Supply and demand form the most fundamental concepts of economics. Whether you are an academic, farmer, pharmaceutical manufacturer or simply a consumer, the basic premise of supply and demand equilibrium is integrated into your daily actions. Only after understanding the basics of these models can the more complicated aspects of economics be mastered.
Although most explanations typically focus on explaining the concept of supply first, understanding demand is more intuitive for many, and thus helps with subsequent descriptions.
Figure 1: Price and Demand
The figure above depicts the most basic relationship between the price of a good and its demand from the standpoint of the consumer. This is actually one of the most important differences between the supply curve and the demand curve. Whereas supply graphs are drawn from the perspective of the producer, demand is portrayed from the perspective of the consumer.
As the price of a good increases the demand for the product will, except for a few obscure situations, tend to decrease. For purposes of our discussion, let's assume the product in question is television sets. If TVs are sold for the cheap price of $5 each, then a large number of consumers will purchase the sets at a high frequency. Most people would even buy more TVs than they need, putting one in every room and perhaps even some in storage. Essentially, because everyone can easily afford a TV, the demand for these products will remain high. On the other hand, if the price of television sets is $50,000, this gadget will be a rare consumer product as only the wealthy will be able to afford the purchase. While most people would still like to purchase TVs, at that price, demand for them would be extremely low. (For related reading, see: Is demand or supply more important to the economy?)
Of course, the above examples take place in a vacuum. A pure example of a demand model assumes several conditions. First, product differentiation does not exist—there is only one type of product sold at a single price to every consumer. Second, in this closed scenario, the item in question is a basic want and not an essential human necessity such as food (although having a TV provides a definite level of utility, it is not an absolute requirement). Third, the good does not have a substitute and consumers expect prices to remain stable into the future.
The supply curve functions in a similar fashion, but it considers the relationship between the price and available supply of an item from the perspective of the producer rather than the consumer.
Figure 2: Price and Supply
When prices of a product increase, producers are willing to manufacture more of the product to realize greater profits. Likewise, falling prices depress production as producers may not be able to cover their input costs upon selling the final good. Going back to the example of the television set, if the input costs to produce a TV are set at $50 plus the variable costs of labor, production would be highly unprofitable when the selling price of the TV drops below the $50 mark.
On the other hand, when prices are higher, producers are encouraged to increase their levels of activity to reap more benefit. For example, if television prices are $1,000, manufacturers can focus on producing television sets in addition to other possible ventures. Keeping all variables the same but increasing the selling price of the TV to $50,000 would benefit the producers and provide the incentive to build more TVs. The behavior to seek maximum amounts of profits forces the supply curve to be upward sloping. (See: Understanding Supply-Side Economics.)
An underlying assumption of the theory lies in the producer taking on the role of a price taker. Rather than dictating prices of the product, this input is determined by the market and suppliers only face the decision of how much to actually produce, given the market price. Similar to the demand curve, optimal scenarios are not always the case, such as in monopolistic markets.
Finding an Equilibrium
Consumers typically look for the lowest cost, while producers are encouraged to increase outputs only at higher costs. Naturally, the ideal price a consumer would pay for a good would be "zero dollars." However, such a phenomenon is unfeasible as producers would not be able to stay in business. Producers, logically, seek to sell their products for as much as possible. However, when prices become unreasonable, consumers will change their preferences and move away from the product. A proper balance must be achieved whereby both parties are able to engage in ongoing business transactions to the benefit of consumers and producers. (For related reading, see: Effects of Taxes on Supply and Demand.)
Theoretically, the optimal price that results in producers and consumers achieving the maximum level of combined utility occurs at the price where the supply and demand lines intersect. Deviations from this point result in an overall loss to the economy, commonly referred to as a deadweight loss.
Figure 3: Supply and Demand and Price
Law or Theory?
The law of supply and demand is actually an economic theory that was popularized by Adam Smith in 1776. The principles of supply and demand have been shown to be very effective in predicting market behavior. However, there are multiple other factors that affect markets on both a microeconomic and a macroeconomic level. Supply and demand heavily guides market behavior, but does not outright determine it.
Another way of looking at the laws of supply and demand is by considering them a guide. While they are only two factors influencing market conditions, they are very important factors. Smith referred to them as the invisible hand that guides a free market. However, if the economic environment is not a free market, supply and demand is not nearly as influential. In socialist economic systems, the government typically sets prices for commodities, regardless of the supply or demand conditions.
This creates problems because the government is not always able to control supply or demand. This is evident when examining Venezuela's food shortages and high inflation rates from 2010. The country attempted to take over the food supply from private vendors and establish price controls, but suffered crippling shortages and accusations of corruption as a result. Supply and demand still very much affected the situation in Venezuela, but were not the only influences. (For related reading, see: Venezuela's Food Shortage Explained.)
The principles of supply and demand have been illustrated repeatedly over centuries of different market conditions. However, the current economy is more global than it has ever been, and macroeconomic forces can be difficult to predict. Supply and demand are effective indicators, but not concrete predictors.
The Bottom Line
The theory of supply and demand relates not only to physical products such as television sets and jackets, but also to wages and the movement of labor. More advanced theories of micro and macroeconomics often adjust the assumptions and appearance of the supply and demand curve to properly illustrate concepts like economic surplus, monetary policy, externalities, aggregate supply, fiscal stimulation, elasticity and shortfalls. Before studying those more complex issues, the basics of supply and demand must be properly understood. (For related reading, see: Economic Basics: Supply and Demand.)