relationship between price, supply, and demand.

The law of demand posits that demand declines when prices rise for a given resource, product, or commodity. Demand increases as prices fall. On the supply side, the law posits that producers supply more of a resource, product, or commodity as prices rise. Supply falls as prices fall.

The price at which demand matches supply is the equilibrium, the point at which the market clears. The law of supply and demand is critical in helping all players within a market understand and forecast future conditions.