Supply and Demand – Well-Known, Yet Misunderstood By Many

Overview – Understanding Supply and Demand

When you hear the word “economics”, what are some things that come to mind?

There are many concepts, theories, and topics in this diverse field, but chances are one of the concepts that crossed your mind is Supply and Demand. Supply and Demand is by far one of the most well-known concepts in economics (specifically, microeconomics).

Despite its popularity, Supply and Demand is arguably one of the most misunderstood of all economics concepts. How can that be the case? After all, isn’t Supply and Demand just a matter of how much of something there is and how many people want it?

While the idea of how much there is of something and how many people want it is the basis, there is a bit more to Supply and Demand than that. Let’s go over a simple explanation of how this popular economics concept works.

Demand

Many people believe that demand is what you wish for or want. If that were the case, whenever we “demand” something we would immediately get it. If we demanded 100 laptops, then we would get 100 laptops.

Some people may also believe that demand is the quantity of an item we get. If we receive 6 loaves of bread, then that must be the demand for the loaves.

Demand is neither how much of a good we want nor how much of it we get. In an economics context, “demand” can be defined as follows¹:

“a list or schedule of all alternative (different) quantities of a particular good that a buyer would be willing and be able to buy at alternative prices.”

What’s important to remember here is that demand deals with the consumer (or in other words, the buyer). If you’re looking to buy something, then the concept of demand will apply to your purchase decision.

Below is an example of a demand schedule for someone looking to buy boxes of cookies:

Sample Demand Schedule for a Box of Cookies

The table above shows how many boxes of cookies a consumer would be willing to buy and are able to buy at each price.

When the demand schedule is plotted, the following curve is produced. This is called a demand curve:

Notice that as the price decreases, the consumer wants more boxes of cookies and vice versa. This behaviour can be observed in all demand curves and is called the law of demand.

The law of demand shows an inverse relationship between the price of a good and the quantity demanded of that good. If the price goes up, the quantity demanded goes down, and vice versa.

This law can be supported by empirical evidence, such as your own buying experiences.

Whenever you see a good you want for a low price, chances are you’re likely to buy more of it. Once the price increases, you no longer have the desire to buy as much, until you reach a price that’s so high that you won’t buy any at all.

At $8 apiece, a chocolate bar may be a bit too expensive for you, but at $2, you’re suddenly interested in buying more than one. When you buy more chocolate bars because they’re on sale, you’re subconsciously referencing your demand schedule in response to the lower price.

Now let’s look at the other side of the coin: supply.

Supply

Like demand, “supply” is a common term that has taken on many meanings.

Many people think of supply as the amount of output that a producer makes. If a bakery produces 1,000 cookies, then that is their supply.

However, supply has only one definition in the context of economics¹:

“a list or schedule of alternative prices and the amount of the product that the seller is willing and able to offer for sale at each price.”

This time, instead of concerning ourselves with the consumer, supply deals with the producer. Below is an example of a supply schedule for the boxes of cookies we looked at earlier:

Sample Supply Schedule for a Box of Cookies

The supply curve for this supply schedule would look like this:

Now, in this case, when the price per box of cookies increases, the number of boxes supplied increases. This is the law of supply.

The law of supply shows a direct relationship between the price of a good and the quantity supplied of that good.

Again, this makes sense logically. If you’re trying to sell something, the higher the price of the good, the more of that good you want to sell. As the price goes lower, the less likely you’re willing to sell because the price may not be high enough to turn a profit.

Go too low, and you probably won’t be willing to sell anything at all because the cost of the good is higher than its selling price, so a transaction wouldn’t even be worth it.

Notice how supply and demand are more than just how much of a good there is and the desire for it. In both instances, the key variable that relates to both concepts is price.

In the example above, the producer can bake all the cookies they want, and the consumer can demand as many cookies as they want, but until pricing is introduced neither party will get anywhere. That’s because there’s no monetary value being assigned to the cookies.

Supply and Demand is essentially a tug of war between the producer and consumer: how high of a price can a producer sell their good for, and how low can a consumer go when trying to buy that good?

Until both parties settle on what they believe is a fair price, no transaction will occur. So how exactly do you discover that price?

Equilibrium, Shortage, and Surplus

If the consumer is only willing to buy a certain quantity of goods at a certain price, and if the producer is only willing to sell a certain quantity of goods at a certain price, at what point will a transaction occur?

In other words, at what price and quantity will both the consumer and producer agree to a transaction?

The answer to that question is provided when we plot the demand and supply curves simultaneously. When that is performed, we get the following curve:

The point where the supply and demand curves intersect is called the equilibrium point. At this point, at that price, the quantity demanded and the quantity supplied is the same, meaning a transaction between the consumer and producer can proceed without much hassle, if any at all.

Based on the equilibrium curve above, a transaction will occur when the cookies are priced at $6/box. At this point, both the producer and consumer believe that they’re getting a fair deal because their respective supply and demand curves intersect.

But what happens in the areas where the curves don’t intersect?

Below the equilibrium point, at a given price, the quantity being demanded exceeds the quantity being supplied. At $4 per box, consumers want 5 boxes of cookies, whereas the producer will only sell 1 box of cookies at that price. This results in a shortage.

Similarly, above the equilibrium curve, at a given price the quantity supplied exceeds the quantity demanded. At $8 per box, consumers are only willing to buy 1 box of cookies, whereas the producer is willing to sell 5 boxes. This results in a surplus.

Remember, the key consideration here is that a price must always be defined. If a price isn’t defined, then there’s no way of telling whether a shortage, surplus, or equilibrium has been achieved.

In a shortage, in order for equilibrium to be restored, the price must be driven up. In a surplus, the price must be driven down.

Wrapping Up

The concept of supply and demand is widely known, but for the most part, remains poorly understood.

Supply and demand go beyond the idea of how much of a good someone has, and how much of a good someone wants. It’s a matter of how much of a good a producer is willing to sell and the quantity of that good a consumer is willing to buy at different prices.

The different quantities of goods being sold/asked for at various prices can be graphed. These subsequent graphs are known as a supply curve and a demand curve.

Price is the unifying variable between the supply and demand of a good. Without price, it would be impossible to produce supply and demand curves because you wouldn’t know how much money either party is willing to spend or take for a given quantity of that good.

When the supply and demand curves intersect, this is known as the equilibrium point, and this is where the producer and consumer are willing to perform a transaction.

References