Law of Supply and Demand

What is the Law of Supply and Demand

The law of supply and demand is a theory that explains the interaction between the supply of
a resource and the demand for that resource. The theory defines the effect that the availability
of a particular product and the desire (or demand) for that product has on its price.
Generally, low supply and high demand increase price. In contrast, the greater the supply and
the lower the demand, the price tends to fall.

BREAKING DOWN Law of Supply and Demand

The law of supply and demand, one of the most basic economic laws, ties into almost all
economic principles in some way. In practice, supply and demand pull against each other until
the market finds an equilibrium price. However, multiple factors can affect both supply and
demand, causing them to increase or decrease in various ways.

How Do Supply and Demand Create an Equilibrium Price?

Also called a 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.

For a simple illustration of how supply and demand determine equilibrium price, imagine a
business launching a new product. It sets a high price, but only a few consumers buy it. The
business anticipated selling more units, but due to lack of interest, it has warehouses full of
the product. Due to the high supply, the business lowers the product price. Demand
increases, but as the supply dwindles, the business raises the price until it finds the perfect, or
equilibrium, price to balance its product supply with consumer demand.

Factors Affecting Supply

The above example takes into account the supply created only by a single business. In the
real world, supply is determined by many other factors. Production capacity, production
costs such as labor and materials, and the number of competitors directly affect how much
supply businesses can create. Ancillary factors such as material availability, weather and the
reliability of supply chains also can affect supply.

Factors Affecting Demand

Demand is affected by the quality and cost of a product, among other factors. The number of
available substitutes, amount of advertising and the shifts in the price of complementary
products also affect demand. For example, if the price of video game consoles drops, the
demand for games for that console may increase as more people buy the console and want
games for it.

Do Supply and Demand Only Affect Prices?

The law of supply and demand does not apply just to prices. It also can be used to describe
other economic activity. For example, if unemployment is high, there is a large supply of
workers. As a result, businesses tend to lower wages. Conversely, when unemployment is
low, the supply of workers is also low, and as a result, to entice workers, employers tend to
offer higher salaries. Similarly, in the world of stock investing, the law of supply and demand
can help to explain a stock's price at any given time.
The law of supply states that the quantity of a good supplied (i.e., the amount owners or producers
offer for sale) rises as the market price rises, and falls as the price falls. Conversely, the law of
demand (see demand) says that the quantity of a good demanded falls as the price rises, and vice
versa.