Law of Supply and Demand in Economics: How it Works (2023)

What is the law of supply and demand?

The law of supply and demand combines two basic economic principles that describe how changes in the price of a resource, commodity, or product affect supply and demand.

When the price increases, the supply increases while the demand decreases. On the other hand, when the price falls, the supply decreases while the demand increases.

The supply and demand levels for different prices can be plotted as curves on a graph. The intersection of these curves marks thebalance, omarket equilibrium pricewhere demand is equal to supply and represents the processprice discoverynot market.

Understand the law of supply and demand.

It may seem obvious that this is the case with all salestransactionThe price satisfies both the buyer and the seller and matches supply and demand. The interactions between supply, demand and price in a (more or less) free market have been observed for thousands of years.

Many medieval thinkers, as well as modern critics of market prices for selected goods, made a distinction between a "fair" price based on reasonable costs and returns, and a price at which the sale actually took place.Our understanding of price as a signaling mechanism linking supply and demand isrooted in the work of Enlightenment economistswho examined and summarized the relationship.

It is important to note that supply and demand do not necessarily respond proportionally to price movements. The extent to which price changes affect the supply or demand for a product is called price elasticity. products with highthe price elasticity of demandDepending on the price, there will be greater fluctuations in demand. Conversely, basic necessities will be relatively inelastic in price because people cannot easily do without them, which means demand will change less relative to price changes.

Price discovery based on supply and demand curves assumes a market where buyers and sellers may or may not trade freely, depending on price. Factors such as government taxes and regulations, the market power of suppliers, the availability of substitutes, and business cycles can change or alter the shape of supply or demand curves. But as long as buyers and sellers have leeway, merchandise affected by these external factors will remain subject to the fundamental forces of supply and demand. Now let's take a look at how demand and supply react to price changes.

The Law of Demand

Olaw of demandIt states that the demand for a product changes inversely with its price, other things being equal. In other words, the higher the price, the lower the demand.

Since buyers have limited resources, their spending on a particular product or item is also limited, so higher prices reduce the quantity demanded. On the other hand, when the product becomes more accessible, the demand increases.

As a result, the demand curves slope from left to right, as shown in the graph below. Changes in the level of demand as a function of the price of a product relative to the income or resources of buyers are calledperformance effect.

Of course there are exceptions. one andGiffen merchandise, usually budget staples, akainferior goods. Inferior goods are those for which demand falls as income rises because consumers switch to higher value products. But when the price of an inferior good goes up and demand goes up because consumers are using more instead of more expensive alternatives, thereplacement effectconverts the product into a Giffen good.

At the other end of the income and wealth spectrumVeblen-Warethey are luxuries that increase in value as their price increases and, consequently, generate greater demand because the price of these luxuries signals (and possibly even increases) the status of the owner. Veblen products are named after economists and sociologists.Thorstein Veblen, who developed the concept and coined the term “conspicuous consumption”.

The law of supply

Olaw of supplyrelates the price variations of a product to the quantity shipped. Unlike the law of demand, the law of supply is simple, not the other way around. The higher the price, the higher thedelivered quantity. Lower prices mean less supply, all else being equal.

Higher prices give suppliers an incentive to offer more of the product or merchandise, as long as their costs do not increase too much. Lower prices lead to acost pressurethat limits supply. As a result, the supply slopes increase from left to right.

As with demand, supply constraints can limit thisprice elasticity of supplyfor a product whilesupply shocksmay result in a disproportionate change in the price of an essential good.

equilibrium price

The equilibrium price, also known as the clearing market price, is the price at which demand equals supply and an acceptable market equilibrium is established for buyers and sellers.

At the point where an ascending supply curve and a descending demand curve intersect, supply and demand balance in terms of quantity of goods, leaving no excess supply or unsatisfied demand. The market equilibrium price level depends on the shape and position of the respective supply and demand curves, which are influenced by numerous factors.

Factors influencing supply

In industries where suppliers are not willing to lose money, the prices of the products below will tend to be close to zero supply.production costs.

Price elasticity also depends on the number of sellers, their total production capacity, the ease with which it can be reduced or increased, and the industry.competitive dynamics. Taxes and regulations can also play a role.

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 product preferences.Marktdurchdringung, from themarginal utilityof goodsdecreaseswhen the possessed mob increases. The first car is more life-changing than the fifth addition to the fleet; the television in the room more useful than the room for the garage.