What is the 'Law Of Supply And Demand'
The law of supply and demand is the theory explaining the interaction between the supply of a resource and the demand for that resource. The law of supply and demand defines the effect the availability of a particular product and the desire (or demand) for that product has on price. Generally, a low supply and a high demand increases price, and in contrast, the greater the supply and the lower the demand, the lower the price tends to fall.
BREAKING DOWN 'Law Of Supply And Demand'One of the most basic economic laws, the law of supply and demand ties into almost all economic principles in one way or another. In practice, supply and demand pull against each other until the market finds an equilibrium price. However, multiple factors 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 brings out 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 its high supply, the business lowers the price. Demand increases, but as the business's supply dwindles, it raises the price until it finds the perfect price to balance its supply with consumer demand.
What Factors Affect Supply?
In the above example, supply only takes into account the supply created by a single business. In real economies, supply is predicated on many other factors. Production capacity, production costs such as labor and materials, and the number of competitors directly affect how a much supply businesses can create. Ancillary factors such as material availability, weather and the reliability of supply chains can also affect supply.
What Factors Affect Demand?
Demand is affected by the quality and cost of a product. The number of available substitutes, advertising and shifts in the price of complementary products also affect its demand. For example, if the price of video game console drops, demand for games for that console may increase as more people buy the console and want games for it.
Does Supply and Demand Only Affect Prices?
The law of supply and demand does not just apply to prices. It may also 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.