Supply and demand is an economic theory that's used to explain the relationship between the availability of a commodity and the willingness of consumers to buy that commodity.
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Supply refers to the market’s ability to produce a good or service, whereas demand refers to the market’s desire to purchase the good or service.
Supply and demand is often considered to be a fundamental concept within economics and is primarily used to describe the price and availability of commodities.
What are the laws of demand and supply?
The law of demand states that, if all other factors remain the same, the price will be the main factor to influence how much of a commodity is sold. Typically, increasing the price of a commodity will result in a lower quantity sold (lower demand), whereas decreasing the price will increase the quantity sold (higher demand).
The law of supply is essentially the opposite of the law of demand. According to the law of supply, if no other factors change, price is the main factor influencing how much of a commodity is produced. If the price of a particular product or service increase, suppliers will want to offer more of that product or service.
However, the price of some commodities affects supply and demand more so than the price of others - this is known as price elasticity. When the price of a commodity easily affects supply and demand, it's described as price elastic. Alternatively, a commodity is described as inelastic if its price doesn't significantly affect supply or demand.
How does supply and demand affect price?
In economic theory, supply and demand is the main model of price determination. In other words, the price of a good or service is set by the dynamic between supply and demand. As a general rule, prices will fall when supply is greater than demand, whereas prices will rise when demand is greater than supply.
If the demand for a product or service is equal to the supply, it will reach ‘equilibrium price’ – a stable market value that's satisfactory for both consumers and producers.
Exceptions to the rule of supply and demand
Although supply and demand is often referred to as a law or rule, the concept is better described as a general guide to pricing in free market economies. There are many exceptions to the rule of supply and demand because several other factors can affect pricing and availability of goods and services. These factors might include:
Public perception: if the public doesn't know about a product, there's likely to be less demand. According to the rules of supply and demand, the manufacturer will decrease the price; however, the price decrease is unlikely to have any effect on supply if consumers are still unaware of the product.
Price controls and regulations: in many countries, governments regulate how much (or sometimes how little) particular commodities should cost. This artificially distorts the relationship between price and supply and demand.
Planned economies: planned economies are economic systems in which prices, distribution, and production are controlled and regulated by the government. In these economies, supply and demand has less of an effect on production levels or price.
Supply and demand in other contexts
While supply and demand is typically used to refer to the pricing and availability of commodities, it can also be used to describe other economic activity – for example, wages.
When unemployment levels are high, employers tend to lower wages. Because there's a larger supply of workers and increased demand for jobs, wages don't need to be competitive. On the other hand, businesses often need to increase wages when unemployment levels are low; as there's less demand for jobs, employers need to find a way to make their vacancies more appealing.
