Law of Supply and Demand

The law of supply and demand is a theory that explains the interaction between the supply of a resource and the demand for that resource. The theory defines the effect that 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. In contrast, the greater the supply and the lower the demand, the price tends to fall.

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.

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.

For a simple illustration of how supply and demand determine equilibrium price, imagine a business launching a new product. It sets a high price, but only a few consumers buy it. The business anticipated selling more units, but due to lack of interest, it has warehouses full of the product. Due to the high supply, the business lowers the product price. Demand increases, but as the supply dwindles, the business raises the price until it finds the perfect, or equilibrium, price to balance its product supply with consumer demand.

The above example takes into account the supply created only by a single business. In the real world, supply is determined by many other factors. 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.

Demand is affected by the quality and cost of a product, among other factors. The number of available substitutes, amount of advertising and the shifts in the price of complementary products also 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.

The law of supply and demand does not apply just to prices. It also can be used to describe other economic activity. For example, if unemployment is high, there is a large supply of workers. As a result, businesses tend to lower wages. Conversely, when unemployment is low, the supply of workers is also low, and as a result, to entice workers, employers tend to offer higher salaries. Similarly, in the world of stock investing, the law of supply and demand can help to explain a stock's price at any given time.