What is the Law of Supply and Demand?

The law of supply and demand is a theory that explains the interaction between the sellers of a resource and the buyers for that resource. The theory defines how the relationship between the availability of a particular product and the desire (or demand) for that product has on its price. Generally, low supply and high demand increase price and vice versa.

Key Takeaways

  • The law of demand says that at higher prices, buyers will demand less of an economic good.
  • The law of supply says that at higher prices, sellers will supply more of an economic good.
  • These two laws interact to determine the actual market prices and volume of goods that are traded on a market.
  • Several independent factors can affect the shape of market supply and demand, influencing both the prices and quantities that we observe in markets.
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Law of Supply and Demand

Understanding the Law of Supply and Demand

The law of supply and demand, one of the most basic economic laws, ties into almost all economic principles in some way. In practice, supply and demand pull against each other until the market finds an equilibrium price. However, multiple factors can 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.

At any given point in time, the supply of a good brought to market is fixed. In other words the supply curve in this case is a vertical line, while the demand curve is always downward sloping due to the law of diminishing marginal utility. Sellers can charge no more than the market will bear based on consumer demand at that point in time. Over time however, suppliers can increase or decrease the quantity they supply to the market based on the price they expect to be able to charge. So over time the supply curve slopes upward; the more suppliers expect to be able to charge, the more they will be willing to produce and bring to market.

With an upward sloping supply curve and a downward sloping demand curve it is easy to visualize that at some point the two will intersect. At this point, the market price is sufficient to induce suppliers to bring to market that same quantity of goods that consumers will be willing to pay for at that price. Supply and demand are balanced, or in equilibrium. The precise price and quantity where this occurs depends on the shape and position of the respective supply and demand curves, each of which can be influenced by a number of factors. 

Factors Affecting Supply

Production capacity, production costs such as labor and materials, and the number of competitors directly affect how much supply businesses can create. Ancillary factors such as material availability, weather, and the reliability of supply chains also can affect supply.

Factors Affecting Demand

The number of available substitutes, consumer preferences, and the shifts in the price of complementary products affect demand. For example, if the price of video game consoles drops, the demand for games for that console may increase as more people buy the console and want games for it.