Economics' Law of Supply and Demand: How It Operates

Zarith Sofea · 23 Feb 7.9K Views

What Does Supply and Demand Law Mean?

The law of supply and demand integrates two essential economic concepts that explain the impact of price changes on the availability and desire for a resource, commodity, or product.

When the price goes up, the supply increases, but the demand decreases. Conversely, when the price decreases, the supply tightens while the demand expands.

Supply and demand levels corresponding to different prices can be illustrated on a graph as curves. The point where these curves intersect identifies the equilibrium, or market-clearing price. This is the point at which demand matches supply, reflecting the mechanism of price discovery in the market.

Understanding the Law of Supply and Demand

It is evident in any sales transaction that the price plays a crucial role in satisfying both the buyer and the seller, aligning supply with demand. This dynamic interaction between supply, demand, and price has been observed for thousands of years in more or less free marketplaces.

Many medieval thinkers, akin to contemporary critics of market pricing for specific commodities, drew distinctions between a "just" price, grounded in costs and equitable returns, and the actual transactional price.

Our contemporary understanding of price as a signaling mechanism that aligns supply and demand has its roots in the work of Enlightenment economists who extensively studied and summarized this relationship.

It's important to note that supply and demand may not always respond proportionally to price movements. The extent to which price changes influence a product's demand or supply is referred to as its price elasticity. Products with high price elasticity of demand will experience significant fluctuations in demand based on price changes. Conversely, essential goods tend to be relatively inelastic in price, as people can't easily do without them. This means that demand for such goods changes less relative to alterations in price.

The process of price discovery, based on supply and demand curves, assumes a marketplace where buyers and sellers have the freedom to transact or not based on the price. External factors like taxes, government regulations, supplier market power, substitute goods' availability, and economic cycles can shift the supply or demand curves or alter their shapes. However, as long as buyers and sellers retain agency, commodities affected by these external factors remain subject to the fundamental forces of supply and demand. Let's now explore how demand and supply respond to changes in price.

The Law of Demand

The law of demand asserts that the demand for a product changes inversely to its price, assuming all other factors remain constant. Simply put, when the price increases, the demand tends to decrease, and vice versa.

Buyers, having limited resources, face constraints on their spending for a particular product. Higher prices typically lead to a reduction in the quantity demanded, reflecting the finite nature of buyers' resources. Conversely, demand tends to increase when a product becomes more affordable.

This relationship is visually represented by demand curves sloping downward from left to right, as illustrated in the accompanying chart. Changes in demand levels concerning a product's price relative to buyers' income or resources are often referred to as the income effect.

However, there are exceptions to this general rule. Giffen goods, for instance, are typically low-priced staples, also known as inferior goods. These goods experience a decrease in demand when incomes rise because consumers tend to upgrade to higher-quality products. Yet, when the price of an inferior good rises, demand may increase as consumers opt for it over costlier alternatives, thereby transforming it into a Giffen good due to the substitution effect.

On the other end of the income and wealth spectrum, we have Veblen goods—luxury items that gain in perceived value and, consequently, experience higher demand as their prices increase. This phenomenon occurs because the elevated price of these luxury goods signals and may even enhance the owner's status. The term "Veblen goods" is attributed to economist and sociologist Thorstein Veblen, who introduced the concept and coined the term "conspicuous consumption" to describe this behavior.

The Law of Supply

The law of supply establishes a connection between changes in the price of a product and the quantity supplied. Unlike the law of demand, the relationship in the law of supply is direct, not inverse. When the price rises, the quantity supplied also increases, and when prices drop, the supply decreases, assuming other factors remain constant.

Higher prices act as an incentive for suppliers to produce more of a product or commodity, provided their costs do not rise significantly. Conversely, lower prices create a financial constraint that limits the supply. Consequently, the supply curves slope upwards from left to right.

Similar to demand, supply constraints can restrict the price elasticity of supply for a product, while unexpected events affecting supply (supply shocks) may lead to disproportionate price changes, especially for essential commodities.

Factors Impacting Supply

In sectors where suppliers are averse to incurring losses, the supply tends to dwindle towards zero when product prices fall below production costs. The elasticity of price is contingent on various aspects such as the number of sellers, their combined production capacity, the flexibility to adjust it, and the competitive dynamics within the industry. Additionally, taxes and regulations can play a significant role in shaping supply.

Factors Influencing Demand

Critical determinants of demand include consumer income, preferences, and the inclination to substitute one product for another.

Consumer preferences are influenced, in part, by a product's market penetration, as the marginal utility of goods decreases with an increasing quantity owned. For instance, the impact of the first car on one's life is more substantial than the fifth addition to the vehicle fleet, and the usefulness of the living-room TV outweighs that of the fourth TV for the garage.

Conclusion

The principles of supply and demand encapsulate fundamental economic dynamics that elucidate the interplay among price, supply, and demand. According to the law of demand, when prices ascend for a particular resource, product, or commodity, demand diminishes; conversely, as prices decline, demand surges. On the supply side, the law asserts that with a price increase, producers amplify the supply of a resource, product, or commodity, and as prices decrease, supply contracts.

The equilibrium, the point at which demand equals supply, delineates the market-clearing price. The law of supply and demand plays a pivotal role in enabling market participants to comprehend and project future conditions.

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