Law of Supply and Demand in Economics: How It Works

Introduction

• Definition: The law of supply and demand combines two fundamental economic principles that describe how changes in the price of a resource, commodity, or product affect its supply and demand.

What Is the Law of Supply and Demand?

• Supply and Demand Relationship:
  • Supply rises while demand declines as the price increases.
  • Supply constricts while demand grows as the price drops.
• Graphical Representation:
  • Can be plotted on a graph as curves.
  • Intersection marks the equilibrium or market-clearing price.

Key Takeaways

• Law of Demand: Demand declines as price rises; increases as price falls.
• Law of Supply: Higher prices boost supply; lower prices diminish it.
• Market-Clearing Price: Represents equilibrium.
• Price Elasticity: Degree to which price changes affect demand and supply.
• Inelastic Demand: Basic necessities with less price responsiveness.

Understanding the Law of Supply and Demand

• Price as a Signaling Mechanism: Matches supply and demand in a free market.
• Price Elasticity: Changes in price affect the product's demand or supply.
• Factors Influencing Curves:
  • Taxes, regulation, market conditions, substitute goods, economic cycles.

The Law of Demand

• Inverse Relationship: Demand decreases as the price rises and vice versa.
• Concepts:
  • Income Effect: Changes in demand relative to income.
  • Giffen Goods: Demand drops when income rises.
  • Veblen Goods: Luxury items with increased demand as price rises.

The Law of Supply

• Direct Relationship: Higher price leads to higher supply.
• Supply Incentives: Higher prices encourage more supply.
• Constraints: Supply elasticity can be limited; supply shocks affect prices.

Equilibrium Price

• Definition: The price at which demand matches supply.
• Market Equilibrium: No surplus or unmet demand.

Factors Affecting Supply

• Production Costs: Supply tends to zero below production costs.
• Market Dynamics: Number of sellers, production capacity, regulations.

Factors Affecting Demand

• Determinants: Consumer income, preferences, substitution willingness.
• Marginal Utility: Decreases as quantity owned increases.

Simple Explanation of the Law of Supply and Demand

• Higher prices increase supply and decrease demand; lower prices boost demand and limit supply.

Importance of the Law of Supply and Demand

• Helps predict market conditions and understand pricing strategies.

Example of the Law of Supply and Demand

• Gasoline Consumption: Demand and price fluctuations during COVID-19.

The Bottom Line

• Central Economic Principles: Describe the relationship between price, supply, and demand.
• Equilibrium: The point at which market clears.