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.
Demand Schedule
What is the 'Demand Schedule'
In economics, the demand schedule is a table showing the quantity demanded of a good or
service at different price levels. The demand schedule can be graphed as a continuous demand
curve on a chart where the Y-axis represents price and the X-axis represents quantity.

BREAKING DOWN 'Demand Schedule'

The demand schedule most commonly consists of two columns. The first column lists a price for
a product in ascending or descending order. The second column lists the quantity of the product
that is desired, or demanded, at that price, which is determined based on research of the
market. When the data in the demand schedule is graphed to create the demand curve, it
provides a visual demonstration of the relationship between price and demand, allowing an easy
estimation of the demand for a product or service at any point along the curve.

Demand and Supply Schedules

A demand schedule is typically used in conjunction with a supply schedule, which shows the
quantity of a good that would be supplied to the market by producers at given price levels.
Graphing both schedules on a chart with the axes described above, it is possible to obtain a
graphical representation of the supply and demand dynamics of a particular market. In a typical
supply and demand relationship, as the price of a good or service rises, the quantity
demanded tends to fall. If all other factors are equal, the market reaches equilibrium where the
supply and demand schedules intersect. At this point, the corresponding price is the equilibrium
market price, and the corresponding quantity is the equilibrium quantity exchanged in the
market.

Additional Factors on Demand

Price is not the sole factor that determines demand for a particular product. Demand may also
be affected by the amount of disposable income available, shifts in the quality of the goods in
question, effective advertising and even weather patterns. Price changes of related goods or
services may also affect demand. If the price of one product rises, demand for a substitute of
that product may rise, while a fall in the price of a product may increase demand for
its complements. For example, a rise in the price of one brand of coffeemaker may increase the
demand for a relatively cheaper coffeemaker produced by a competitor. If the price of all
coffeemakers falls, the demand for coffee, a complement to the coffeemaker market, may rise,
as consumers take advantage of the price decline in coffeemakers.
Demand Curve

What is the 'Demand Curve'

The demand curve is a graphical representation of the relationship between the price of a good or service
and the quantity demanded for a given period of time. In a typical representation, the price will appear
on the left vertical axis, the quantity demanded on the horizontal axis.

BREAKING DOWN 'Demand Curve'

The demand curve will move downward from the left to the right, which expresses the law of
demand — as the price of a given commodity increases, the quantity demanded decreases, all else being
equal.
Visualizing the Demand Curve
Note that this formulation implies that price is the independent variable, and quantity the dependent
variable. In most disciplines, the independent variable appears on the horizontal or x-axis,
but economics is an exception to this rule.
For example, if the price of corn rises, consumers will have an incentive to buy less corn and substitute it
for other foods, so the total quantity of corn consumers demand will fall.
The degree to which rising price translates into falling demand is called demand elasticity or price
elasticity of demand. If a 50 percent rise in corn prices causes the quantity of corn demanded to fall by 50
percent, the demand elasticity of corn is 1. If a 50 percent rise in corn prices only decreases the quantity
demanded by 10 percent, the demand elasticity is 0.2. The demand curve is shallower (closer to
horizontal) for products with more elastic demand, and steeper (closer to vertical) for products with less
elastic demand.
If a factor besides price or quantity changes, a new demand curve needs to be drawn. For example, say
that the population of an area explodes, increasing the number of mouths to feed. In this scenario, more
corn will be demanded even if the price remains the same, meaning that the curve itself shifts to the right
(D2) in the graph below. In other words, demand will increase.
Other factors can shift the demand curve as well, such as a change in consumers' preferences. If cultural
shifts cause the market to shun corn in favor of quinoa, the demand curve will shift to the left (D3). If
consumers' income drops, decreasing their ability to buy corn, demand will shift left (D3). If the price of a
substitute – from the consumer's perspective – increases, consumers will buy corn instead, and demand
will shift right (D2). If the price of a complement, such as charcoal to grill corn, increases, demand will shift
left (D3). If the future price of corn is higher than the current price, the demand will temporarily shift to
the right (D2), since consumers have an incentive to buy now before the price rises.

The terminology surrounding demand can be confusing. "Quantity" or "quantity demanded" refers to the
amount of the good or service, such as ears of corn, bushels of tomatoes, available hotel rooms or hours
of labor. In everyday usage, this might be called the "demand," but in economic theory, "demand" refers
to the curve shown above, denoting the relationship between quantity demanded and price per unit.
Exceptions to the Demand Curve
There are some exceptions to rules that apply to the relationship that exists between prices of goods and
demand. One of these exceptions is a Giffen good. This is one that is considered a staple food, like bread
or rice, for which there is no viable substitute. In short, the demand will increase for a Giffen good when
the price increases, and it will fall when the prices drops. The demand for these goods are on an upward-
slope, which goes against the laws of demand. Therefore, the typical response (rising prices triggering a
substitution effect) won’t exist for Giffen goods, and the price rise will continue to push demand.