What is the Law of Supply and Demand?

Two stamps with 'supply' and 'demand' written on them
Image source: Getty Images

The law of supply and demand is an economic theory that explains how buyers and sellers interact to determine the price and supply of a resource. The theory explores the impacts of availability and demand for products and services. 

The law of supply and demand can be applied to all types of goods – everything from fresh produce to ASX shares. 

What is the law of supply? 

The law of supply says that suppliers will produce more of a good if it sells at higher prices. This makes sense, as higher prices mean increased revenue. Suppliers are willing to deliver more products and services where they are paid more for doing so. 

The law of supply can be graphed via the supply curve, which shows the correlation between the price of a good or service and the quantity supplied for a given period.

What is the law of demand? 

The law of demand says that demand for a particular product will increase as the price reduces. This is because consumers can afford to buy more if prices are lower. 

Conversely, the higher the price, the less people will demand. This is because the opportunity cost of purchasing a particular good increases with the price. The law of demand can be graphed via the demand curve, which shows the correlation between the price of a good or service and the quantity demanded in a given period.

How does the law of supply and demand work?

The law of supply and demand says that the price of a particular good will be determined by the point at which the supply and demand curves intersect. At this point, buyers are willing to buy the same quantities as sellers are willing to produce. 

This is the market-clearing price, known as the ‘equilibrium price’. At the equilibrium price, suppliers can sell all the units they wish to supply, and buyers can buy all the units they want to buy.

Which factors impact demand?

The level of demand for different goods and services can be impacted by numerous factors. Total demand depends on how much of a product consumers are willing and able to purchase at a particular price. 

If we do not want or need something, we are unlikely to buy it. Our willingness to buy products can be influenced by advertising and publicity, brand awareness, and perceived value. Our ability to buy products is a function of our incomes and other expenses. Therefore, as incomes increase, consumption tends to increase. 

The price of related and complementary goods can also impact demand. If you are shopping for a new car, you may compare similar models from different manufacturers. The price of one model will impact on how much you are willing to pay for another. 

When goods are complementary, a change in the price or demand for one affects the other. For example, a decrease in the price of video game consoles may increase the demand for video games.

Factors impacting supply 

The level of supply can be impacted by factors that can encourage or discourage production. The availability of workers, weather, technology, and government subsidies can cause shifts in the supply curve. 

Where the price of inputs or the cost of production falls, businesses can supply more goods at a lower price. Similarly, improvements in productivity and investments in capacity can increase supply. 

Supply can be constrained by factors such as bad weather, which can cause agricultural yields to fall, and higher taxes, which increase the cost of goods. 

Why is the law of supply and demand important?  

By understanding the law of supply and demand, we can better understand the factors impacting the price and availability of resources. 

The law of supply and demand also applies to the share market. The price of a share is the equilibrium price of the supply and demand curves at the time the share is sold. 

Share prices fluctuate as a result of changes in supply and demand. When a company reports good news, sellers may demand a higher price for their shares, and buyers may be more willing to pay that price. Conversely, if there is a deterioration in a company’s outlook, buyers may offer less for shares. 

Motley Fool contributor Katherine O’Brien has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.