The law of supply and demand is probably the most basic “rule” in Economics, it is a theory that describes and explains the various interactions that take place between the sellers and the buyers of a specific good (or service) and defines the effects that these forces have on the determination of the price of that good (or service).
To be specific, this rule states that the price of a commodity is determined by the interaction of supply and demand in the market.
In order to better understand this theory is important to understand in the first place what supply and demand are.
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What is the supply?
In economics, supply is the amount of a resource that firms, producers, laborers, providers of financial assets, or other economic agents are willing and able to provide to the marketplace or directly to another agent in the marketplace.
In other words, the supply side of the equation represents “the sellers” of a specific good or service, in other words, it is composed by all those persons (actors) that want to sell a certain quantity of a product or service, at a certain price and at a certain point in time.
It is represented by the supply curve (the relationship between price and quantity provided), as you can see in the following graph. It is a curve that starts at the bottom left and then proceeds on the top right of the graph, which means that when price (P) is low, the producers will be less likely to produce in big quantities (Q), while when prices are high, they will produce more.
This is very intuitive, in fact, if for example you own a shoe factory you would be more willing to produce more shoes at higher selling price because profits will increase.
Factors influencing supply
Supply can be affected by innumerable factors and circumstances, the most basic is that of “good’s own price” that describes the fact that an increase in price will induce an increase in the quantity supplied, then some of other most common are:
– Prices of related goods: these are the goods that in some way or another can influence the decisions of the supplier in relation to the price or quantity that decides to produce. For example, if we have opened a bakery and therefore we produce bread, if the price of flour increases, our costs of production will increase as well, which could mean that we will have to start selling bread at a higher price or on the other hand we may decide to produce less of it.
– Expectations: it relates to the fact that sellers tend to decide how much to produce in relation to what they expect the market will be in the foreseeable future, which means that if a seller believes that the demand for his product will increase in the near future, he may immediately increase production, expecting price increases in the future.
– Government policies and regulations: Independently from the economy we operate, government intervention tend to have always a significant effect on supply. In fact, the government can influence the economic equilibrium in different forms, like by introducing new regulations, by modifying hour and wage laws, increasing or lowering taxes, etc.
– The number of suppliers: Given that the market supply curve is the summation of the supply curves of all individuals that participate in a certain market, as more firms enter the same market, prices will tend to be driven down.
What is demand?
In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given period of time.
In other words, the demand side of the equation represents “the buyers” of a specific good or service, it is composed by all those persons (actors) that want to buy a certain quantity of a product or service, at a certain price and at a certain point in time.
It is represented by the supply curve (the relationship between price and quantity demanded), as you can see in the following graph. It is a curve that starts at the top left and ends on the bottom right of the graph, which means that when price (P) is high, the buyers will be less likely to purchase in big quantities (Q), while when prices are low, they will be likely to buy a lot more.
This is easy to understand, in fact, when you go to the supermarket and you see that your favorite snacks are 50% off, you will be likely to buy a larger quantity than you would normally do.
Factors influencing demand
As in the case of the supply curve, the demand curve can be influenced by many different factors and circumstances in addition to the most basic one, that is the “good’s own price” that describes the fact that an increase in price will induce a decrease in the quantity demanded, then some of other most common are:
– Tastes or preferences: it is based on the idea that the greater the desire to own a good, the more likely one is to buy that good.
– Disposable Income: it is the income after tax and receipt of benefits that an individual has. The higher this number is, the greater is the increase in quantity demanded.
– Population: generally, when the population grows, demand tends to increase as well.
– Price of related goods: When talking about related goods we need to distinguish between complements and substitutes.
Complements are goods that are used with the primary good, like automobiles and gasoline, they are very connected from various points of view, and in this case, they tend to behave as a single good, therefore if the price of the complement (gasoline) goes up, the quantity demanded of the other good (automobiles) goes down.
On the other hand, substitutes are goods that can be used in place of the primary good, like butter and margarine. In this case, if the price of the substitute (margarine) goes down, the demand for the good in question (butter) goes down, because buyers prefer to buy the cheaper option.
Understanding the law of supply and demand
Until now we have analyzed supply and demand separately, however, the final stage in understanding the law of demand and supply is putting them together and understanding how they behave in relation to one another when facing real-life situations.
Suppose that we are wine producers, we sell our wine at a price of $15 a bottle, that is p1.
Then, due to an increase in disposable income and an increasing passion for good wine, people start demanding more and more bottles, therefore the demand curve shifts from D to D’, and the new equilibrium point is found at p2, the new price of our wine, $20 per bottle.
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