Law of Supply and Demand in Economics: How It Works
What Is the Law of Supply and Demand?
The law of supply and demand combines two fundamental economic principles describing how changes in the price of a resource, commodity, or product affect its supply and demand.
As the price increases, supply rises while demand declines. Conversely, as the price drops supply constricts while demand grows.
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.
- 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.
- Conversely, the law of supply says higher prices boost supply of an economic good while 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, meaning it is less responsive to changes in their price.
Understanding the Law of Supply and Demand
It may seem obvious that in any sale transaction the price satisfies both the buyer and the seller, matching supply with demand. The interactions between supply, demand, and price in a (more or less) free marketplace have been observed for thousands of years.1
Many medieval thinkers, like modern day critics of market pricing for select commodities, distinguished between a “just” price based on costs and equitable returns and one at which the sale was in fact transacted.2 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.
Importantly, supply and demand do not 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. Products with a high price elasticity of demand will see wider fluctuations in demand based on the price. In contrast, basic necessities will be relatively inelastic in price because people can’t easily do without them, meaning demand will change less relative to changes in the price.
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. 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. But so long as buyers and sellers retain agency, the commodities affected by these external factors remain subject to the fundamental forces of supply and demand. Now let’s consider in turn how demand and supply respond to price changes.
The Law of Demand
The law of demand holds that demand for a product changes inversely to its price, all else being equal. In other words, the higher the price, the lower the level of demand.
Because buyers have finite resources, their spending on a given product or commodity is limited as well, so higher prices reduce the quantity demanded. Conversely, demand rises as the product becomes more affordable.
As a result, demand curves slope downward from left to right, as in the chart below. Changes in demand levels as a function of a product’s price relative to buyers’ income or resources are known as the income effect.
Naturally, there are exceptions. One is Giffen goods, typically low-priced staples also known as inferior goods. Inferior goods are those that see a drop in demand when incomes rise because consumers trade up to higher-quality products. But when the price of an inferior good rises and demand goes up because consumers use more of it in place of costlier alternatives, the substitution effect turns the product into a Giffen good.
At the opposite end of the income and wealth spectrum, Veblen goods are 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 with the quantity supplied. In contrast with the law of demand 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 held 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. As a result, supply slopes are upwardly sloping from left to right.
As with demand, supply constraints may limit the price elasticity of supply for a product, while supply shocks may cause a disproportionate price change for an essential commodity.
Also called a market-clearing price, the equilibrium price is the price at which demand matches supply, producing a market equilibrium acceptable to buyers and sellers.
At the point where an upward-sloping supply curve and a downward-sloping demand curve intersect, supply and demand in terms of the quantity of the goods are balanced, 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
In industries where suppliers are not willing to lose money, supply will tend to decline toward zero at product prices below production costs.
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, since 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 more useful than the fourth one for the garage.
What Is a Simple Explanation of the Law of Supply and Demand?
If you’ve ever wondered how the supply of a product matches demand, or how market prices are set, the law of supply and demand holds the answers. Higher prices cause supply to increase while 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. For example, a company 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 regardless.
What Is an Example of the Law of Supply and Demand?
When gasoline consumption plunged with the onset of the COVID-19 pandemic in 2020, prices quickly followed suit because the industry ran out of storage space. The price decline, in turn, served as a powerful signal to suppliers to curb gasoline production. Conversely, crude oil prices in 2022 provided producers with additional incentive to boost output.
- SSRN. “The First Laws in Economics and Indian Economic Thought – Thirukkural.”
- Worthwhile Canadian Initiative. “A Very Brief History of Demand and Supply.”