The law of supply and demand is an economic theory that explains how supply and demand are related to each other and how that relationship affects the price of goods and services. It's a fundamental economic principle that explains when supply exceeds demandfor a good or service, prices fall. When demand exceeds supply, prices tend to rise.
Key Takeaways
- When supply is greater than demand, prices drop; when demand is greater than supply, prices rise.
- Price elasticity of demand refers to the sensitivity of prices in relation to demand.
- Inelastic prices are those that have a weak influence on demand.
- The law of supply and demand applies to a nation's money supply, as well as to products and services.
- There are exceptions to the rule of supply and demand.
Understanding the Law of Supply and Demand
There is an inverse relationship between the supply and prices of goods and services when demand is unchanged. If there is an increase in the supply of goods and services while demand remains the same, prices tend to fall to a lower equilibrium price and a higher equilibrium quantity of goods and services.
If there is a decrease in the supply of goods and services while demand remains the same, prices tend to rise to a higher equilibrium price and a lower quantity of goods and services.
The same inverse relationship holds for the demand for goods and services; however, when demand increases and supply remains the same, the higher demand leads to a higher equilibrium price and vice versa.
Supply and demand rise and fall until an equilibrium price is reached. For example, suppose a luxury car company sets the price of its new car model at $200,000. While the initial demand may be high due to the company hyping and creating buzz for the car, most consumers are not willing to spend $200,000 for an auto. Demand then falls.
As a result, the sales of the new model quickly fall, creating an oversupply of the car. In response, the company reduces the price of the car to $150,000 to balance the supply and the demand for the car and to reach an equilibrium price, ultimately.
The four fundamental principles of supply and demand are:
- If supply increases while demand remains constant, price decreases.
- If supply decreases while demand remains constant, price increases.
- If supply is static while demand increases, price increases.
- If supply is static while demand decreases, price decreases.
Price Elasticity
Increased prices typically result in lower demand, and demand increases generally lead to increased supply; however, the supply of different products responds to demand differently, with some products' demand being less sensitive to prices than others.
Economists describe this sensitivity as price elasticity of demand; products with pricing sensitive to demand are said to be price elastic. Inelastic pricing indicates a weak price influence on demand. The law of demand still applies, but pricing is less forceful and therefore has a weaker impact on supply.
The price elasticity of a product may be caused by the presence of more affordable alternatives in the market, or it may mean the product is considered nonessential by consumers. Rising prices will reduce demand if consumers are able to find substitutions.
They will have less of a dampening effect on demand when alternatives are not available. Healthcare services, for example, have few substitutions, and demand remains strong even when prices increase.
Exceptions to the Rule
While the laws of supply and demand act as a general guide to free markets, they are not the sole factors that affect pricing and availability. These principles are merely spokes of a much larger wheel. While extremely influential, they assume that consumers are fully educated about a product and that there are no regulatory barriers to getting that product to them.
Public Perception
Misinformation
If consumer information about available supply is skewed, the resulting demand is affected as well. One example of this occurred immediately after the terrorist attacks in New York City on Sept. 11, 2001.
The public immediately became concerned about the future availability of oil. Some companies took advantage of this and temporarily raised their gas prices. There was no actual shortage, but the perception of one increased the demand for gasoline. This resulted in stations suddenly charging up to $5 a gallon for gas when the price had been less than $2 a day earlier.
Lack of Information
Likewise, there may be a very high demand for a benefit that a particular product provides. But if the general public does not know about that item, the demand for the benefit won't impact the product's sales.
If a product is struggling, the company that sells it often chooses to lower its price. The laws of supply and demand indicate that sales typically increase as a result of a price reduction. That is unless consumers are not aware of the reduction. The invisible hand of supply and demand economics does not function properly when public perception is incorrect.
Fettered Markets
Monopolies
Supply and demand also do not affect markets nearly as much when a monopoly exists. The U.S. government has passed laws to try to prevent monopolies, but everyday examples still show how a monopoly can negate supply and demand principles.
For instance, movie houses typically do not allow patrons to bring outside food and beverages into the theater. This gives that business a temporary monopoly on food services, which is why popcorn and other concessions are so much more expensive than they would be outside of the theater.
Planned Economies
In contrast, planned economies use central planning by governments instead of consumer behavior to create demand. In a sense, then, planned economies represent an exception to the law of demand in that consumer desire for goods and services may be irrelevant to actual production.
Price Controls
Price controls can also distort the effect of supply and demand on a market. Governments sometimes set a maximum or a minimum price for a product or service, and this results in either the supply or the demand being artificially inflated or deflated.
This was evident in the 1970s when the U.S. temporarily capped the price of gasoline at around $1 per gallon. Demand increased because the price was artificially low, making it more difficult for the supply to keep pace. This resulted in much longer wait times and people making side deals with stations to get gas.
Traditional supply and demand theories rely on a competitive business environment to function as expected, trusting the market to correct itself.
Supply, Demand, and Monetary Policy
While this article has mainly been discussing consumer goods, the law of supply and demand affects more abstract things as well, including a nation's monetary policy. This happens through the adjustment of interest rates. Interest rates are the cost of money: They are the preferred tool for central banks to expand or decrease the money supply.
Lower Interest Rates
When interest rates are lower, more people borrow money. This expands the money supply; there is more money circulating in the economy. This translates to more hiring, increased economic activity, more spending, and a tailwind for asset prices.
Higher Interest Rates
Rising interest rates lead people to take their money out of circulation (decreasing the money supply) and put it in the bank or investments, thereby taking advantage of the increase in risk-free and higher rates of return. It also often discourages borrowing and activities or purchases that require financing. This tends to decrease economic activity and put a damper on asset prices.
In the United States, the Federal Reserve increases the money supply when it wants to stimulate the economy, prevent deflation, boost asset prices, and increase employment. When it wants to reduce inflationary pressures, it raises interest rates and decreases the money supply.
Basically, when it anticipates a recession, it begins to lower interest rates. It raises rates when the economy is overheating.
Asset Prices
The law of supply and demand is also reflected in how changes in the money supply affect asset prices. Cutting interest rates increases the money supply; however, the amount of assets in the economy remains the same but demand for these assets increases, driving up prices.
More dollars are chasing a fixed amount of assets. Decreasing the money supply works in the same way. Assets remain fixed, but the number of dollars in circulation decreases, putting downward pressure on prices, as fewer dollars are chasing these assets.
What Is Supply and Demand?
It's the relationship between the amount of available goods and the demand for them that can affect prices for those goods.
Why Are Supply and Demand Important to Know?
It's important and useful to understand the concept because, despite the change in prices caused by supply and demand imbalances, consumers can take advantage of them. If you understand the relationship, you can try to buy when you believe prices may drop and avoid purchases when prices are higher than they have been.
What Is Supply- and Demand-Driven Inflation?
It's inflation that's caused (or supported) by the effects of either supply or demand factors on personal consumption. Tracking this data can help the government understand the unexpected changes in prices as opposed to expected changes, e.g., those due to demographic changes, improvements in technology, and wage increases.
The Bottom Line
The law of supply and demand centers on prices that change when either the supply of goods and services or the demand for them changes. Normally, when supply increases and demand doesn't, prices go down. If supply remains unchanged while demand increases, prices rise.
Things beyond essential supply and demand can alter this reality, such as monopolies, price controls, and misinformation.
Consumers can take advantage of the law of supply and demand to make purchases at lower prices if they become aware of events that could affect either supply or demand.
