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The Economic Principle of Supply and Demand

The law of supply and demand is a core principle of modern economics that explains how market prices for goods are determined. In a competitive market, the price of a product will vary until it settles at a point where the quantity demanded by consumers equals the quantity supplied by producers. This point of balance is known as the equilibrium price. At this price, the market is said to be "in equilibrium," because there is neither a surplus nor a shortage of the good.

The law of demand states that, all else being equal, as the price of a good decreases, the quantity consumers are willing to buy increases. Think of a sale on a popular brand of shoes—lower prices encourage more people to purchase them. Conversely, the law of supply states that as the price of a good increases, the quantity producers are willing to make and sell also increases, because it is more profitable to do so. These two laws work in opposition, with consumer desire for low prices and producer desire for high prices pushing and pulling the market toward equilibrium.

Market imbalances occur when the price is not at equilibrium. If the price is set too high, supply will exceed demand, creating a surplus. Producers will then likely lower their prices to sell their excess inventory. If the price is set too low, demand will exceed supply, creating a shortage. In this case, the high demand allows producers to raise their prices. Through these adjustments, the market naturally moves toward the equilibrium price where supply and demand meet.