The Law of Supply and Demand
The law of supply and demand is possible one of the most important principles that can lead to the understanding of how the prices and quantity of goods in a market are determined. The law also explains more or less how these prices influence the decisions regarding the production and the consumption of goods, which is considered a basic framework of any economic system. In other words, it can be deduced that the price of a good or item in the market is directly affected by its supply and its demand, which form one of fundamental principles in economics (Investopedia, 2008)
The concepts of supply and demand are generally applied in a type of free market which is called a “perfect competition.” Under this premise, there is not a single seller or buyer that can affect the changes in prices. Moreover, it is first necessary to elaborate their individual laws. The law of supply generally states that the quantity of goods is directly proportional to its price. In other words, as the price of goods increases, its quantity will also increase (Investopedia, 2008). In addition, the law states that producers generate more goods at a higher price because this increases profits (Investopedia, 2008).
On the other hand, the law of demand is considered the reverse of the law of supply. According to the law, the quantity of goods is inversely proportional to its price. As the price of goods increases, its quantity will decrease or as the price of goods decreases, its supply will increase (Investopedia, 2008). In other words, the higher and more expensive the price of a good is, the less people will buy that good or vice versa. Generally, higher prices of goods cause people to avoid buying products which can compel them to skip consuming other items that have more value (Investopedia, 2008). Furthermore, both the law of supply and the law of demand are applied under the assumption that all the other factors continue to remain equal.
However, the law of supply and demand predicts that under a competitive and free market, the value of a good will eventually shift to the right price called the “clearing market price” (Kirzner, 2000). Basically, the market price is a good’s “ideal price” (Kirzner, 2000) at which consumers who would like to buy can find producers and all producers who wish to sell can find prospective buyers. In this case, the amount of goods being supplied and the demand for them is equal. In short, the law of supply and demand states that the quantity and the demand of a good will always move towards equilibrium (Kirzner, 2000). Moreover, this law is possible the most important principle of Adam Smith’s famous concept, the invisible hand.
However, equilibrium can also be affected by various factors. These include excess supply and excess demand (Investopedia, 2008). Excess supply, as the name implies, is the production of excess goods. This usually happens when goods are priced too high, causing consumers to purchase less. On the other hand, excess demand, is the instance when consumers buy too much of a product. This usually occurs when prices of a good are too low, causing a lot of consumers to purchase more than the quantity supplied by the producers (Investopedia, 2008).
Furthermore, two concepts that illustrate the relation of supply and demand are the movements and shifts. Generally, a movement is change along the curve (Investopedia, 2008). On the demand curve, a movement symbolizes a change in both the quantity and the price of a good from one point to another along the curve. In addition, this movement indicates that the relationship between price and quantity remains consistent. In short, a movement can only occur when a change in a good’s quantity is the direct result of a change in its price (Investopedia, 2008). The same principle also applies during a movement on the supply curve.
A shift, on the other hand, happens when the demand for or supply of the quantity of a good changes while prices remain constant (Investopedia, 2008). For example, if the amount of bread being demanded increases even though its price remains at $1, then a shift for its demand would occur. Likewise, if the supply of bread decreases even though its price remains the same, then a shift in the quantity of beer. It can then be deduced that the shifts on the supply and demand curves are caused by factors other than price changes (Investopedia, 2008).
Finally, two important factors that impact supply and demand are scarcity and choice. Scarcity occurs when the resources available are not enough to fulfill the wants of the people. This is a universal problem due to the fact that the wants and desires of humans always exceed the resources available (University of Maryland University College Europe, 2008). Because humans cannot have everything they want, they are compelled to make choices. This is an act of ranking their personal preferences that serve as alternatives to satisfy their wants (University of Maryland University College Europe, 2008). For example, they rank their preferences as first choice, second choice etc.
The first effect of scarcity on supply and demand is that it causes the amount of goods available to decrease. When this happens, the demand for those goods grows and in effect, not everyone is satisfied. In addition, due to the scarcity of one particular type of good, people will then make choose from alternatives which they will rank based on their needs and preferences. Subsequently, due to the sudden demand for the alternative types of good, their prices will increase and will eventually cause the demand to gradually decrease. In short, the main effect of scarcity and choice on supply and demand is that it causes various shifts and movements in their respective curves. However, this is a normal occurrence in a free market and is considered one of the backbones of the study of economics.
Investopedia. (2008). Economic Basics: Demand and Supply. Retrieved October 4, 2008 from http://www.investopedia.com/university/economics/economics3.asp.
Krizner, I. M. (2000). The Law of Supply and Demand. Foundation for Economic Education. The Freedman: Ideas on Liberty. Vol. 50. No. 1. Retrieved October 4, 2008 from http://www.fee.org/publications/the-freeman/article.asp?aid=1629.
University of Maryland University College. (2008). Chapter 4. Scarcity and Choice: The Economic Problem. Retrieved October 4, 2008 from http://faculty.ed.umuc.edu/~shadjida/Lectures/basconc3.htm.