What are the Laws of Supply and Demand?

The laws of supply and demand are microeconomic concepts that state that
in efficient markets, the quantity supplied of a good and quantity demanded of that
good are equal to each other. The price of that good is also determined by the point at
which supply and demand are equal to each other. Supply and demand are usually
expressed in a line graph format, with Quantity (the independent variable) on the y-
axis and Price (the dependent variable) on the x-axis.

Understanding Supply

Generally speaking, the supply of a good and its price are directly proportional to
each other and follow a linear relationship. In other words, as price increases, the
supply of that good also increases – as demonstrated by the chart below:

The supply line is seen from a seller’s perspective. The higher the price of a good, the
more of that good a seller will want to sell, since doing so will be profitable.
Conversely, a low price will not attract many sellers to the market, and the quantity
supplied will be lower. Thus, we get a linear relationship.

Understanding Demand

Demand works in the opposite way that supply does, and is inversely proportional to
price. In other words, as price increases, the demand for that good will decrease – as
demonstrated by the chart below:
The demand line is seen from a buyer’s perspective. The higher the price of a good,
the lower the number of interested buyers, since buyers want to save as much money
as possible. Conversely, a low price will attract many buyers to the market, therefore,
the quantity demanded will be higher. Thus, we see an inverse relationship.

Supply and Demand Graph

Now, let’s combine the above two graphs into one:

By combining the two graphs, we can observe the point of equilibrium, where the
supply and demand lines intersect. Tracing lines directly from the equilibrium point to
the x- and y-axes will reveal the Price at Equilibrium (Pe) and Quantity at Equilibrium
(Qe), respectively.

Does the Model Hold True in Real Life?

It is important to note that the supply and demand framework does not always happen
in real life. It is impossible to calculate Pe and Qe in real life since every individual
buyer shows a different willingness to pay for goods, and every seller demonstrates a
different willingness to accept prices.

Furthermore, there are a host of other real-life factors that interfere with the supply
and demand model, such as:

Monopolies

The supply and demand model assumes perfect competition, which rarely occurs. In
some markets, we see a single very powerful producer of goods. Since buyers are
unable to find another place to purchase the goods, they are forced to accept whatever
price the seller decides to set. This has been the case for goods with inelastic
demand (i.e., essential goods) such as oil, medication, or cigarettes.

In such a scenario, the increase in price will deter a small number of buyers from
participating in the market, but the majority will still purchase the monopolized goods
at a higher price. The practice is hugely profitable for the seller and, in most cases,
illegal.

Price Floors

Price floors are price minimums put in place by the government to protect vulnerable
sellers. For example, the government might put in a place a price floor on farm goods
such as potatoes. Thus, farmers will be guaranteed a certain amount of revenue and
will be able to afford a living. In such a scenario, the absence of a price floor may see
the price of potatoes plummet to a very low equilibrium price and farmers go into
bankruptcy.

Subsidies

Subsidies can be thought of as an alternative to price floors. Thinking back to the

potato example, a subsidy will cover a certain portion of production costs for a
farmer. Thus, the farmer will have fewer costs to cover and will be able to capture
more sales revenue. This will ensure that the farmer can still afford a living even if the
equilibrium price of potatoes ends up being very low.

Taxes

Government-imposed taxes are sometimes put in place to boost government revenue.

This may be due to political agendas or a lack of available capital to fund public
infrastructure projects. A tax on buyers will mean that buyers will need to purchase a
good at a price above the equilibrium. However, the additional profits generated this
way will be collected by the government rather than the seller.

What is Demand Theory?

Demand theory is a principle that emphasizes the relationship between consumer

demand and the price for goods and services within a market. It can also be illustrated
as the demand curve, which is downwards sloping in a horizontal manner, as the price
of the good decreases as quantity increases. Vice-versa, where the price of the good
increases as the quantity decreases.

Ultimately, when applying the supply curve together, the equilibrium price shifts
accordingly. Essentially, demand theory highlights the consumer’s perspective, while
supply focuses on the business’s point of view.

Understanding Demand Theory

Demand is the quantity of a good or service the consumer is willing to purchase at

specific prices during a time period. The demand for a good at a certain price
generally reflects the consumer’s willingness to pay and expectation for consuming
that product. The goods indeed range in price, from necessities to luxuries.

For example, regarding necessities, people need food, healthcare, clothing,

entertainment, shelter, and water across all welfares. The price of the goods tends to
be fairly affordable for most individuals. Whereas, designer bags, for example, tend to
be priced at a premium, as such goods are considered wants and are not required to
continue to live a healthy life.
The demand for a good or service is generally driven by two factors – utility and
ability to pay for the good or service.

The two aspects coincide with one another. Demand happens when a good or
service yields some level of utility while being backed by the ability, which ultimately
provides satisfaction to the consumer.

Demand aims to convey how bad people wish to purchase specific goods, along with
how much is bought based on their income levels and utility. Based on the satisfaction
that the good provides, companies adjust their supply level accordingly, which
changes prices.

For example, if a good is extremely popular and with high utility, companies will first
see a scarce supply, shifting the supply curve and raising prices. However, over time,
they will increase production, shifting the supply curve back to its original position
and bringing the price back down.

Factors That Affect Demand

Various factors affect demand, including:

 Consumer preferences
 Taste
 Choices
 Income
 Related goods

As various factors may affect demand, businesses need to evaluate demand, as it is

one of the most integral decision-making drivers that must be considered to grow the
business and continue to stay competitive within the market.

Defining the Market System

Supply and demand determine the price within the market. When supply is equivalent
to demand, price is in a state of equilibrium. However, when demand is higher than
price, prices rise to reflect scarcity in quantity. On the other hand, when supply is
higher than demand, then prices fall due to a surplus in goods.

The Law of Demand

The law of demand illustrates the inverse relationship between price and demand for a
good or service within the market. As the commodity increases in price, the demand
decreases. However, if the commodity decreases in price, the demand increases,
assuming all other factors remain constant.

At times, consumers may purchase goods or services beyond factors in price. It is also
known as a change in demand. A change in demand is a shift in the curve from right
to left or left to right, based on the factors mentioned above.

For example, if an individual has more disposable income, they may be willing to
spend more goods within the market, regardless of whether the price lowers; in such a
case, the demand curve would shift to the right.

Expansion and Contraction of Demand

An expansion or contraction of demand may occur during the income or substitution

effect.

As the price of a commodity drops, an individual may receive the same satisfaction
for spending less, assuming it is a normal good. Given that the price of the commodity
falls, it will allow the consumer to purchase more of the goods with their current
financial position. It is known as the income effect.

The substitution effect happens when the consumer transitions from purchasing costly
goods to ones that have fallen in price. As people purchase goods with lower prices,
demand rises for such products and less for the original.

What is Supply?

Supply is a term in economics that refers to the number of units of goods or services a
supplier is willing and able to bring to the market for a specific price. The willingness
and ability to avail products to the market are influenced by stock availability and the
determiners driving the supply. A change in prices impacts the market equilibrium
too. A price increase will result in more supplies, and a decrease will result in the
opposite effect.

Understanding Supply

Ideally, in economics, consumers influence the supply of a product by indicating they

need more units of a product, which drives prices higher. To the supplier, the market
movements are a positive indication to increase the volume of supplies. However, the
pattern may vary across products. At the point when the supply is equal to the
demand, the price is said to be at equilibrium, i.e., there is no surplus supply or
shortages.

However, as far as supply is at equilibrium, the consumer maximizes utility, and the
suppliers enjoy optimal profits. Any more push of supplies in the market will
disproportionately lead to suppliers incurring losses. Such an effect will reduce
supply, which will tend to decrease prices until equilibrium is regained again.

Supply Elasticity Example

Products and services supply can only make sense when expressed against price and
time. It is, therefore, sensible to state a farmer produced 20 crates of tomatoes over
one month rather than just 20 crates, without expression of a time frame. In terms of
supply, the farmer may sell a crate of tomatoes for $110. In this case, the farmer can
produce 20 crates per month, where a crate is sold at $110.

Economically, price and time are an expression of the quantity of tomatoes produced
and sold. This introduces the concept of elasticity. In supply elasticity, a shift in price
can influence the farmer’s supply behavior. For example, the price per crate of
tomatoes may rise to $115. This may be a positive indicator for suppliers to increase
tomato supplies, for example, to 40 crates.

Such a noticeable transformation in the supply of goods is called elastic supply.

However, if the change only leads to a minimal to no response, it is known as
inelastic. The reasoning behind evaluating elasticity is to check the proportion change
of supplied quantity when price changes. A significant increase in supply is marked as
more elastic – the opposite calls for less elasticity or inelastic.

Overview of Supply Formulas

In economics, several mathematical formulas are used to calculate supply. However,

the general concept is to express the impact of supply factors on the supply of goods
and services.

One popular tool used to graphically simplify the concept is the use of the supply
curve, which depicts the association between the price of a product and its quantity.
An influence of a supply factor may lead to a shift in prices. The curve can show how
many quantities are supplied when the price shifts. It is also used to explain market
elasticity.

What is the Law of Supply?

The law of supply is a basic principle in economics that asserts that, assuming all else
being constant, an increase in the price of goods will result in a corresponding direct
increase in the supply thereof. The law works similarly with a decrease in prices.
The law of supply depicts the producer’s behavior when the price of a good rises or
falls. With a rise in price, the tendency is to increase supply because there is now
more profit to be earned. On the other hand, when prices fall, producers tend to
decrease production due to the reduced economic opportunity for profit.

Law of Supply Formula

QxS = QxS = Φ (Px)

Where:

 QxS – Quantity supplied of commodity/good x by the producers

 Φ – Function of
 Px – Price of commodity/good x
Limitations and Factors Affecting the Law of Supply

The overarching relationship is between price and quantity, and applies only if all
other factors remain constant. There are other factors that can affect the quantity
supplied of a given. The following are some of the more common factors:

 Cost of Production – When there are changes in the cost of raw materials or
labor to produce a unit of supply, the volume will change as well, assuming
the selling price remains the same. The variable cost affecting profit margins
is a big factor in targeting the quantity to produce.
 Technological Changes – Advancement in technology can boost the
efficiency with which units are produced, lessening the cost of production.
This then has a similar effect to that outlined under “Cost of Production”.
 Taxes – The imposition of taxes in the production of goods limits profitability.
If a producer is required to remit a portion of sales as tax, then the producer
will be less inclined to increase supply.
 Legislation – Certain regulatory laws or quotas may be put in place that limit
the quantity of a given product that can be produced. For example, in the
energy industry, carbon offsets limit the amount certain companies can supply.
 Periods of Uncertainty – In situations of higher business risk, producers may
be inclined to reduce supplies so that they can offload older inventory. During
 war or civil unrest, for example, producers are more than eager to sell, even
possibly at a lower price.

What is Elasticity?

Elasticity is a general measure of the responsiveness of an economic variable in

response to a change in another economic variable. Economists utilize elasticity to
gauge how variables affect each other. The three major forms of elasticity are price
elasticity of demand, cross-price elasticity of demand, and income elasticity of
demand.

Price Elasticity of Demand

Price elasticity of demand demonstrates how a change in price affects the quantity
demanded. It is computed as the percentage change in quantity demanded over the
percentage change in price, and it will commonly result in a negative elasticity
because of the law of demand.

The law of demand states that an increase in price reduces the quantity demanded, and
it is why demand curves are downwards sloping unless the good is a Giffen good. It is
common to simply drop the negative of the quotient.
The larger the price elasticity of demand, the more responsive quantity demanded is
given a change in price. When the price elasticity of demand is greater than one, the
good is considered to demonstrate elastic demand. When the quantity demanded drops
to zero with a rise in price, it is said that demand is perfectly elastic. If the price of an
elastic good increases, there is a corresponding quantity effect, where fewer units are
sold, and therefore reducing revenue.

The lower the price elasticity of demand, the less responsive the quantity demanded is
given a change in price. When the price elasticity of demand is less than one, the good
is considered to show inelastic demand. When the quantity demanded does not
respond to a change in price, it is said that demand is perfectly inelastic. If an inelastic
good has its price increased, it will lead to increased revenues because each unit will
be sold at a higher price.

If a change in price comes with the same proportional change in the quantity
demanded, it is said that the good is unit elastic. Indicating that X% change in price
results in an X% change in the quantity demanded. Therefore, if the price elasticity of
demand equals one, the good is unit elastic. If a good shows a unit elastic demand, the
quantity effect and price effect exactly offset each other.

Calculation of Price Elasticity of Demand through the Midpoint Method

The midpoint method is a commonly used technique to calculate the percent change
of price. The primary difference is that it calculates the percentage change of quantity
demanded and the price change relative to their average.
Examples of Goods with a Price Inelastic Demand

1. Beef
2. Gasoline
3. Salt
4. Textbooks
5. Prescription drugs
Examples of Goods with a Price Elastic Demand

1. Housing
2. Furniture
3. Cars
Factors That Affect the Price Elasticity of Demand

1. Availability of close substitutes

If consumers can substitute the good for other readily available goods that consumers
regard as similar, then the price elasticity of demand would be considered to be
elastic. If consumers are unable to substitute a good, the good would experience
inelastic demand.

2. If the good is a necessity or a luxury

The price elasticity of demand is lower if the good is something the consumer needs,
such as Insulin. The price elasticity of demand tends to be higher if it is a luxury
good.
3. The proportion of income spent on the good

The price elasticity of demand tends to be low when spending on a good is a small
proportion of their available income. Therefore, a change in the price of a good exerts
a very little impact on the consumer’s propensity to consume the good. Whereas,
when a good represents a large chunk of the consumer’s income, the consumer is said
to possess a more elastic demand.

4. Time elapsed since a change in price

In the long term, consumers are more elastic over longer periods, as over the long
term after a price increase of a good, they will find acceptable and less costly
substitutes.

Other Demand Elasticities

1. Cross-Price Elasticity of Demand

The cross-price elasticity of demand measures how the demand for one good is
impacted by a change in the price of another good. It is calculated as the percentage
change of Quantity A divided by the percentage change in the price of the other.

If the cross-price elasticity of demand between two goods is positive, it implies that
the two goods are substitutes. Consider the following substitute goods – good A and
good B. If the price of good B rises, the demand for good A rises.

On the contrary, if the aforementioned goods were complements, when the price of
good B increases, the demand for good A should decrease. It is what is implied
through the cross-price elasticity of demand formula. It is important to note that the
cross-price elasticity of demand is a unitless measure.
2. Income Elasticity of Demand

The income elasticity of demand is defined as the measure of the percentage change
of the quantity demanded of a good in reference to changes in the consumer’s income.
Calculating the income elasticity of demand allows economists to identify normal and
inferior goods, as well as how responsive quantity demanded is to changes in income.

If the income elasticity of demand is positive, the good is considered to be a normal

good – implying that when income increases, the quantity demanded at any given
price increases.

If the income elasticity of demand is negative, the good is considered to be an inferior

good – implying that when income increases, the quantity demanded at any given
price decreases.

If the income elasticity of demand is higher than 1, then the good is considered to be
income elastic – implying that demand rises faster than income. Luxury goods include
international vacations or second homes.

If the income elasticity of demand is higher than 0 but less than 1, then the good is
income inelastic – implying that demand for income-inelastic goods rises but at a
slower rate than income.

What is Unit Elastic?

In economics, unit elastic (also known as unitary elastic) is a term that describes a
situation in which a change in one variable results in an equally proportional change
in another variable. The concept of unit elastic is primarily associated with elasticity,
which is one of the fundamental concepts in economics. In this context, elasticity
indicates the sensitivity of one variable in response to the changes in another variable.
Economists use elasticity primarily to assess the demand or supply of a good in
response to changes in the price of a good or income of consumers. As such, the term
“unit elasticity” is frequently used to describe demand or supply curves that are
perfectly responsive to price changes.

Note that it is extremely difficult to encounter unit elastic goods. In most cases, a
good is either elastic or inelastic relative to market changes.

Unit Elastic Demand

Unit elastic demand is referred to as a demand in which any change in the price of a
good leads to an equally proportional change in quantity demanded. In other words,
the unit elastic demand implies that the percentage change in quantity demanded is
exactly the same as the percentage change in price. Demand elasticity of a good with
unit elastic demand is 1 (strictly speaking, elasticity equals -1 since the demand
curve is downward sloping; but in most cases, elasticity is calculated as an absolute
value).

The concept of elasticity comes with some crucial implications for businesses. If a
company sells goods with unit elastic demand, it must carefully assess its pricing
strategy. The main reason is that a substantial change in price will result in a
substantial change in the quantity demanded.

Obviously, significant changes in demand can significantly impact a

company’s profitability. For example, if it sells smartphones with unit elastic demand,
a 10% price increase will lead to a 10% decrease in the quantity demanded. Thus, the
company’s revenue will decline by 10% as well.

Graphically, unit elastic demand is depicted as a curve rather than a straight line.
Unit Elastic Supply

Unit elastic supply is referred to as a supply that is perfectly responsive to price

changes. In other words, any change in the price of a good with unit elastic supply
results in an equally proportional change in quantity supplied. Supply elasticity of a
good with unit elastic supply is 1 (unlike the demand curve, the supply curve is
upward sloping; thus, the elasticity of unit elastic supply is simply 1).

Similar to unit elasticity of demand, unit elasticity of supply has great implications in
a business context. For example, if a company produces goods with unit elastic
supply, it indicates that the company’s production capacities should take into
consideration price fluctuations. If the price of a good changes significantly, a
company should respond with a respective change in its production.

Graphically, unit elastic supply is depicted as a straight line that starts from the origin
(point 0;0).

What is Arc Elasticity?

Arc elasticity is the sensitivity of one variable to another between two points on a
curve. It is often used in the context of the law of demand to measure the inverse
relationship between price and demand.

Arc elasticity measures the responsiveness of demand to price changes over a range of
values. The magnitude of change in price and demand is divided by its midpoint to
arrive at a measure of change over a curve rather than at a point.

Arc Elasticity Formula

Arc elasticity is calculated as:

Practical Examples

Let’s calculate the arc elasticity for an equal dollar price increase and decrease.

Case 1

Price increases from $6 to $8, quantity demanded decreases from 40 units to 20 units.

Case 2

Price decreases from $8 to $6, quantity demanded increases from 20 units to 40 units.

In both cases, arc elasticity remains at 2.3. From here, it’s evident that a price increase
and decrease of $2 indicates the same sensitivity of demand for a company’s
customers.
Why Use Arc Elasticity?

 Arc elasticity is useful for larger price changes.

 It provides the same absolute elasticity measure when prices rise and fall.
Applications in Pricing

Arc elasticity is an alternative approach to measure elasticity rather than using price
elasticity. Based on whether elasticity is equal to, greater than, or less than one,
demand is considered unit elastic, elastic, and inelastic. Elasticity of demand can be
used to understand a customer’s willingness to pay and price products in a way that
maximizes profits.

Monopoly Pricing

Elasticity measures are used in monopoly pricing. If the monopolist believes that the
demand for a product is inelastic, then the demand for that product should not
decrease significantly with a price increase.

So, a monopolist may set high prices to capitalize on a consumer’s willingness to pay.
Profits will be maximized under the assumption that the decrease in demand is
compensated by higher prices.

Price Discrimination

Price discriminators charge different prices for providing the same goods or services.
For example, business trips are essential, and thus the business travelers’ demand is
inelastic. So, an airline company can set a high price for business travelers. As a
result, airfare for business travelers is typically higher than airfare for leisure
travelers.

Similarly, airfare is higher for flights booked closer to the travel date compared to
those booked in advance. It is estimated that people who book flights at shorter notice
are in urgent need of travel and show an inelastic demand. Therefore, airline
companies charge higher prices to such travelers.

Meaning of Price Theory:

Every individual is interested in prices; and rightly so. Everyone whether he is a

consumer or a producer is affected by rise or fall in prices. A consumer is anxious
to find out whether the goods he wants to buy have become cheaper or dearer.
Similarly, producer is interested in whether the prices of the products he produces
and the inputs he uses, have gone up or down.

Oscar Wilde once remarked – “An economist is someone who knows the price of
everything and the value of nothing.” This observation may not be true at all. But
economists right from Adam Smith, Marx, Jevons and Marshall to Joan Robinson,
Chamberlin and Hicks have been engaged in explaining how prices are determined
and why and when they are high or low. This is the Subject matter of price theory.

Price theory, also known as microeconomics, is concerned with the economic

behaviour or individual consumers, producers, and resource owners. It explains the
production, allocation, consumption and pricing of goods and services.

Price theory, as defined by Prof. Leftwich, “is concerned with the flow of goods
and services from business firms to consumers, the composition of the flow, and
the evaluation or pricing of the component parts of the flow. It is concerned, too,
with the flow of productive resources (or their services) from resource owners to
business firms, with their evaluation, and with their allocation among alternative
uses.”

Limitations of Price Theory:

Price theory has its limitations:

1. It simply provides a theoretical analysis of the working of the individual parts of
the economy. But the operation of individual parts does not give a true picture of
the working of the economy. Every economic unit is so complex and requires such
minute description and analysis that price theory is unable to do justice.

2. It only lays down guidelines based on a given data. Often the data are not
reliable. It is based on estimation which may prove to be wrong.

3. Even the assumption of rationality on which decision-making is based to achieve

the most efficient use of scarce resources is seldom observed by businessmen and
consumers. Still, the assumption of rationality helps in economizing scarce
resources with efficiency.

4. Price theory may not give a description of the real world since it is based on
limited data and unrealistic assumptions but by concentrating on the most important
data we get an insight into the working of the economy.

As put by Leftwich:

“We may lose sight of individual trees but we gain more understanding and a better
view of the forest as a whole.” Price theory is no doubt abstract but it should be
judged for its truth and not for its realism.

Dynamic Theory of price

The dynamic theory of price, in economics, focuses on how prices fluctuate and
change over time due to shifts in supply and demand, and other market forces, rather
than just a static equilibrium.

Focus on Change:
Unlike static price theory, which assumes a fixed market equilibrium, dynamic
theory acknowledges that markets are constantly evolving.
Market Dynamics:
It examines the forces that drive these changes, including:
 Shifts in Supply: Changes in production costs, technology, or the number of
producers can affect supply.

Shifts in Demand: Changes in consumer preferences, income, or the price of

related goods can influence demand.

Other Factors: External shocks, such as government policies or global events, can
also impact prices.

Pricing Signals:
Market dynamics create pricing signals that reflect the interplay of supply and
demand, guiding producers and consumers' decisions.

Real-World Applications:
The dynamic theory of price is relevant to understanding a wide range of economic
phenomena, including:

Inflation and Deflation: Changes in the overall price level of goods and services.

Economic Cycles: Fluctuations in economic activity, such as booms and recessions.

Industry Growth and Decline: Shifts in market share and the emergence of new
technologies.

Examples:
The price of gasoline might rise due to increased demand during a holiday weekend
or a sudden drop in supply due to a refinery issue.

The price of a new smartphone might fall as technology advances and production
costs decrease.

The price of a commodity like coffee might fluctuate based on weather patterns and
global demand.