One of the first things they teach you when you start to study economics, is the law of supply and demand which explains the relationship between price, supply and demand. If you don’t know what happens to the amount of supply and demand when the price goes up or down, if you want to understand how prices change and the market finds its equilibrium and if you want to hear a story about a chair, you should read on.
What is the definition of supply?
In economics, supply is the aggregate amount of a product or service that is available to buy. The amount of supply (quantity supplied) at any given moment is dependent on the price.
If you want a visual representation, a supply curve usually looks like this:
What is the definition of demand?
The other side of supply is demand: the aggregate amount of a product or service that people want to buy. The amount of demand (quantity demanded) at any point in time is also dependent on the price.
A demand curve looks like this:
Note: there is a difference between supply and the amount of supply or quantity supplied. And there is a difference between demand and the amount of demand or quantity demanded. Supply and demand are a whole curve but their quantity is just one point on the curve.
In comes our chair and its father, the chair-maker
Imagine someone who wants to make and sell chairs for a living. After building his first chair, which is a pretty basic chair, he puts a price of 10 dollars on it. People who want to buy a chair, come and go. But no one seems to want to buy this chair. This means that there is no demand for this particular kind of chair at this price in this moment. So what’s our chair-maker to do?
He can lower his price. If he wants to stay in business, he should try not to sell his chair at a loss. But to create demand, he can lower the amount of his profits. So let’s say he lowers the price to 8 dollars and voila! Now people want to buy his chair. He sells one and makes more. He keeps selling at 8 dollars and seems to be meeting every demand. But after a while, two things can happen:
- There can be a shortage of chairs. People can become used to chairs and buy more and more. If our chair-maker can’t meet this increasing level of demand or if he concludes from the behavior of the buyers that they will pay more for a chair because they just want to sit so much, he can start to increase the price of his chairs.
This increase in price, will have an effect on the demand. If people just love chairs and buy more and more every day, this effect will be slow at the start. But inevitably, the amount of demand will decrease over time.
- There can suddenly be too much chairs in the market. Another chair-maker could appear and offer more chairs. Or people’s needs could be met after a while, because chairs don’t get broken every day and people can have no more than a certain amount of chairs in their homes. In this case, our chair-maker will have to lower his price even further so he can sell his products.
So what’s the relationship between price, supply and demand? (What’s the law of supply and demand?)
As you saw in the example above, any increase in price will increase the amount of supply and decrease the amount of demand. And any decrease in price will decrease the amount of supply and increase the amount of demand. This is the law of supply and demand.
But this is just a move on the curve. There are things that can change or shift the whole curve of supply or demand. (the two things that can happen after a while in our chair story.)
For example, more income and credit will mean more demand and any increase in the costs of production or transport will mean less supply. Certain trends, shifts in people’s tastes and preferences, changes in the price of alternatives and even the change of seasons and weather can affect the whole supply or demand for a good or service, changing or moving the whole curve.
Governments can do many things to change the amount of supply and demand as well. And then there is advertising! A whole industry dedicated to increase demand for certain things.
What is the market equilibrium price?
When the market price of a good or service is at a point that every seller can produce and sell as much as they want and every buyer can buy and have as much as they want, we can say that we are at the equilibrium price. At this price, supply and demand are in balance with each other and nothing is wasted! (In our chair story, equilibrium seems to happen around the price 0f 8 dollars before any shift in supply and demand.)
If we go back to the supply and demand curves that you saw at the beginning of this post, equilibrium will look like this:
To reach the equilibrium price:
– If the amount of supply decreases without any changes to demand, price will go higher to decrease the amount of demand and make a new equilibrium.
– If the amount of demand decreases without any changes to supply, price will go lower to decrease the amount of supply and make a new equilibrium.
The opposites of these cases are also true. And remember, the market will always move towards equilibrium.
Note: Any shifts in the whole curves of supply or demand will also change the equilibrium.
Why is understanding supply and demand important?
You can’t understand any market or price movement without understanding supply and demand first. So if you want to invest your money with open eyes or if you want to trade in any securities market, this is one of the first steps.
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***Last Updated on 23 January 2022 by Guy with a Wallet