Law of Supply and Demand

What Is the Law of Supply and Demand?

The law of supply and demand is a theory that explains the interaction between the sellers of a resource and the buyers for that resource. The theory defines the relationship between the price of a given good or product and the willingness of people to either buy or sell it. Generally, as price increases, people are willing to supply more and demand less and vice versa when the price falls.

The theory is based on two separate "laws," the law of demand and the law of supply. The two laws interact to determine the actual market price and volume of goods on the market.

Key Takeaways

  • The law of demand says that at higher prices, buyers will demand less of an economic good.
  • The law of supply says that at higher prices, sellers will supply more of an economic good.
  • These two laws interact to determine the actual market prices and volume of goods that are traded on a market.
  • Several independent factors can affect the shape of market supply and demand, influencing both the prices and quantities that we observe in markets.
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Law of Supply and Demand

Understanding the Law of Supply and Demand

The law of supply and demand, one of the most basic economic laws, ties into almost all economic principles somehow. In practice, people's willingness to supply and demand a good determines the market equilibrium price or the price where the quantity of the good that people are willing to supply equals the quantity that people demand.

However, multiple factors can affect both supply and demand, causing them to increase or decrease in various ways.

Demand

The law of demand states that if all other factors remain equal, the higher the price of a good, the fewer people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good.

As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

Supply

Like the law of demand, the law of supply demonstrates the quantities sold at a specific price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. From the seller's perspective, each additional unit's opportunity cost tends to be higher and higher. Producers supply more at a higher price because the higher selling price justifies the higher opportunity cost of each additional unit sold.

It is important for both supply and demand to understand that time is always a dimension on these charts. The quantity demanded or supplied, found along the horizontal axis, is always measured in units of the good over a given time interval. Longer or shorter time intervals can influence the shapes of both the supply and demand curves.

Supply and Demand Curves

At any given point in time, the supply of a good brought to market is fixed. In other words, the supply curve, in this case, is a vertical line, while the demand curve is always downward sloping due to the law of diminishing marginal utility. Sellers can charge no more than the market will bear based on consumer demand at that point in time.

Over longer intervals of time, however, suppliers can increase or decrease the quantity they supply to the market based on the price they expect to charge. So over time, the supply curve slopes upward; the more suppliers expect to charge, the more they will be willing to produce and bring to market.

For all periods, the demand curve slopes downward because of the law of diminishing marginal utility. The first unit of a good that any buyer demands will always be put to that buyer's highest valued use. For each additional unit, the buyer will use it (or plan to use it) for a successively lower-valued use.

Shifts vs. Movement  

For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena.

A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes per the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price and vice versa.

Like a movement along the demand curve, the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes by the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price and vice versa.

Shifts

Meanwhile, a shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though the price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A change in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is impacted by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.

Equilibrium Price

Also called a market-clearing price, the equilibrium price is the price at which the producer can sell all the units he wants to produce, and the buyer can buy all the units he wants.

With an upward-sloping supply curve and a downward-sloping demand curve, it is easy to visualize that the two will intersect at some point. At this point, the market price is sufficient to induce suppliers to bring to market the same quantity of goods that consumers will be willing to pay for at that price. Supply and demand are balanced or in equilibrium. The exact price and amount where this occurs depend on the shape and position of the respective supply and demand curves, each of which can be influenced by several factors. 

Factors Affecting Supply

  • Supply is largely a function of production costs, including:
  • Labor and materials (which reflect their opportunity costs of alternative uses to supply consumers with other goods)
  • The physical technology available to combine inputs
  • The number of sellers and their total productive capacity over the given time frame
  • Taxes, regulations, or additional institutional costs of production

Factors Affecting Demand

Consumer preferences among different goods are the most important determinant of demand. The existence and prices of other consumer goods that are substitutes or complementary products can modify demand. Changes in conditions that influence consumer preferences can also be significant, such as seasonal changes or the effects of advertising. Changes in incomes can also be important in either increasing or decreasing the quantity demanded at any given price.

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

In essence, the Law of Supply and Demand describes a phenomenon familiar to all of us from our daily lives. It describes how, all else being equal, the price of a good tends to increase when the supply of that good decreases (making it rarer) or when the demand for that good increases (making the good more sought after). Conversely, it describes how goods will decline in price when they become more widely available (less rare) or less popular among consumers. This fundamental concept plays a vital role throughout modern economics.

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. For example, a company launching a new product might deliberately try to raise the price of its product by increasing consumer demand through advertising.

At the same time, they might try to further increase their price by deliberately restricting the number of units they sell to decrease supply. In this scenario, supply would be minimized while demand would be maximized, leading to a higher price.

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

To illustrate, let us continue with the above example of a company wishing to market a new product at the highest possible price. To obtain the highest profit margins likely, that same company would want to ensure that its production costs are as low as possible.

To do so, it might secure bids from a large number of suppliers, asking each supplier to compete against one another to supply the lowest possible price for manufacturing the new product. In that scenario, the supply of manufacturers is being increased to decrease the cost (or “price”) of manufacturing the product.