The Law of Supply and Demand is one of the fundamental principles of economics. It states that the quantity of a good or service that a seller is willing to supply is directly related to the price at which they can sell it, while the quantity of a good or service that a buyer is willing to purchase is directly related to the price at which they can buy it. In other words, the higher the price, the more willing sellers are to supply a good or service, and the lower the price, the less willing they are to supply it. Similarly, the higher the price, the less willing buyers are to purchase a good or service, and the lower the price, the more willing they are to purchase it.
There are several factors that can influence the supply and demand for a good or service. Some of these include the availability of resources, the cost of production, and the overall level of economic activity. For example, if there is a shortage of a particular resource, it may become more expensive to produce a good or service, which could lead to a decrease in the supply of that good or service. On the other hand, if there is an increase in the cost of production, it may become less profitable for sellers to produce a good or service, which could also lead to a decrease in supply.
The interaction between supply and demand determines the market price of a good or service. When the supply of a good or service is greater than the demand, the market price will tend to be lower, as sellers will be willing to lower their prices in order to attract buyers. Conversely, when the demand for a good or service is greater than the supply, the market price will tend to be higher, as buyers are willing to pay more in order to obtain the good or service.
The Law of Supply and Demand plays a central role in determining the allocation of resources in a market economy. By setting prices and determining the quantities of goods and services produced and consumed, it helps to ensure that resources are used efficiently and that the needs and preferences of consumers are met. The following are illustrative examples of the implications of this fundamental economic principle.
Price Decreases Demand
The basic direction of a demand curve points down as people generally demand less of a good when it is more expensive.
Price Increases Supply
The basic direction of a supply curve points up as market participants will find ways to increase supply as a higher price is offered.
Demand Increases Supply
More demand increases the price, creating more supply. For example, a television show talks about the health benefits of a particular fruit. Other media outlets pick up on the idea and a large number of people start buying the fruit. Demand increases dramatically, driving up prices. Farmers see these prices and begin to allocate land, labor and capital to producing the fruit. In the following years, the supply of the fruit doubles.
Supply Decreases Price
Increased supply results in a lower price. For example, if there were 10,000 computer science graduates each year they might each have multiple job offers and be in a good position to negotiate a high salary. However, if the number of computer science graduates suddenly jumped to 1 million, salaries would drop as competition for each position would become more intense.
Supply Increases Demand … Sometimes
In many cases, more supply ends up creating more demand by pushing prices down. This isn’t always true because if you’re supplying something people don’t want it will not impact demand. However, a product with healthy demand will generally see an increase in demand when supply increases. For example, if the supply of apples doubled next year prices would tumble and some consumers would buy more apples based on price comparisons with other foods.
The law of supply and demand explains the cycles of boom and bust experienced by many industries. A rising price causes capital investment to increase supply. Depending on the industry, it can take months or years for the new supply to show up. When supply does finally increase it causes prices to decline. The declining prices cause supply to drop as firms reallocate resources or exit the industry. The price begins to increase again due to less supply and the cycle repeats.
Extremely high inflation can cause the laws of supply and demand to break down. For example, inflation causes people to buy goods more quickly because money loses its value. This is a situation whereby higher prices may actually stimulate more demand as it simply causes people to fear the prices of tomorrow.
Giffen goods are a category of goods that people buy more as the price rises. This is another exception to the laws of supply and demand. For example, in some nations rice may be a giffen good. When the price of rice increases, people may buy less meat as they need to conserve their food budget. The decline in meat consumption results in more rice consumption as people need to replace the calories.