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Law of Supply and Demand

Definition

The law of supply and demand states that if a product has a high demand and low supply, the price will increase. Conversely, if there is low demand and high supply, the price will decrease. Market equilibrium occurs when demand and supply intersect to create a stable price.

Also known as:No synonym exists
First Seen:First seen: The term supply and demand was first seen in Sir James Steuart's 1796 treatise An Inquiry Into the Principles of Political Economy.

When figuring out your monthly budget, microeconomic theory plays a part whether or not you’re familiar with this concept. The law of supply and demand can be particularly useful to individuals who want to make smart buying and selling decisions. This fundamental economic concept can be tricky, but, once understood, can be easily applied to your money management decisions, especially when buying consumer goods.

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The law of supply and demand

The law of supply and demand is a fundamental principle of the free market economy. In this type of economy, consumers purchase goods and services at a price that is acceptable to both the buyer and seller without interference from the government. The law of supply and demand indicates that when there is a high demand for a product, there will also be a high level of need for its supply. High demand for a product with low supply is likely to increase the price of the product.

Two things determine a product’s price: the available supply of that product and the overall demand for it. For example, if demand for tennis balls is suddenly high, the supply may tighten, so the price increases. But when tennis players turn to pickleball, the demand for tennis balls drops along with the price.

This is basic economics, which factors in the cost to produce, market and sell products at a price by which both the retailer and manufacturer profit. Since you can buy the same product from several different companies, there is a natural price ceiling — manufacturers need to be in line with their competitors to sell cans of balls.

As with anything involving economics, the theory of supply and demand is slightly more complicated than identifying the point at which the two meet on a graph. Four basic guidelines define how prices are established:

  • If supply increases while demand remains static, the price goes down.
  • If supply decreases while demand stays the same, the price goes up.
  • If the supply stays the same while demand rises, the price goes up.
  • If the supply stays the same while demand drops, the price goes down.

Keep in mind that the market does not exist in a vacuum. There’s constant movement in supply, demand and price. High prices for everyday commodities result in a drop in demand, because consumers drive less, buy generic corn flakes, for instance, and grill hot dogs instead of rib eye steaks.

Incrementally, this decrease in demand leads to lower prices, and the cycle begins again. When product demand and supply are balanced the market reaches equilibrium, also known as the market-clearing price.

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What affects supply and demand?

The law of supply and demand attempts to establish whether buyers and sellers in the marketplace can transact based on the price of the goods or services. Essentially, three tenets affect the supply and demand of a product: consumer trends, environmental factors and the price of the product.

Consumer trends. Consumer demand for a product drives our economy forward. From demand for the newest computers to the most effective pharmaceuticals, consumers have a never-ending need for more. However, trends in exactly which products are most widely desired shifts from moment to moment. Initial consumer demand is most likely to occur when the product is cheap and readily available.
Environmental factors. The production of many goods depends on environmental factors. For example, weather conditions are likely to affect the availability of fruits and vegetables at your local grocery. When environmental factors limit the availability of a product and demand remains the same, suppliers increase the price of the product.
Price of the product. As consumer demand increases, product supply is likely to decrease. If suppliers manage to keep up with the demand for a product, they are likely to increase prices. Sellers keep a close eye on taxes and government regulations, as these are two factors that influence the net cost to supply the product. Economic cycles drive other aspects, such as the supply chain and the availability of substitute goods. Essentially, as the price of the product increases, the demand for the product will decrease, as consumers will find viable alternatives to expensive “brand name” products.

For example, during the pandemic, premium toilet tissue was a blisteringly hot commodity, to the point that retailers were rationing how much you could buy. Prices skyrocketed to the point that a large pack of Charmin would set you back as much as an ounce of caviar. So, what did consumers do? They found cheaper generic brands, and when the supply increased, Charmin had two choices — lose market share because people found that the Walmart brand worked just as well or lower their prices to pre-pandemic levels.

What changes the demand?

There are five components of demand, and any or all of them cause disruptions in the equilibrium:

Income. As consumers' income increases, they are able to afford more goods and services. For example, in a period of economic boom (as opposed to an economic recession or depression), consumers are much more likely to buy new cars, bedding, to eat out, and buy the latest gadget.
Population. A growing population leads to greater demand. More people means greater need for food, transportation and medicine. In areas where the population is declining, demand for certain products also declines. This is true for several parts of the Netherlands that project a population decline of 16% by 2040, along with fewer jobs, less demand for rented housing, fewer construction projects, higher prices for transport and other decreases in demand.

Trends and preferences. Consumer tastes, trends and technology all change, so demand fluctuates accordingly. When the iPhone first came out, consumer demand skyrocketed, decreasing product availability and increasing pricing for subsequent models.

Competitor pricing. If one company raises its prices, then the demand for competing products increases. If a company can find a way to make a comparable product for less money and is also willing to pass the low pricing on to the consumer, other companies are forced to lower their prices or face a lower demand for their product.

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Supply and demand in real life

The laws of supply and demand influence our day-to-day lives in major ways, from product trends and price increases to inflation and corporation consolidation. When you are in the market for a new car or the latest tech gadget, be sure to inform yourself of current supply and demand trends to make informed purchasing decisions.