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Law of Supply and Demand: What Is It and How to Apply It?
3 min read
The law of supply and demand is perhaps one of the most fundamental concepts and it is the backbone of a market economy.
Demand refers to the quantity of a product or service that buyers want.
The quantity demanded of a product is the quantity that people are willing to buy at a given price; the relationship between the price and the quantity demanded is known as the demand ratio.
Supply represents how much the market can supply.
The quantity supplied of a given good is the quantity that producers are willing to supply when they receive a given price.
The correlation between the price and the quantity of a good or service supplied to the market is known as the supply ratio.
Price, therefore, is a reflection of supply and demand.
The relationship between demand and supply underlies the forces behind the allocation of resources.
In theories of market economics, the theory of demand and supply will allocate resources in the most efficient way possible.
How? Let us take a closer look at the law of demand and the law of supply.
The law of demand.
The law of demand states that, all other things being equal, the higher the price of a good, the less people will demand that good.
In other words, the higher the price, the smaller the quantity demanded.
The quantity of a good that buyers purchase at a higher price is less because as the price of a good rises, so does the opportunity cost of buying that good.
As a result, people will naturally avoid buying a good that forces them to forego consumption of something else they value more.
The graph below shows that the curve is downward sloping:
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P).
Thus, at point A, the quantity demanded will be Q1 and the price will be P1, and so on.
The demand ratio curve illustrates the negative relationship between price and quantity demanded.
The higher the price of a good, the lower the quantity demanded (A), and the lower the price, the more the good will be demanded (C).
The law of supply.
Like the law of demand, the law of supply shows the quantities that will be sold at a given price.
But unlike the law of demand, the supply ratio shows an upward slope.
This means that the higher the price, the higher the quantity supplied.
Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.
A, B and C are points on the supply curve.
Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P).
At point B, the quantity supplied will be Q2 and the price will be P2, and so on.
Time and supply.
However, unlike the demand relationship, the supply relationship is a factor of time.
It is important for supply because suppliers must, but cannot always, react quickly to a change in demand or price.
Therefore, it is important to try to determine whether a price change caused by demand will be temporary or permanent.
Say there is a sudden increase in demand and price for umbrellas in an unexpected rainy season; suppliers can simply accommodate the demand by using their production equipment more intensively.
However, if there is a climate change and the population needs umbrellas all year round, the change in demand and price is expected to be long-term; suppliers will have to change their equipment and production facilities to meet long-term demand levels.
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