You Never Learnt The Actual Law of Demand and Supply.

There are three basic questions in economics; “What to produce?”, “How to produce?” and “For whom to produce?” These questions can be answered by understanding the market demand and supply trends. But have you ever wondered how the market functions smoothly day in and day out? 

At a micro level, a house functions through the mutual understanding between family members where the roles of each member are clearly distributed. An imbalance in one’s job disrupts the entire house’s system. The economy too, at large, depends on multiple such codependent relationships for its daily functioning. One such relationship is that of price, demand and supply, which chalks out the production and consumption of the nation. 

The law of demand and supply is a theory which encompasses almost all economic theories and works as its own little family. How about we give this family a visit? 

What is the Law of Demand and Supply?

The law of demand and supply is one of the most fundamental concepts and the very backbone of the market economy. It explains how sellers and buyers of a resource interact with each other. The laws of demand and supply work together to determine the final quantity of goods and services offered in the market. The equilibrium price at which producers are willing to sell, and consumers desire to buy is also dependent on this law.

Law of Demand

Demand refers to the quantity of goods and services the buyers want. The law of demand states that while other factors remain constant, the demand decreases as the price of goods increases. In other words, price and demand are inversely related. 

Say you pay ₹100 for coffee every day, while your friend buys tea for ₹60. If the price of coffee increases to ₹150, so does your opportunity cost. This is because now, instead of paying ₹40 extra (100-60), you are paying ₹90 (150-60) more than your friend. You might feel tempted to switch to tea, and thus the demand for coffee will decrease.

This is the effect of the law of demand, as when the price of a commodity increases, its value decreases. This is because consumers are paying more for the same product, and the price no longer seems worthwhile, decreasing its overall demand. 

Law of Supply

Supply represents the goods produced and available in the market. The law of supply says that while other things remain constant, as the price of goods increases, their supply increases, i.e. there is a direct relationship between price and supply. With an increase in price, the same goods are sold at a higher price, and therefore more revenue is collected. This acts as an incentive for the producer to manufacture more, increasing the overall supply. 

Collectively, the law of demand and supply also explains how prices of goods increase when their demand increases, i.e. they become more popular, or their supply decreases, i.e. they become rare. For example, prices of sanitisers and soaps increased during the pandemic. Conversely, prices of goods decrease when their supply increases excessively or when their demand decreases. 

Supply and Demand Curves

Information becomes easier to grasp when represented pictorially. The supply and demand curves are a way to graphically represent the quantity of goods and services demanded and supplied in the market at any given price. 

Quantity demanded and supplied is on the x-axis, and the price is on the y-axis. Here, the time interval being represented plays a very important role as it determines the shape of the curves. Typically, the graph represents a single point in time. In such a case, the supply curve is a vertically straight line as the supply of goods is fixed.

The supplier has no control over the quantity output as it increases in proportion to the prevalent price and demand. The supplier also needs time to produce additional units of goods and/or services. However, over a longer period of time, suppliers can increase or decrease the quantity of goods based on how much they intend to charge and take control of the prices. So over time, the supply curve (blue) then slopes upwards. 

Irrespective of whether the graph is prepared for a fixed point or over a period of time, the demand curve (red) slopes downwards from left to right. This is due to the law of diminishing marginal utility, which simply means that as consumers consume additional units of a product, the satisfaction derived from consuming it successively decreases, and therefore its demand decreases. 

As you can see, at lower prices, the demand is more, but the supply is less. Whereas at higher prices, the demand is less but supply is more. What happens when these curves intersect? Let’s learn more about it!

Equilibrium Price

You may have heard yoga instructors or spiritual enthusiasts talk about mind-body equilibrium, which is a healthy state where your mind and body are in complete sync. Similarly, equilibrium is the point in the market which represents the price level at which demand and supply are equal. It occurs when there is a state of no change. 

Equilibrium price (red dot) is that price level where the producers are willing to manufacture and sell goods, and the consumers are willing to purchase them. Market demand and supply are balanced, and prices become steady. This depends largely on the shape and position of the respective curves, which are influenced by several factors such as production costs, labour and material, technology, taxes, etc. 

The Bottom Line

It's hard to manually set the alarm every day, but it's great when you naturally wake up early. Everyone prefers things to happen automatically without having to provide too many inputs. The law of demand and supply does just that where it continuously keeps the market in check by automatically regulating prices and managing quantities of commodities.

We participate in this phenomenon every single day by demanding more or fewer goods according to their prices. So the next time you see the prices of certain goods increasing rapidly, before blaming the government for being unfair, check if that could be because of a sudden increase in demand or a shortage in its supply.