Supply and demand

The law of supply and demand is a fundamental law of economics. It can be stated as follows:

• the quantity of a commodity that consumers are prepared to buy, rises when the price of that commodity falls (and vice versa);
• the quantity of a commodity that suppliers are prepared to sell, rises when the price of that commodity rises (and vice versa); so that,
• the price at which transactions eventually take place is that at which the quantity that consumers are prepared to buy is the same as the quantity that suppliers are prepared to sell.

The eventual price at which the hypothetical bargaining settles down is referred to as the market clearing or equilibrium price (higher prices result in unsold surpluses, prompting suppliers to reduce their prices and vice versa).

This is among the most familiar of all economic concepts; so much so that one might be tempted to regard it as a statement of the obvious, but its dissemination by the British economist Alfred Marshal in 1891 introduced a major departure in economic theory. Previous economists, from Adam Smith to Karl Marx, had taught that prices were determined by the cost of production. (See history of economic thought).

It is important to understand that the general rules stated above depend on a large number of assumptions, some or all of which may not be correct in a particular situation. For example, for certain goods that are absolutely necessary, or almost necessary, a rise in price may not affect the demand to any significant degree. Instead, consumers will simply spend more money on that good or service. Governments tend to rely on this fact, and often impose taxes on those goods or services the demand for which is insensitive to price. When demand or supply changes significantly in response to small changes in price, it is called "elastic." When demand or supply is relatively insensitive to such changes, it is called "inelastic."

In his further exploration of the concept, Marshall introduced some further concepts that have since been widely used by economists.

• Consumer's surplus denotes the amount by which consumers value a commodity over above what they have to pay for it.
• The income effect denotes the fact that the demand for most products increases as consumers' income increases.
• The substitution effect denotes the fact that the demand for a commodity is influenced by the price of close substitutes.
• Elasticity denotes the change in demand in response to changes of price, income or the prices of substitutes.

The use of the concepts of supply and demand in economic theory is further explained in the article on microeconomics.