The Law of Supply and Demand
For a market economy to function, producers must supply the goods that consumers want. This is known as the law of supply and demand. “Supply” refers to the amount of goods a market can produce, while “demand” refers to the amount of goods consumers are willing to buy. Together, these two powerful market forces form the main principle that underlies all economic theory.
The law of supply and demand explains how prices are set for the sale of goods. The process starts with consumers demanding goods. When demand is high, producers can charge high prices for goods. The promise of earning large profits from high prices inspires producers to manufacture goods to meet the demand. However, the law of demand states that if prices are too high, only a few consumers will purchase the goods and demand will go unmet. To fully meet demand, producers must charge a price that will result in the required amount of sales while still generating profits for themselves.
For example, assume that a cell phone manufacturing company perceives demand for new cell phones. The company invests in market research to produce the exact cell phone that consumers want. The company then produces 5,000 units and puts them up for sale at $300 each. Consumers who find the phone to be valuable pay the full $300, and half of the units are soon sold.
Because of the high price, however, sales gradually begin to drop off. Many consumers still want the phone, but are unwilling or unable to pay $300 for one. Because the cell phone company loses money on unsold products, it reduces the phone’s price to $250 in hopes of increasing sales. Consumers begin buying again. The process continues until a price is reached that will both meet demand and maximize the company’s profits. That price is known as the “market-clearing price.”
When supply becomes balanced with demand, the market is said to have reached equilibrium. At equilibrium, resources are used at their maximum efficiency. The study of economics is largely a study in how market economies can best achieve equilibrium, which is why economists spend a great deal of time analyzing the relationship between supply and demand.
The law of supply and demand explains why people behave in certain ways within a market economy, and can even be used to predict behavior and, thereby, economic outcomes. Manufacturers who want the highest price possible for their products, utilize inventory management protocols and invest in advertising to encourage consumers to buy. Consumers who value a low price over the quality or popularity of a product shop at outlets and discount stores, while those who favor popularity over price purchase goods from retail stores at the height of the market.
The law of supply and demand is not just limited to the sale of products, however. It can be used to explain almost any economic phenomenon, such as a rise or drop in employment, increased or decreased enrollment in colleges, the expansion or shrinking of government programs, and increases or reductions in available resources. Therefore, the law of supply and demand is not only vital to economic theory, it is the foundation of economics itself.