Supply and Demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers resulting in an economic equilibrium of price and quantity. This relationship between supply and demand can be seen in a plot of the classic supply-demand curve on the right. [1]
Definition: 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.
What are the Supply and Demand Laws?
The Supply and Demand model has two “laws,”: the (1) Law of Demand and the (2) Law of Supply. These laws interact with each other to determine the market price and volume of goods. The key components to the theory are:
Supply and Demand Outcomes
The four (4) basic outcomes of supply and demand are: [3]
- If demand increases and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.
- If demand decreases and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.
- If demand remains unchanged and supply increases, a surplus occurs, leading to a lower equilibrium price.
- If demand remains unchanged and supply decreases, a shortage occurs, leading to a higher equilibrium price.
(1) What is the Law of Demand?
The Law of Demand refers to the number of products people are willing to buy at different prices at a specific time. The law states that the higher the product price, the fewer people will demand the product. As a consumer, the higher a product costs, the less the amount of the product the consumer will purchase. This means the opportunity cost of buying that product goes down. [2]
Factors that influence the supply are:
- Consumer Preference
- Influence
- Number of Sellers
- Taxes and Regulations
(2) What is the Law of Supply?
Supply refers to the quantities of product manufacturers or owners are willing to sell at different prices at a specific time. The higher the price will result in the higher quantity supplied. As a seller, the opportunity cost of each product is higher, so they want to sell more, and producers want to produce more. [1]
Factors that influence the supply are:
- Labor and Materials costs
- Technology availability
- Number of sellers
- Capacity
- Taxes and Regulations
What is Supply and Demand Equilibrium?
The market price is the intersection of the demand price and quantities of products manufactured, and the intersection is called the equilibrium price or 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.
It is visualized on a chart at the intersection of the supply and demand curve. This intersection is the market price at which suppliers bring to market that same quantity of product that consumers will be willing to buy. They then say the Supply and Demand are in equilibrium. [1]
Purpose of the Supply and Demand Theory
The purpose of the Supply and Demand theory is to help people, businesses, bankers, investors, entrepreneurs, economists, government, and others understand and predict conditions in the market for best optimization.
Example of the Supply and Demand Theory
What Is an Example of the Law of Supply and Demand?
A bread company wants to introduce a new french bread to its market at the best possible price. To ensure the lowest production price, the manufacturer gets bids from many suppliers to obtain the lowest possible price for manufacturing the new bread. The lower the cost of the bread, the more profit the company can make if it determines the best price that sells the most quantity of bread. The equilibrium (Market Price) between the quantity of bread sold and the price should bring the most profit.
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Updated: 8/9/2022
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A Summary of how Demand and Supply Changes Affect Prices and Quantities
The following summarizes the important relationships between changes in demand and supply and their corresponding equilibrium prices and equilibrium quantities changes. These are changes that take place in the short-term (usually within several months). In the long run (one year or longer), most products (especially manufactured goods subject to a fair amount of competition) will experience further price and quantity changes. Long run price changes are discussed in more detail in a later section in this unit. When we refer to “equilibrium price” it represents the price or market price, meaning the price that the grocery store, department store, gas station, etc. charges in a free market. When we mention “equilibrium quantity”, it represents quantity or the amount of a certain product bought and sold in a store or where ever goods and services are sold.
When Demand Increases ==> Price Increases and Quantity Increases
When Demand Decreases ==> Price Decreases and Quantity Decreases
When Supply Increases ==> Price Decreases and Quantity Increases
When Supply Decreases ==> Price Increases and Quantity Decreases
A Simultaneous Increase in Demand and Supply
So we know that an increase in demand increases equilibrium price and quantity (and vice versa), and an increase in supply decreases equilibrium price and increases quantity (and vice versa). What happens if both demand and supply change at the same time?
Let’s analyze the following examples.
Example 1 Problem: Suppose that consumers’ incomes have gone up, and that an advance in technology has lowered the cost of making computers. Assuming that a computer is a normal good, what will happen to the equilibrium price and quantity of computers as a result of these two simultaneous changes?
Solution: An increase in consumers’ incomes increases the demand for computers. This increases the equilibrium price and equilibrium quantity. An advance in technology increases the supply. This decreases the equilibrium price and increases the equilibrium quantity. Combining these two effects, the equilibrium quantity increases because the equilibrium quantity increases in both instances. The equilibrium price increased and then decreased, so on balance, it will either increase, decrease, or stay the same, depending on the size of the shifts in the curves. If demand increases more than supply, then the price increases, and vice versa. If we don’t know the magnitude of the shifts, we say that the price is indeterminate.
In summary: Consumer Incomes ↑ ⇒Demand ↑ ⇒ Price ↑ and Quantity ↑ Advance in Technology ⇒ Supply ↑ ⇒ Price ↓ and Quantity ↑ ————————————————————————-
Combined Effect = Price change unknown (indeterminate) and Quantity increases
Example 2
Problem: Buyers expect prices of jewelry to increase in the near future, and at the same time, the government decides to tax the production of jewelry. What effect does this have on the market price and output of jewelry?
Solution: Current demand for jewelry increases because buyers expect the price to increase in the future. This increases the equilibrium price and the equilibrium quantity. Supply of jewelry decreases because the increased tax makes it less attractive for firms to supply the product. This increases the price of jewelry and decreases the quantity bought/sold. The combined effect is that the price of jewelry increases, and the equilibrium quantity change is indeterminate. Note that when both demand and supply shift, one variable (price or quantity) experiences a definite change, and the other is indeterminate (unless you know the magnitude of the shifts). When only one curve shifts, both equilibrium price and quantity experience a definite change.
In summary: Expected Future Price ↑ ⇒ Demand ↑ ⇒ Price ↑ and Quantity ↑ Production tax ↑ ⇒ Supply ↓ ⇒ Price ↑ and Quantity ↓ ————————————————————————-
Combined Effect = Price increases and Quantity change unknown (indeterminate)
Video Explanations
For video explanations of how changes in both demand and supply affect the equilibrium price and quantity of a product, please watch the following:
The labor market is a special case of supply and demand. The demand for labor is the businesses’ willingness and ability to hire workers. The supply of labor is the workers’ willingness and ability to work at certain wage rates.
For a labor market application of supply and demand changes and their effects on the equilibrium price of labor (the wage rate) and the equilibrium quantity (the number of workers hired), watch: