Understand Supply and Demand

Understand Supply and Demand

Many people quote the laws of supply and demand, but few actually understand how it works. Here is a simple step by step method for thinking through the basic laws of economics.

Check your assumptions. The laws of supply and demand are only laws if the good is a commodity like lumber, crude oil or concrete. A commodity is a good that is perceived to be worth the same amount regardless of the supplier.
Pretend that you are a consumer. This is easy because you are a consumer. Let's say that you buy 7 apples a week at a price of fifty cents per apple. If the price of those apples goes up to one dollar per apple, will you buy more or less apples? When the price of a good rises, the demand for that good decreases and when the price falls, the demand for that good increases. This is the law of demand.
Pretend that you are a supplier. This may be more difficult to do. Let's say that you own a farm and you sell apples along with other fruits. One day, you sell your apples at the farmer's market for fifty cents per apple and sell out. The next day you sell your apples for a dollar a piece and you run out of apples again. Now you are making twice as much revenue from apples. Since you know you can sell apples for a dollar a piece, will you bring more or less apples to the market? Will you plant more or less apples next year? When the price of a good rises, the supply for that good increases and when the price of a good falls, the supply for that good decreases. This is the law of supply.
Picture yourself at a market with three apple stands in front of you. Also assume that all of the apples look exactly the same as far as you can tell. Two of the apple stands are selling them for sixty cents an apple and one of the apple stands is selling them for fifty cents an apple. How much will you pay for an apple? Perfect price information and equivalency of goods are some principles of perfect competition.
Picture yourself as the owner of one apple stand. You sell apples for fifty cents a piece and run out of apples. The next day you sell apples for sixty cents a piece and run out of apples. How much will you sell your apples for the next day? Instantaneous price adjustments are another aspect of perfect competition.
Let's assume that at a price of one dollar a piece, suppliers bring 100 apples to the market and consumers are willing to buy 90 apples at that price. There is a of ten apples. The only way to sell these surplus apples is to lower the price or perhaps give them away. Next time you come to the market, you may sell your apples at a discounted price to increase the demand (see law of demand) and eliminate the surplus. Another solution would be to bring less apples to the market next time or plant less apples in the future. Both of these options are called market corrections.
Now let's assume that at a price of ninety cents a piece, suppliers bring 100 apples to the market and consumers are willing to buy 110 apples. There are ten people who want apples and do not have them. This is called a shortage. If the seller wants to make a greater profit, he will bring more apples to the market or sell the apples for a higher price the next day. These options are also called market corrections.
See that the market will correct itself until a point of equilibrium is reached. That is, until there is neither a surplus nor a shortage.
It is often said that, "if there is less supply, the price goes up." This is a misstatement of the law of supply and is more akin to the resulting effect of a shortage. The laws of supply and demand both refer to how price affects the market, not the other way around.
Knowledge of economics will help you understand how the market works, but keep in mind that the laws of supply and demand are very limited.
You will often hear the laws of supply and demand referenced by those who have very limited knowledge of economics. It is not a good idea to get in arguments with them.