Supply and Demand

The Law of Supply and Demand

Behind the interaction between consumers and producers is the theory known as the law of supply and demand. This law is defined by the relationship between the price of a product or service and the willingness of market actors to either provide or consume that product or service based off that price.

You may think of the law of supply and demand as a theory compounded by two complimentary laws, the law of demand and the law of supply. The law of demand states that the higher the price of a good, the lower the quantity consumers will wish to buy. The law of supply, on the other hand, states that the higher the price, the more of that good producers will want to supply. Together, these laws act to drive the price and quantity of goods in the market. The compromise between consumers and producers in price and quantity is known as the equilibrium.

Some supply and demand examples include markets for physical goods, where producers supply the product and consumers then purchase it. Another example is markets for various services, where service providers are the producers and users of that service are the consumers.

Regardless of what the commodity that is being transacted, the supply and demand relationship between producers and consumers is what fine-tunes the price and quantity of that commodity available, thus allowing the market for it to exist.

Supply and Demand Graph

The supply and demand graph has two axes: the vertical axis represents the price of the good or service, while the horizontal axis represents the quantity of the good or service. The supply curve is a line that slopes upwards from left to right, indicating that as the price of the good or service increases, producers are willing to supply more of it. The demand curve is a line that slopes downwards from left to right, indicating that as the price of the good or service increases, consumers are willing to demand less of it.

The graph is easily recognizable by its "criss-cross" system of two functions, one representing supply and the other representing demand.

Fig. 1 - Basic Supply and Demand Graph

Supply and demand schedule

Since the supply and demand functions represent data in a market, you need data points to put on a graph to ultimately draw the functions. To make this process organized and easy to follow, you may want to enter your data points, which are different quantities of product or service demanded and supplied at a range of price points, into a table that you will refer to as a schedule. Take a look at Table 1 below for an example:

Whether you are drawing your supply and demand graph by hand, using a graphing calculator, or even spreadsheets, having a schedule will not only help you stay organized with your data but insure that your graphs are as accurate as they can be.

Supply and demand curves

Now that you are familiar with supply and demand schedules, the next step is to put your data points into a graph, thus producing a supply and demand graph. You can do this either by hand on paper or let software do the task. Regardless of the method, the outcome will likely look similar to the graph you can see in Figure 2 provided below as an example:

Fig. 2 - Supply and demand graph

As you can see from Figure 2, demand is a downward-sloping function and supply slopes upward. Demand slopes downward mainly due to diminishing marginal utility, as well as the substitution effect, which is characterized by consumers seeking alternatives at cheaper prices as the price of the original product rises.

Notice that while both the supply and demand functions in the graph above are linear for the sake of simplicity, you will often see that supply and demand functions can follow different slopes and can often look more like curves rather than simple straight lines, as shown in Figure 3 below. How the supply and demand functions look on a graph depends on what kind of equations provide the best fit for the data sets behind the functions.

Fig. 2 - Non-linear supply and demand functions

Supply and Demand: Equilibrium

So why graph supply and demand in the first place? Besides visualizing data about consumers' and producers' behavior in a market, one important task that a supply and demand graph will help you with is finding and identifying the equilibrium quantity and price in the market.

Looking back at the supply and demand graph provided above, you will notice that the point of intersection between the supply and demand functions is labeled as "equilibrium". The equilibrium equating to the point of intersection between the two functions ties into the fact that equilibrium is where consumers and producers (represented by the demand and supply functions, respectively) meet at a compromising price-quantity.

Refer to the mathematical representation of the equilibrium below, where Q_s equals quantity supplied, and Q_d equals quantity demanded.

Equilibrium occurs when:

\(\hbox{Qs}=\hbox{Qd}\)

\(\hbox{Quantity Supplied}=\hbox{Quantity Deamnded}\)

There are many other valuable conclusions that you can gather from a supply and demand graph, such as surpluses and shortages.

To learn more about surpluses as well as get a deeper understanding of equilibrium, take a look at our explanation on Market Equilibrium and Consumer and Producer Surplus.

Determinants of demand and supply

Changes in the price of a good or a service will lead to a movement along the supply and demand curves. However, changes in the demand and supply determinants will shift either the demand or the supply curves respectively.

Shifters of supply and demand

Determinants of demand include but are not limited to:

• Changes in prices of related goods
• Consumers' income
• Consumers' tastes
• Consumers' expectations
• Number of consumers in the market

Determinants of supply include but are not limited to:

• Changes in input prices
• Price of related goods
• Changes in technology
• Producers' expectations
• Number of producers in the market

The elasticity of supply and demand

As you become more familiar with supply and demand and interpreting their corresponding graphs, you will notice that different supply and demand functions vary in the steepness of their slopes and curvatures. The steepness of these curves reflects the elasticity of each supply and demand.

While both supply and demand are subject to variation in elasticity, it is interpreted differently for each function.

Elasticity of demand

Elasticity of demand represents how sensitive demand is to a change in various economic factors in the market. The more the consumers are responsive to an economic change, in terms of how much that change affects the consumers' willingness to still purchase that good, the more elastic the demand. Alternatively, the less flexible the consumers are to economic fluctuations for a specific good, meaning they likely have to continue purchasing that good regardless of the changes, the more inelastic demand is.

You can calculate the price elasticity of demand, for example, simply by dividing the percentage change in quantity demanded by the percentage change in price, as shown by the formula below:

\(\hbox{Price elasticity of demand}=\frac{\hbox{% $\Delta$ Quantity demanded}}{\hbox{% $\Delta$ Price}}\)

There are three main types of elasticity of demand that you will need to focus on for now:

• Price elasticity: measures how much the quantity demanded of a good varies due to changes in the good's price. Learn more in our explanation on Price elasticity of demand.
• Income elasticity: measures how much the quantity demanded of a specific good varies due to changes in income of the consumers of that good. Check out our explanation on Income Elasticity of Demand.
• Cross elasticity: measures how much the quantity demanded of one good changes in response to a change in the price of another good. See more in our explanation for Cross Elasticity of Demand.

Elasticity of supply

Supply can also vary in elasticity. One specific type of elasticity of supply is price elasticity of supply, which measures how responsive producers of a certain commodity are to a change in market price for that commodity.

You can calculate price elasticity of supply by dividing the percentage change in quantity supplied by the percentage change in price, as shown by the formula below:

\(\hbox{Price elasticity of Supply}=\frac{\hbox{% $\Delta$ Quantity Supplied}}{\hbox{% $\Delta$ Price}}\)

There are numerous factors that can affect price elasticity of supply, such as availability of resources needed for production, changes in demand for the product that the firm produces, and innovations in technology.

Supply and Demand Examples

Let's consider and example of the supply and demand of ice-cream in a small city in the UK.

At a price of $2 per scoop, there is excess demand for ice cream, meaning that consumers want to buy more ice cream than suppliers are willing to provide. This shortage will cause the price to increase.

As the price increases, the quantity demanded decreases and the quantity supplied increases, until the market reaches an equilibrium price of $4 per scoop. At this price, the quantity of ice cream that consumers want to buy is exactly equal to the quantity that suppliers are willing to provide, and there is no excess demand or supply.

If the price were to increase further to $6 per scoop, there would be excess supply, meaning that suppliers are willing to provide more ice cream than consumers want to buy, and this surplus will cause the price to decrease until it reaches a new equilibrium.

The concept of supply and demand is relevant throughout the entire field of economics, and that includes macroeconomics and economic government policies.

Supply and Demand Example: Global Oil Prices

From 1999 to 2007, the price of oil increased due to rising demand from countries like China and India, and by 2008, it reached an all-time high of $147 a barrel. However, the financial crisis of 2007-2008 led to a decline in demand, causing the price of oil to plummet to $34 a barrel by December 2008. After the crisis, the price of oil rebounded and rose to $82 a barrel in 2009. Between 2011 and 2014, the price of oil remained mostly between $90 and $120 due to demand from emerging economies, especially China. However, by 2014, oil production from unconventional sources like hydraulic fracturing in the United States caused a significant increase in supply, leading to a decline in demand and a subsequent drop in oil prices. In response, OPEC members increased their oil production to try and maintain their market share, causing a surplus of oil and further driving down prices. This demonstrates the relationship between supply and demand, where an increase in demand results in an increase in prices, and an increase in supply leads to a decrease in prices.

Effect of Government Policies on Supply and Demand

Governments may intervene in the course of economies in order to correct for undesirable effects of the current economic climates, as well as attempt to optimize future outcomes. There are three main tools that regulatory authorities may use to create targeted changes in the economy:

• Regulations and policies
• Taxes
• Subsidies

Each of these tools may cause either positive or negative changes in the cost of production of various goods. These changes will impact the behavior of producers, which will ultimately affect the price in the market. You can learn more about the effects of these factors on supply in our explanation of Shift in Supply.

The change in market price, in turn, will likely have an effect on consumers' behavior and subsequently, demand. See more on what factors affect demand and how, as well the extent to which these factors will influence demand based on various circumstances, in our explanations on Shifts in Demand and Price Elasticity of Demand.

Thus, government policies can have a domino-like effect on supply and demand that can entirely change the state of markets. To find out more about this, check out our explanation on The Effects of Government Intervention in Markets.

Government policies may also affect property rights to various resources. Examples of property rights include copyright and patents, which can be applied to intellectual property as well as physical objects. Owning patents or copyrights grants enables exclusivity over the production of a good or service, which leaves consumers with fewer options in the market. This will likely result in the market price increasing, as consumers will have no other choice but to take the price and make a purchase.