In economics, the law of supply and demand is a common term and one of the fundamentals of economic theory. Supply and demand express a direct relationship between what producers supply and what consumers demand in an economy and how that relationship affects the price of a specific product or service.
Aggregate supply and aggregate demand are the total supply and total demand in an economy at a particular period of time and a particular price threshold. Aggregate supply is an economy's gross domestic product (GDP), the total amount a nation produces and sells. Aggregate demand is the total amount spent on domestic goods and services in an economy. Aggregate supply and aggregate demand convey how much firms are willing to produce and how much consumers are willing to demand at a specific price point.
Understanding Aggregate Supply and Aggregate Demand
Aggregate supply and demand are represented separately by their own curves. Aggregate supply is a response to increasing prices that drive firms to utilize more inputs to produce more output. The incentive is that if the price of inputs remains the same but if the price of outputs increase, the firm will generate larger profits and margins by producing and selling more. The aggregate supply curve is represented by a curve that slopes upward, which indicates that as the price per unit goes up, a firm will supply more. The supply curve eventually becomes vertical, indicating that at a certain price point a firm cannot produce anymore, as they are limited by certain inputs, e.g. number of employees and number of factories.
Aggregate demand is the total expenditure of a company, which includes consumer consumption, investments, government spending, and net exports. The aggregate demand curve is a downward sloping curve, indicating that when the price level increases the total spending of an economy decreases. Consumption levels fall because people spend less as higher prices have reduced their purchasing power. As outputs rise there is an increase in demand for money and credit to produce them, which leads to higher interest rates. Higher interest rates lead to lower investments. Furthermore, if prices in one nation go up making their goods more expensive relative to other nations, that will reduce exports.
Supply and Demand Fluctuations and Curves
Increased supply generally occurs in response to a demand increase and results in lower prices over time. The amount of time required for businesses to respond to an increase in demand by increasing production varies significantly, depending on the product and industry. If materials are difficult to obtain, the length of time required to bring additional products to market may increase in an economic model that is less responsive to demand changes. Price increases may result in reduced demand and cause too much supply.
The Bottom Line
As discussed, this relationship between supply and demand can be expressed using an aggregate supply or aggregate demand curve. Using this economic law, businesses create better forecasts for future production needs to improve profitability. Pricing and marketing considerations are also directly impacted by supply and demand and represent another facet of this economic modeling.