Law of Supply and Demand in Economics: How It Works

What Is the Law of Supply and Demand?

The law of supply and demand combines two fundamental economic principles describing how changes in the price of a resource, commodity, or product affect its supply and demand.

As the price increases, supply rises while demand declines. Conversely, as the price drops, supply constricts while demand grows.

Supply and demand levels for varying prices can be plotted on a graph as curves. The intersection of these curves marks the equilibrium or market-clearing price at which demand equals supply and represents the price discovery process in the marketplace.

KEY TAKEAWAYS

The law of demand holds that the demand level for a product or a resource will decline as its price rises and rise as the price drops.
Conversely, the law of supply says higher prices boost the supply of an economic good while lower ones tend to diminish it.
A market-clearing price balances supply and demand and can be graphically represented as the intersection of the supply and demand curves.
The degree to which price changes translate into changes in demand and supply is known as the product’s price elasticity. Demand for necessities is relatively inelastic, meaning it is less responsive to changes in their price.

Understanding the Law of Supply and Demand

It may seem obvious that in any sale transaction, the price satisfies both the buyer and the seller, matching supply with demand. The interactions between supply, demand, and cost in a (more or less) free marketplace have been observed for thousands of years.1

Like modern-day critics of market pricing for select commodities, many medieval thinkers distinguished between a “just” price based on costs and equitable returns and one at which the sale was transacted.2 Our understanding of price as a signaling mechanism matching supply and demand is rooted in the work of Enlightenment economists who studied and summarized the relationship.

Importantly, supply and demand do not necessarily respond to price movements proportionally. The degree to which price changes affect the product’s demand or supply is known as its price elasticity. Products with a high price elasticity of demand will see wider fluctuations in order based on the price. In contrast, necessities will be relatively inelastic in price because people can’t easily do without them, meaning demand will change less relative to changes in price.

Price discovery based on supply and demand curves assumes a marketplace where buyers and sellers are free to transact, depending on the price. Factors such as taxes and government regulation, suppliers’ market power, substitute goods’ availability, and economic cycles can all shift the supply or demand curves or alter their shapes. But so long as buyers and sellers retain agency, the commodities affected by these external factors remain subject to the fundamental forces of supply and demand. Now let’s consider how demand and supply respond to price changes.

The Law of Demand

The law of demand holds that demand for a product changes inversely to its price, all else being equal. In other words, the higher the price, the lower the level of demand.

Because buyers have finite resources, their spending on a given product or commodity is also limited, so higher prices reduce the quantity demanded. Conversely, demand rises as the product becomes more affordable.

As a result, demand curves slope downward from left to right, as in the chart below. Changes in demand levels as a function of a product’s price relative to buyers’ income or resources are known as the income effect.

Naturally, there are exceptions. One is Giffen goods, typically low-priced staples also known as inferior goods. Inferior goods see a drop in demand when incomes rise because consumers trade up for higher-quality products. But when an inadequate good’s price increases and the market goes up because consumers use more of it instead of costlier alternatives, the substitution effect turns the product into a Giffen good.

At the opposite end of the income and wealth spectrum, Veblen goods are luxury goods that gain in value and consequently generate higher demand levels as they rise in price because the price of these luxury goods signals (and may even increase) the owner’s status. Veblen goods are named for economist and sociologist Thorstein Veblen, who developed the concept and coined the term “conspicuous consumption” to describe it.

The Law of Supply

The law of supply relates price changes for a product to the quantity supplied. In contrast with the law of demand, the law of supply relationship is direct, not inverse. The higher the price, the higher the quantity supplied. Lower prices mean reduced supply, all else held equal.

Higher prices incentivize suppliers to supply more of the product or commodity, assuming their costs aren’t increasing as much. Lower prices result in a cost squeeze that curbs supply. As a result, supply slopes are upwardly sloping from left to right.

As with demand, supply constraints may limit the price elasticity of supply for a product, while supply shocks may cause a disproportionate price change for an essential commodity.

Equilibrium Price

Also called a market-clearing price, the equilibrium price is the price at which demand matches supply, producing a market equilibrium acceptable to buyers and sellers.

When an upward-sloping supply curve and a downward-sloping demand curve intersect, supply and demand in terms of the quantity of the goods are balanced, leaving no surplus supply or unmet demand. The level of the market-clearing price depends on the shape and position of the respective supply and demand curves, which are influenced by numerous factors.

Factors Affecting Supply

In industries where suppliers are unwilling to lose money, supply will tend to decline toward zero at product prices below production costs.

Price elasticity will also depend on the number of sellers, their aggregate productive capacity, how easily it can be lowered or increased, and the industry’s competitive dynamics. Taxes and regulations may matter as well.

Factors Affecting Demand

Consumer income, preferences, and willingness to substitute one product for another are among the most important determinants of demand.

Consumer preferences will depend, in part, on a product’s market penetration since the marginal utility of goods diminishes as the quantity owned increases. The first car is more life-altering than the fifth addition to the fleet; the living-room TV is more valuable than the fourth one for the garage.

What Is a Simple Explanation of the Law of Supply and Demand?

If you’ve ever wondered how the supply of a product matches demand or how market prices are set, the law of supply and demand holds the answers. Higher prices cause supply to increase while demand drops. Lower prices boost demand while limiting collection. The market-clearing price is one at which supply and demand are balanced.

Why Is the Law of Supply and Demand Important?

The Law of Supply and Demand is essential because it helps investors, entrepreneurs, and economists understand and predict market conditions. For example, a company considering a price hike on a product will typically expect demand to decline and will attempt to estimate the price elasticity and substitution effect to determine whether to proceed regardless.

What Is an Example of the Law of Supply and Demand?

When gasoline consumption plunged with the onset of the COVID-19 pandemic in 2020, prices quickly followed suit because the industry ran out of storage space. The price decline, in turn, served as a powerful signal to suppliers to curb gasoline production. Conversely, crude oil prices in 2022 provided producers additional incentives to boost output.