Supply and Demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers resulting in an economic equilibrium of price and quantity. This relationship of supply and demand can be seen in a plot of the classic supply-demand curve on the right. [1]
Definition: The law of supply and demand is a theory that explains the interaction between the sellers of a resource and the buyers for that resource.
What are the Supply and Demand Laws?
The Supply and Demand model has two “laws,”: the (1) Law of Demand and the (2) Law of Supply. These laws interact with each other to determine the market price and volume of goods. The key components to the theory are:
Supply and Demand Outcomes
The four (4) basic outcomes of supply and demand are: [3]
- If demand increases and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.
- If demand decreases and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.
- If demand remains unchanged and supply increases, a surplus occurs, leading to a lower equilibrium price.
- If demand remains unchanged and supply decreases, a shortage occurs, leading to a higher equilibrium price.
(1) What is the Law of Demand?
The Law of Demand refers to the number of products that people are willing to buy at different prices at a specific time. The law states that the higher the price of a product the fewer people will demand the product. As a consumer, the higher a product costs the less the amount of the product the consumer will purchase. This means the opportunity cost of buying that product goes down. [2]
Factors that have influence over the supply are:
- Consumer Preference
- Influence
- Number of Sellers
- Taxes and Regulations
(2) What is the Law of Supply?
Supply refers to the quantities of product manufactures or owners are willing to sell at different prices at a specific time. The higher the price will result in higher the quantity supplied. As a seller, the opportunity cost of each product they sell is higher so they want to sell more and producers want to produce more. [1]
Factors that have influence over the supply are:
- Labor and Materials costs
- Technology availability
- Number of sellers
- Capacity
- Taxes and Regulations
What is Supply and Demand Equilibrium?
The market price is the intersection of the demand price and quantities of products manufactured and the intersection are called the equilibrium price or Market Clearing Price. The equilibrium price is the price at which the producer can sell all the units he wants to produce and the buyer can buy all the units he wants.
It is visualized on a chart at the intersection of the supply and demand curve. This intersection is the market price at which suppliers bring to market that same quantity of product that consumers will be willing to buy. They then say the Supply and Demand are in equilibrium. [1]
Purpose of the Supply and Demand Theory
The purpose of the Supply and Demand theory is to help people, businesses, bankers, investors, entrepreneurs, economists, government, and others understand and predict conditions in the market for best optimization.
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Updated: 6/27/2021
Rank: G16.9
Demand and Supply models are very easy to use, when there is a change in either demand or supply. However, in reality, there are number of situations which lead to simultaneous changes in both demand and supply. (I) Both Demand and Supply decrease (II) Both Demand and Supply increase (III) Demand decreases and Supply increases (IV) Demand increases and Supply decreases
Let’s relate this to ridesharing businesses — Uber, Lyft, Ola — where the simultaneous shifts are seen in action. In the case of ridesharing businesses, the demand is the number of riders (Q) and the supply is the number of drivers (S).
(I) Both Demand and Supply Decrease:
Original Equilibrium is determined at point E, when the original demand curve DD and the original supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the equilibrium price. The effect of decrease in both demand and supply on equilibrium price and equilibrium quantity can be better analyzed under three different cases:
Case 1: Decrease in Demand = Decrease in Supply:
When decrease in demand is proportionately equal to decrease in supply, then leftward shift in demand curve from D to D¹ is proportionately equal to leftward shift in supply curve from SS to S¹S¹ . The new equilibrium is determined at E¹ As demand and supply decrease in the same proportion, equilibrium price remains same at OP, but equilibrium quantity falls from OQ to OQ¹.
Impact: No change in Price for Riders. No change in Earnings for Drivers
Case 2: Decrease in Demand > Decrease in Supply:
When decrease in demand is proportionately more than decrease in supply, then leftward shift in demand curve from D to D¹ is proportionately more than leftward shift in supply curve from S to S¹. The new equilibrium is determined at E¹, equilibrium price falls from OP to OP¹ and equilibrium quantity falls from OQ to OQ¹.
Impact: Drop in Price for Riders. Drop Earnings for Drivers
Case 3: Decrease in Demand < Decrease in Supply:
When decrease in demand is proportionately less than decrease in supply, then leftward shift in demand curve from D to D¹ is proportionately less than leftward shift in supply curve from S to S¹. The new equilibrium is determined at E¹ equilibrium price rises from OP to OP¹ whereas, equilibrium quantity falls from OQ to OQ¹.
Impact: Increase in Price for Riders. Increase in Earnings for Drivers
(II) Both Demand and Supply Increase:
Original Equilibrium is determined at point E, when the original demand curve DD and the original supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the equilibrium price. The effect of increase in both demand and supply on equilibrium price and equilibrium quantity is discussed under three different cases:
Case 1: Increase in Demand = Increase in Supply:
When increase in demand is proportionately equal to increase in supply, then rightward shift in demand curve from D to D1 is proportionately equal to rightward shift in supply curve from S to S¹. The new equilibrium is determined at E¹. As both demand and supply increase in the same proportion, equilibrium price remains the same at OP, but equilibrium quantity rises from OQ to OQ¹.
Impact: No change in Price for Riders. No change in Earnings for Drivers
Case 2: Increase in Demand > Increase in Supply:
When increase in demand is proportionately more than increase in supply then rightward shift in demand curve from D to D¹ is proportionately more than rightward shift in supply curve from SS to S1S1. The new equilibrium is determined at E1equilibrium price rises from OP to OP¹ and equilibrium quantity rises from OQ to OQ¹.
Impact: Increase in Price for Riders. Increase in Earnings for Drivers
Case 3: Increase in Demand < Increase in Supply:
When increase in demand is proportionately less than increase in supply, then rightward shift in demand curve from D to D¹ is proportionately less than rightward shift in supply curve from S to S¹. The new equilibrium is determined at E¹ equilibrium price falls from OP to OP¹ whereas, equilibrium quantity rises from OQ to OQ¹.
Impact: Decrease in Price for Riders. Decrease in Earnings for Drivers
(III) Demand decreases and Supply increases:
The effect of simultaneous decrease in demand and increase in supply on equilibrium price and equilibrium quantity is analyzed in the following three cases:
Case 1: Decrease in Demand = Increase in Supply:
Impact: Decrease in Price for Riders. Decrease in Earnings for Drivers
Case 2: Decrease in Demand > Increase in Supply:
Impact: Greater decrease in Price for Riders. Greater decrease in Earnings for Drivers
(IV) Demand increases and Supply decreases:
The effect of increase in demand and decrease in supply on equilibrium price and equilibrium quantity is discussed in the following three cases:
Case 1: Increase in demand = Decrease in supply:
Impact: Increase in Price for Riders. Increase in Earnings for Drivers
Case 2: Increase in Demand > Decrease in Supply:
Impact: Greater increase in Price for Riders. Greater increase in Earnings for Drivers
Case 3: Increase in Demand < Decrease in Supply:
Impact: Increase in Price for Riders. Increase in Earnings for Drivers
In this article, we just looked at the different possibilities of changes in supply and demand, and the impact on the pricing and earnings. In the next article, we look at levers such as surge pricing and incentives, which act as levers to adjust both supply and demand.