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Supply and demand: understanding the market

October 5, 2022

9 min

Supply and demand: understanding the market
Beginner

The law of supply and demand provides a basic but effective explanation of market dynamics. Let’s find out what supply and demand are, their influencing factors and the characteristics of their respective curves in price graphs. How do these two economic forces reach equilibrium?

The law of supply and demand

The market is the place where buyers and sellers meet to voluntarily exchange goods and services for a common benefit. Imagine you want to buy an ice cream: your interest is to enjoy the snack, so you freely choose to pay 3€ for a cone. The ice-cream seller has the product you are looking for, so he is willing to serve it to you in exchange for money.

This situation is a simple explanation of the supply and demand mechanism. It corresponds to an exchange of value between buyer and seller, which must satisfy both parties in order to take place. Imagine that you do not want to pay more than 2€ for your ice cream, but the ice-cream vendor has set the price at 5€. You both have to adjust your choices for mutual benefit. This trade-off is represented by the equilibrium price, i.e. the intersection of the curves in the supply and demand graph.

Supply and Demand graph

The meeting of the supply and demand curves identifies the equilibrium price automatically and efficiently: buyers and sellers do not have to haggle at every exchange because the agreement has already been found by the market as a whole. In fact, the market already considers the different factors influencing supply and demand in order to bring them into equilibrium.

First of all, the market takes care of the distribution of resources. If a good is in high demand but scarce, consumers will be willing to pay more for it. Therefore, companies will have an incentive to produce more goods of that type. This will thus bring supply back to the same level as the demand, and the price will adjust accordingly. Conversely, goods produced in excessive quantities will have a lower price on the market, because they do not exhaust demand. Companies will therefore decrease production of that good due to poor earnings, and this will still balance supply and demand.

A synthetic form of the law of supply and demand could be explained like this: the more demand there is, the higher the price, and the greater the supply is, the lower the price is. Therefore, the market will always tend towards equilibrium, balancing quantities and adjusting prices.

However, product availability is not the only factor the market considers in managing its two fundamental forces. Let’s delve into what supply and demand are by discovering their individual characteristics and components.

The law of demand

The law of demand states that the demand for a good (or service) increases as its cost decreases, i.e. demand and price are inversely proportional. In particular, market (or total) demand is the sum of the demand of all individuals in the market. In other words, it is the total quantity demanded for a certain good as the price changes.

The market consists of different consumers, but their distribution does not depend only on price. There are other factors that influence demand:

  • The consumer’s income – the price of a good is assessed on the basis of the capital that a buyer has available, in terms of constant savings and income. Spending capacity in turn influences demand, because it indicates the amount of moneya buyer is willing to put into the purchase.
  • Cost of money – as we explained when discussing investing or saving, interest rates and inflation affect prices, hence purchasing power and demand.
  • Consumer preferences – products are not all the same, even if they are of the same type. The psychological component often wins out over rationality in purchasing, so we simply buy what we ‘like best’.
  • Subjective consumer expectations – in anticipation of a future price increase, buyers will purchase a larger quantity of a certain product, exceeding their immediate needs. This behaviour can be generated by real facts, such as rising inflation, or by psychological biases: a sense of urgency is decisive in behavioural finance.
  • Price of complementary goods and substitutes – some goods can be substituted when their price increases: for example, butter can be replaced by margarine, because they satisfy the same need. Complementary goods, on the other hand, work together to meet a certain need; this means that an increase in the price of petrol could reduce the demand for cars, for example.

These factors determine the shape of the demand curve, i.e. the function (in its mathematical sense in the field of calculus) that explains how the number of demanded goods changes as the price changes. In particular, the price elasticity of demand is assessed, an index that measures the ‘sensitivity‘ of demand to price changes. For instance, elasticity is used to understand how consumers react when a good increases in price, while the other factors listed above remain unchanged: how much will demand change?

Demand elasticity

In formulae, it is denoted by the letter ‘e’, and can take on any positive numerical value. However, for each category of goods, the elasticity of demand behaves differently. Demand for essential goods is rigid, because it remains constant whatever the price. The demand for luxury goods, on the other hand, is elastic, because they are easily substitutable. A small increase in price greatly decreases demand, because it is transferred to substitute goods.

However, demand has other characteristics besides elasticity, such as concentration. When there is only one buyer, a monopsony occurs. If there are only a few buyers, an oligopsony occurs. On the other hand, demand is pulverised when the market is composed of many consumers.

Finally, the demand curve usually has a negative slope, because as the price increases, demand decreases, except for so-called ‘Giffen goods‘.

Giffen’s paradox

Giffen’s goods do not respect the law of demand, because in this case, demand increases as the price increases. Giffen’s paradox concerns so-called ‘inferior goods’ (or basic necessities). This is the case with bread, or potatoes in famine-ridden Ireland (1845), whereby the increase in price led to the renunciation of ordinary goods (such as meat), which were replaced by an increased consumption of bread.

The law of supply

The law of supply, as opposed to demand, demonstrates a direct proportionality between the price of a good and the quantity offered. This is logical because producers are all the more willing to sell their products the more price increases. The sellers’ interest is in fact profit maximisation. The reasoning seems simple, the more goods are produced, the greater the potential profit, but there are other factors that influence supply:

  • process of producing goods – the quantity on offer is closely dependent on the process of creating goods. In particular, this concerns operations related to the supply chain: the purchase and sourcing of raw materials, the maintenance of machines and workers’ wages, transport and distribution. This, however, is not limited to a cost factor. For example: the pandemic has caused a shortage of microchips, so the availability of electronic devices has decreased.
  • Technological innovation: better machines decrease costs and increase the amount of goods produced. Therefore, supply has a double incentive from technological innovation: profits and overall performance improve. Although, some initial expenditure on research and development is necessary.
  • Government policies: the state could give companies incentives for technological innovation, or it could favour supply with national choices. For example, by abolishing export duties in order to open up new markets for products.

The supply curve has an increasing trend with respect to price. Its shape, just like demand, is determined by its elasticity. This factor depends on the availability of substitute resources for the production of goods and, above all, on the time period considered. In the short term, supply is rigid, i.e. it does not respond to changes in the market price, because it is difficult to change production volumes abruptly. It will therefore be more elastic as time passes.

Labour market

Labour is an atypical good, because it is offered by workers and demanded by companies. Moreover, the social characterisation of the labour ‘product’ influences the purely economic logic of its market. The supply and demand of labour vary according to wages, a specific ‘price’ indicator, and this determines the degree of employment.

Supply also has different characteristics depending on the number of sellers: if a good is available from only one producer, the situation is called a monopoly. When there are several sellers but still only a few, we are in an oligopoly. Finally, a market composed of many sources of supply is in a state of perfect competition. Individual sellers are not able to unilaterally determine the price of the product or service.

In general, now that we know what supply and demand are, we can say that precisely no economic actor (buyer or seller) can decide both the amount of demand or supply and its price, because one of the two values will be determined by the market as a whole.

The explanation of the law of supply and demand gives us the opportunity to look at the economic machine from above, from an impartial point of view. The economy thus appears to be a system dominated by quasi-physical laws, but let us not forget that the market is still composed of human subjects and animated by their complex behaviour. 

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