What Is the Law of Supply and Demand?

What Is the Law of Supply and Demand?

You need to understand that the law of supply and demand brings together two core economic ideas that show how price shifts impact the supply and demand of any resource, commodity, or product.

I'm telling you directly: this law looks at what suppliers want to offer (that's supply) versus what consumers want to buy (that's demand). When everything else stays the same, as the price goes up, supply increases but demand drops. You can plot these levels for different prices on a graph as curves, and where they cross is the equilibrium price— the point where demand equals supply, which is how prices get discovered in the market.

Understanding the Law of Supply and Demand

It might seem straightforward that in any sale, the price works for both the buyer and seller, matching supply with demand. People have observed these interactions in free markets for thousands of years.

Back in medieval times, thinkers talked about a 'just' price based on costs and fair returns, separate from the actual transaction price, much like today's critics of market pricing for certain goods.

Our modern view of price as a signal that balances supply and demand comes from Enlightenment economists who studied and explained this relationship.

Remember, supply and demand don't always change in proportion to price movements. The extent to which price changes affect demand or supply is called price elasticity.

In a marketplace where buyers and sellers can freely choose to transact based on price, that's where price discovery happens through supply and demand curves.

For products with high price elasticity of demand, you'll see bigger swings in demand when prices change. But for basic necessities, demand is relatively inelastic— it doesn't shift much with price changes because people can't easily go without them.

Things like taxes, regulations, supplier market power, substitute goods, and economic cycles can move the supply or demand curves or change their shapes. Still, as long as buyers and sellers have control, the basic forces of supply and demand apply to those commodities.

The Law of Demand

The law of demand states that, all else equal, demand for a product moves inversely with its price. Higher prices mean lower demand levels.

Buyers have limited resources, so spending on a product is capped. That's why higher prices cut the quantity demanded, and demand grows when the product gets cheaper.

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

There are exceptions, though. Take Giffen goods— these are low-priced staples, or inferior goods, where demand drops when incomes rise because people switch to better options.

The substitution effect can make an inferior good a Giffen good: if its price rises, demand increases because consumers use more of it instead of pricier alternatives.

On the other side, Veblen goods are luxury items that gain value and demand as prices increase, signaling higher status for the owner. This comes from economist Thorstein Veblen, who described 'conspicuous consumption'.

The Law of Supply

The law of supply connects price changes to the quantity supplied, and it's a direct relationship. Higher prices lead to more supply; lower prices mean less, all else equal.

Higher prices motivate suppliers to produce more, as long as their costs aren't rising too much. Lower prices squeeze costs and reduce supply, so supply curves slope upward.

Like with demand, constraints can limit supply's price elasticity. Supply shocks can cause big price jumps for essential commodities.

Equilibrium Price

The equilibrium price, or market-clearing price, is where demand equals supply, satisfying both buyers and sellers.

At this point, the upward-sloping supply curve meets the downward-sloping demand curve, balancing quantities with no surplus or shortage.

This price level depends on the curves' shapes and positions, affected by many factors.

Factors Affecting Supply

In industries where prices fall below production costs, supply drops toward zero because suppliers won't take losses.

Price elasticity here depends on the number of sellers, their total capacity, how easily it adjusts, competitive dynamics, plus taxes and regulations.

Factors Affecting Demand

Key drivers of demand include consumer income, preferences, and the option to switch products.

Preferences tie into market penetration, as the utility of additional units decreases— your first car changes your life more than a fifth one, and the main TV is more useful than an extra in the garage.

A Simple Explanation of the Law of Supply and Demand

Higher prices increase supply but decrease demand. Lower prices do the opposite, boosting demand while cutting supply. The balancing point is the market-clearing price.

Why Is the Law of Supply and Demand Important?

This law matters because it lets investors, entrepreneurs, and economists predict market conditions. If a company plans a price increase, they'll expect demand to fall and calculate elasticity and substitution effects to decide.

An Example of the Law of Supply and Demand

During the 2020 COVID-19 pandemic, gasoline use dropped sharply, and prices fell as storage filled up. This signaled suppliers to cut production. Then in 2022, higher crude oil prices encouraged more output.

The Bottom Line

The law of supply and demand captures two key economic principles linking price, supply, and demand.

Demand falls as prices rise for a resource, product, or commodity, and rises as prices drop. Supply increases with higher prices and decreases with lower ones.

Equilibrium is where demand meets supply, clearing the market. This law is essential for understanding and forecasting market conditions.