The basic principles of supply and demand are the key to understanding why market prices and availability of goods and services fluctuate. Using a graph, supply and demand represent the relationship between the quantity of a good that producers are willing to offer for sale and the quantities that consumers are willing and able to purchase at different prices, holding all other factors constant. The point at which these lines intersect is the equilibrium price and quantity for that good.
The slope of the supply curve (shown on the graph) and the shape of the demand curve are important to understand. A generally accepted principle is that the supply curve should be upward sloping, meaning that as the price of a good rises, producers are willing to offer more of it. This is justified by pointing out that as the price of a good rises, the marginal cost of producing additional units of that good decreases.
When the price of a good is lower than its production costs, the marginal cost of additional units declines even further. As this happens, the supply curve shifts to the right to S1. This is because producers are now able to offer more of a product at this price than they could at a higher price when the cost was greater.
The steepness of the slope and curvature of each curve reflects its elasticity. Elasticity is a measure of how sensitive each function is to changes in various economic factors, such as prices, incomes and expectations. The more elastic a demand or supply function, the easier it is for it to move in either direction when these factors change.
In a free market, a balance between the forces of supply and demand determines the market-clearing price. If demand is greater than supply, the prices of goods will rise until there is sufficient supply to meet the demand at a lower price. If the prices of goods are too high, consumers will buy fewer of them. When demand is less than supply, the prices of goods will fall until there is enough supply to meet the demand at a higher price.
However, in the real world, supply and demand are not always perfectly elastic. Many things affect the amount of a commodity that is offered for sale, including taxes and government regulation, monopoly power, the price of substitute goods, natural disasters, weather conditions, competition, and the availability of labor and other resources. These factors can all cause the supply and demand curves to shift, but as long as buyers and sellers retain their agency, they are able to negotiate the market-clearing price. If you are interested in learning more about the real-world issues that can influence supply and demand, please check out our introductory video, A Guide to the Laws of Demand and Supply. You can also read our articles on the subject, such as How to Understand Demand and Supply. If you have any questions about this topic, don’t hesitate to contact us.