Law of Supply and Demand

The law of supply and demand describes how prices, quantities supplied, and quantities demanded interact in a market. Price acts as a signal: higher prices tend to reduce demand and increase supply, while lower prices tend to increase demand and reduce supply. The point where supply and demand balance is the market-clearing (equilibrium) price.

Key takeaways

• Demand typically falls as price rises and increases as price falls (law of demand).
• Supply typically rises as price rises and falls as price falls (law of supply).
• The equilibrium price is where the supply and demand curves intersect.
• Price elasticity measures how strongly quantity demanded or supplied responds to price changes.
• Necessities are often price inelastic (demand changes little with price).

How it works

Supply and demand can be shown as curves on a graph: a downward-sloping demand curve and an upward-sloping supply curve. Their intersection determines the equilibrium price and quantity. Changes in tastes, incomes, production costs, taxes, regulations, and the availability of substitutes shift these curves and change the equilibrium.

The law of demand

The law of demand states that, ceteris paribus, quantity demanded falls as price rises and rises as price falls. Two related ideas explain consumer reaction to price changes:
* Income effect — a price change alters consumers’ real purchasing power and thus their demand.
* Substitution effect — consumers switch between goods when relative prices change.

Exceptions and special cases:
* Giffen goods — low-priced inferior staples that can see demand increase as price rises, typically due to strong income/substitution dynamics.
* Veblen goods — luxury items that may become more desirable as price increases because the high price signals status.

The law of supply

The law of supply states that, ceteris paribus, producers offer more of a good as its price rises and less as its price falls. Higher prices make production more profitable and encourage firms to expand output; lower prices discourage production. Short-term constraints (capacity, input availability) can limit how quickly supply responds.

Equilibrium price

Equilibrium (market-clearing) price is where quantity supplied equals quantity demanded. At that price there is no persistent surplus or shortage. The equilibrium level moves when supply or demand curves shift.

Price elasticity

Price elasticity measures responsiveness:
* Price elasticity of demand — percentage change in quantity demanded divided by percentage change in price. High elasticity means demand is sensitive to price changes; low elasticity (inelastic) means demand changes little.
* Price elasticity of supply — how quickly and strongly producers change output in response to price changes.

Elasticities depend on factors such as availability of substitutes, proportion of income spent on the good, time frame, production capacity, and ease of entry for suppliers.

Factors that shift supply

Supply curves shift when:
* Production costs change (labor, materials, energy).
Technology improves or worsens productivity.
Number of sellers and industry capacity change.
Taxes, subsidies, and regulations alter producer incentives.
Supply shocks (natural disasters, geopolitical events) disrupt output.

If price falls below production cost for many sellers, supply can drop sharply.

Factors that shift demand

Demand curves shift when:
* Consumer income changes (normal vs. inferior goods).
Tastes and preferences evolve.
Prices of substitutes or complements change.
Population, demographics, and market penetration change.
Expectations about future prices or incomes shift.

Marginal utility typically diminishes as consumers acquire more of a good, reducing additional demand at each successive unit.

Example

During the COVID-19 pandemic, gasoline demand collapsed as travel dropped. Prices fell rapidly, signaling suppliers to cut production and reduce shipments. Later shifts in demand and supply (e.g., recovery, geopolitical events) produced further price adjustments.

Why it matters

Understanding supply and demand helps businesses, policymakers, and investors anticipate how prices and quantities will respond to changes in costs, taxes, consumer preferences, and shocks. Estimating elasticities and likely curve shifts informs pricing, production, and policy decisions.

Bottom line

The law of supply and demand is a foundational concept explaining how market prices and quantities emerge. Price balances the incentives of buyers and sellers; changes in underlying conditions shift supply or demand and lead to new equilibria.