Supply and Demand

What It Means

Markets, the physical or virtual places where buyers and sellers come together, have the capability to determine the most efficient ways of meeting the needs of both the buyers and the sellers of a particular product. To understand how markets do this, it is essential to understand the workings of two independent and competing forces: supply and demand.

Supply refers to the amount of a particular product that sellers are willing or able to sell over a range of prices, and demand refers to the amount of a particular product that buyers are willing or able to buy over a range of prices. The law of supply states that, all other factors being constant, sellers will be willing to sell more and more of a particular product as prices for that product rise. The law of demand states that, all other factors being constant, buyers will purchase less and less of a particular product as prices for that product rise. In the marketplace these two laws compete to determine the price at which any given product will be sold.

As a simple illustration of these principles, imagine that you make handcrafted coffee mugs to sell at a flea market every Saturday. Suppose that you have produced 100 mugs to sell initially, and on the first Saturday you arrive at the market with all of them. You set the sale price of your mugs at $8, but only 10 mugs sell. The next weekend, you slash the price of your mugs to $3, and all 90 of your remaining mugs sell within a few hours. This suggests that at the right price there will be demand for your mugs. You cannot, however, justify continuing to produce them at such a low price. You decide to make another 100 mugs that week and to sell them at $5 apiece the following weekend. It turns out that, at this price, you are able to sell all the mugs during the course of a market day, and you feel that $5 per mug justifies the amount of time and effort required to produce and sell 100 of them each week. The market price of $5 has been established by the opposing forces of supply and demand.

Supply and demand play a similar, if sometimes more complex, role in virtually all financial transactions. Together they form the backbone of all economies and of all economic theory.

When Did It Begin

The forces of supply and demand have no doubt always influenced markets in much the same way that they do today, but it was not until the eighteenth century that philosophers and economic thinkers began to analyze the interrelated workings of supply, demand, and price in detail. Sir James Steuart-Denham (1712–80), the Scottish author of what is considered the first systematic work on economics (An Inquiry into the Principles of Political Economy; 1767), was the first to use the phrase “supply and demand” to explain how prices were established.

Another Scottish writer, Adam Smith (1723–90), discussed supply and demand at length in his landmark book An Inquiry into the Nature and Causes of the Wealth of Nations (1776), which helped establish and shape the emerging field of economics. But Smith believed that producers based the price of a good on what it cost them to make and bring the good to market and that consumers had little effect on price; this perspective has since been supplanted by the idea of the simultaneous interaction of supply and demand. The French mathematician Antoine-Augustin Cournot (1801–77) helped further the understanding of the interaction between supply, demand, and prices by devising a way of diagramming these forces at work in a market; today such diagrams, called supply and demand curves, are basic tools for economic analysis. Cournot’s notion of supply and demand was integrated into the growing body of economic thought and was further refined by the British economist Alfred Marshall (1842–1924), whose Principles of Economics (1890) was a standard economics textbook from its publication until the mid-twentieth century. Basic supply-and-demand theory has changed little since Marshall’s time.

More Detailed Information

The laws of supply and demand allow us to understand the interaction of supply, demand, and prices for a given product, assuming that all other factors remain constant. These laws tell us that, when prices rise, sellers are willing to sell more of a product while buyers are less willing to buy that product, and that it is the balancing of these forces that determines the price at which the product will be sold. The real world, however, rarely offers economic situations in which all factors except supply, demand, and price are constant. It is important, then, to note the numerous factors other than price that affect both supply and demand.

The chief factors, aside from a product’s price, that can determine supply of that product are:

The number of sellers of that same product

Variations in the number of sellers of a given product affect supply. For instance, if trade restrictions on beef from foreign countries were relaxed, the supply of beef in the United States would rise as a result of an influx of new, foreign sellers.

New technology that brings changes in production of that product

Technological change makes it possible to increase supply drastically and to supply goods at a wider range of possible selling prices. For instance, the introduction of powerful personal computers into virtually every industry in the world has drastically increased the efficiency and cost of producing many goods, allowing for increased supplies of those goods.

The prices of raw materials as well as labor and other investments needed to operate a business

If any of these prices drops, producers make higher profits and will want to produce more of a given product; correspondingly, if any of these prices rise, supply will decrease. If, for instance, the price of steel drops, carmakers can produce cars more cheaply and will be likely to increase supply.

Taxes and subsidies

All businesses must pay taxes (money charged by the government to fund running the state or country). These ultimately represent an increase in a seller’s expenses; therefore, they work like any other increase, such as an increase in raw materials. Governments also give subsidies (financial assistance) to some companies and organizations. Subsidies function in the same way as decreases in production costs, enabling an increase in supply.

Producers’ expectations about future events

Producers sometimes adjust supply when preparing for future events likely to affect business. If, for instance, farmers expect corn prices to rise in several months’ time, they might decrease the current supply in order to have more corn on hand to sell later, at a higher price.

The prices of other goods the producer might be able to bring to market

Companies are always balancing the profits they derive from a particular product with the profits they might derive by producing a different product. If a producer decides that he or she can make more money by reducing the supply of one product in favor of increasing the supply of another, that producer is likely to do so.

The chief factors, aside from the price of a given product, that can determine demand for that product are:

The number of buyers

Increases or decreases in the potential consumers of a given product affect demand for that product. Take for example, the baby boom generation (those born roughly between 1946 and 1964). It is a much larger generation than preceding generations of Americans, so the demographic shift that will occur as baby boomers age might result in increased demand for condominiums in retirement communities.

Tastes and preferences in the culture at large

Based on a variety of often obscure factors, consumers’ desires sometimes shift dramatically and affect demand. Wool sweaters might suddenly become horribly unfashionable, reducing the demand for them in a short period of time.

Changes in income

When people begin to make more money or fail to make as much money as they did previously, their consumption patterns change. Someone who gets a raise might stop buying frozen dinners and start going out to restaurants, decreasing the demand for one and increasing demand for the other.

Buyers’ expectations

When buyers themselves sense large-scale changes that might affect the price or availability of particular items, they sometimes adjust their consumption patterns as a means of preparing for the changes. For instance, if prospective homebuyers believe that home-loan rates are going to rise in the future, they might rush to buy homes by borrowing money from a bank at the current, lower interest rate (interest is a fee paid to borrow money; for home loans interest payments can add up to huge amounts over time).

Prices of competing goods or complementary goods

Prices of goods that consumers view as alternatives to a given product affect the demand for that product. For instance, if the price of Pepsi dropped significantly, demand for Coke might drop as more soda drinkers choose Pepsi instead. Additionally, the prices of complementary goods (goods that are often bought in combination with, or consumed at the same time as, a certain product) affect demand for a product. A substantial rise in the price of gas, for instance, might decrease the demand for SUVs.

Recent Trends

Although the workings of supply and demand were first outlined by professional thinkers, mathematicians, and economists, almost everyone in the developed world today has an implicit understanding of the laws of supply and demand.

For instance, if you were trying to sell your house for $300,000, and no one made an offer after six months, you would hardly consider attempting to attract new buyers by raising the price. Although you might consult a real estate agent about the fine points, you would have no trouble deciding for yourself that it made sense, after six months in which no demand for your house had surfaced, to lower the price. If you dropped the price to $250,000, you would be doing so because you understood that, at that price, more people would be likely to buy it. This behavior demonstrates a clear understanding of the law of demand, even though you might not recognize it as such.

Similarly, if you were preparing to set up a lawn-mowing service in your town, you might ponder the price per hour that makes the time and effort of mowing lawns seem worthwhile to you. At $15 per hour you might be willing to mow the lawns of as many people as daylight would allow in a given week. At $10 per hour, however, you might only be willing to mow lawns for 20 hours each week, because you know that you could make that much money per hour as a record-shop clerk, which requires much less physical effort. Although you might contemplate these figures purely in terms of your own comfort and desire for money, you would actually be basing your decision on the law of supply.

One of the reasons that these principles remain so central to economic theory is that they make so much intuitive sense. Although economists at elite universities typically master far more complicated concepts and mathematical operations than those represented by the above examples, virtually all of their work builds on the elegantly simple laws of supply and demand.