What is supply and demand?

Supply and demand are one of the most important concepts in economics. They drive the prices of goods and services in a market economy, as well as salary levels.

Demand represents how much of a product or service people want.

Supply represents how much (the quantity) of a good or service a market is able to offer.

The amount of a product people are willing to buy at a price is “the quantity demanded”. The relationship between demand and price is called the demand relationship.

Supply and demandIn a free-market economy, supply and demand determine the prices of goods and services.

The amount of a product supplied at a price is “the quantity supplied”. The relationship between price and supply is called the supply relationship.

Supply and demand are known by economists as market forces.

According to ft.com/lexicon, supply and demand are:

“The relationship between the amount of products and services that are for sale and the amount that people want to buy, especially in the way this affects prices.”

Supply and demand are determined by technology and other conditions that people operate.

Consumers will typically continue buying goods if the fulfillment that comes from the goods or service is worth the price they pay, and suppliers will continue to provide goods if they can sell the them at a profit, i.e. the cost of production is less than the sale price.

This relationship allows us to find the “market price” for goods or services.


Perfect competition

Economists have devised models to describe how different markets work. But one of the most important concepts is that of a market with perfect competition. 

In perfect competition, there are an equal number of suppliers and demanders for a product. As a result, the prices of goods and services don’t change and new producers can enter at any time.

Under perfect competition, the market price for goods or services is where there is no excess supply and no excess demand. 

Economists can determine this point by merging two graphical representations of supply and demand: the demand curve and the supply curve.


Demand and supply curves

You can graphically represent the quantities suppliers are willing to produce at each price with the supply curve.

Similarly, you can show how much of a product consumers are willing to buy at a certain price with the demand curve. 

supply and demand curves

The supply curve slopes upward, showing how as prices increase, production rises. The demand curve slopes downward, which shows how consumers buy less as prices increase.

The point at which the demand curve and supply curve meet is called the equilibrium price.

There are four basic laws of supply and demand:

  • If supply stays the same and demand increases, then a shortage will occur. This causes the equilibrium price to increase.
  • If supply stays the same and demand decreases, then a surplus will occur. This causes the equilibrium price to decrease.
  • If supply increases and demand stays the same, then a surplus will occur. This causes the equilibrium price to decrease.
  • If supply decreases and demand stays the same, then a shortage will occur. This causes the equilibrium price to increase.

Whenever there is a shortage, prices increase, inversely with every surplus there will be a price decrease.

Supply and Demand in history

The principle of supply and demand driving the price of goods and services dates back many hundreds of years. Ibn Taymiyyah (1263-1328), an Islamic scholar (alim), theologian and logician, wrote:

“If desire for goods increases while its availability decreases, its price rises. On the other hand, if availability of the good increases and the desire for it decreases, the price comes down.”

Adam Smith (1723-1790), a Scottish moral philosopher and pioneer of political economy, known today as the father of modern capitalism, wrote regarding supply and demand in his book An Inquiry into the Nature and Causes of the Wealth of Nations:

“The quantity of every commodity brought to market naturally suits itself to the effectual demand. It is the interest of all those who employ their land, labour, or stock, in bringing any commodity to market, that the quantity never should exceed the effectual demand; and it is the interest of all other people that it never should fall short of that demand.”

In a communist system, prices are determined by the government and do not depend on supply and demand, as in free-market systems. It became clear during the second half of the 20th century in the Soviet Union that communism did not work – it led to severe and chronic shortages of goods and services.

Video – Demand and supply