Law of Supply & Demand Explained & Defined
The law of supply and demand is one of the most fundamental concepts of economics.
The law is a theory that explains the relationship between the suppliers of a resource and its buyers.
It provides the primary model for price determination used in economic theory,
This economic theory describes that with all other factors holding equal in a competitive market, the price will be determined by the interaction between the quantity demanded and the amount supplied of a given good.
As demand increases, so to will the price and the amount producers are willing to supply, but as price increases, demand will fall, reducing the amount producers will supply and the resulting price.
This interaction between the amount consumers wish to purchase, and suppliers wish to sell will result in an equilibrium where the resulting price will be set.
The theory itself is based upon two economic laws, the law of demand and the law of supply.
The interaction between these two laws will determine the final market price and the number of goods supplied in a market.
Understanding the Law of Supply and Demand
The law of supply and demand is one of the most fundamental concepts in a competitive market, and as a result, it ties into virtually all other economic principles to some degree.
The amount of a good that people supply and demand will result in an equilibrium price where the amount consumers demand is equivalent to the amount that suppliers are willing to produce.
This is the product of the laws of supply and demand.
The Law of Demand
The law of demand states that if all other factors remain constant, the price and the quantity demanded of a good have an inverse relationship.
This means that as the price of a goods rise, people will demand less of it.
This is because as the price rises, the opportunity cost of buying the good also rises.
This means that as the price of a good rises, people will choose to buy less of it because it would mean giving up a good that they value more.
This is why when represented by a graph, the demand curve will be downward sloping.
The Law of Supply
The law of supply states that if all other factors remain constant, the price and quantity supplied of a good have a direct relationship.
This means that as the price of a good rises, the amount that suppliers are willing to provide increases.
This is because, with every additional unit that a seller provides, the opportunity cost will generally grow.
However, as the price that people are willing to pay for a good increases, the amount that a supplier can justify providing increases.
This means that when represented by a graph, the supply curve will be upward sloping.
Supply and Demand Curves
Supply and demand curves are a way to represent the number of goods demanded and supplied on a graph.
The demand and supply curves represent the amount that is supplied and demanded at a given price on a graph for a given interval of time.
The quantity demanded or supplied will be placed on the horizontal axis and always measures the units of a good for a specific period of time.
It is important to keep the amount of time being represented in mind because this can greatly affect the particular shape of both the supply and demand curves.
At a single point in time, the supply of a good is fixed, which results in a vertical supply line.
In contrast, the demand curve will remain downward, curving like always as a result of the law of diminishing marginal utility.
This law means that the first unit that a buyer purchases will always possess the highest value to and for every additional unit, the value will successively drop.
Though at a single point in time, a seller cannot raise the price over what the market is willing to pay, over time, suppliers can change the quantity they supply to a market in response to what they expect they can charge.
This means that over a period of time, the supply curve will slope upward because the more that suppliers expect they can charge, the more they are willing to bring to the market.
Shift vs. Movement for Supply and Demand Curves
Though often confused, “shifts” and “movements” represent significantly different phenomena.
It is important to understand both of these concepts, so let’s take a look.
A movement refers to a change in the price of a given good which results in a movement along either a demand or supply curve.
In this case, all other factors besides price will remain constant.
As the price changes, the amount demanded or supplied will move as well, and the original relationship between price and demand remains true.
This means that a movement along the demand curve occurs only when the price of a good changes and the buyer’s demand changes in response per the original relationship.
Just like with a demand curve, a movement along the supply curve indicates that the original relationship remains true.
This means that the movement occurs only in response to a change in the price, and the amount supplied changes accordingly.
A shift of the supply or demand curve indicates a change in the quantity supplied or demanded in response to any factor changing other than price.
This results in a shift of the demand or supply curve rather than moving along it.
This means that for the same price of a good, either the amount supplied or demanded will change.
This is caused by reasons such as changes in the taste of consumers or the price of the components used to make a product.
For example, if there was a sudden large increase in the price of lemons, the supply curve for lemonade would shift.
In contrast, the demand curve would shift if consumers decided they preferred fruit punch to lemonade.
The equilibrium price of a product is the price sellers can charge for a unit and sell all the units they want, and consumers can buy all of the units they want.
This concept is easy to picture.
The supply curve, which slopes upward, and the demand curve, which slopes downward, clearly will intersect at a point.
This is the point where the market price is high enough to get suppliers to supply the number of goods that consumers want to buy at this price.
Supply and demand are in sync at this point.
The shape of this curve and the location of the supply and demand curves determine the equilibrium price and amount, and the location of these curves is influenced by a number of elements.
Production costs have the largest effect on supply.
These costs include:
- Material and labor (The costs for these includes the opportunity costs for potential other uses of these things)
- The productive capacity of all of the other sellers during the relevant time period
- Costs of production, including taxes and regulation
- The physical technology that can be used to combine inputs
The most important factor affecting demand is consumer preferences when choosing between different goods.
The availability of substitute goods and their prices can affect demand as well.
Advertising, as well as changes in the season, can affect demand and affect the things that change demand.
Also, if peoples’ incomes change, this can change the quantity of a good demanded regardless of the price.
A Basic Explanation of the Law of Supply and Demand
The law of supply and demand describes something most people find applies to themselves in their daily activities.
It explains the way that if everything else is equal, the price of an item will tend to go up if the supply of that item decreases or the demand for the item increases.
In contrast, the price of an item will go down if the supply of the item increases or peoples’ preference for the item decreases.
This basic idea is important throughout the study of economics.
The Importance of the Law of Supply and Demand
The law of supply and demand is vital due to the way it contributes to economists, investors, and entrepreneurs’ understanding of market conditions and their ability to predict them.
Advertising is one example of this.
Companies will advertise a product in an attempt to raise demand for the product, so they can increase the price of the product.
Another way a company might use their understanding of supply and demand is to try and increase the price of a product by purposely limiting how many units they sell in order to decrease supply.
This would lower supply and increase demand, thus causing an increase in price.
An Example of the Law of Supply and Demand
If a company is trying to get the highest price possible for their product, they will also likely want a high-profit margin.
One way to help achieve a high-profit margin is to keep production costs low.
To do this, the company could solicit bids from several different companies, having them compete to supply production goods for the company at the lowest price.
In this case, the supply of companies the company is getting bids from is decreasing the cost of producing goods, thus increasing the company’s profit margin.
- The law of demand states that other factors remaining equal, a higher price will result in lower demand for a good.
- The law of supply states that other factors remaining equal to a higher price will result in more supply of a good.
- The interaction between the laws of supply and demand result in the actual price and supply of goods in a market.
- In an actual market, many other independent factors can affect the price and quantity supplied of goods.
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