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, (normally) rises when the price of that commodity falls,and vice versa;
• the quantity of a commodity that suppliers are prepared to sell, (normally) 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 word "normally" is inserted in recognition of the exceptions noted in the concluding paragraph of this article)

The eventual price at which the hypothetical bargaining normally 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. Only in some exceptional circumstances (described in the tutorials subpage) can equilibrium not be reached.

This is among the most familiar of all economic laws (so much so that it might be considered to be a statement of the obvious). It has often been referred to as tautological, but its dissemination by Alfred Marshal in 1891 introduced a major departure in economic theory, previous economists, from Adam Smith to Karl Marx, having taught that prices were determined by the cost of production. (See history of economic thought).

In the economics textbooks, the operation of the law of supply and demand is normally explained by means of a diagram in which the equilibrium price is determined as the price (on the vertical axis) at which two curves intersect:

• the demand curve, which slopes downwards from left to right in accordance with the assumption (explained in the article on utility) of a product's diminishing marginal rate of substitution with money; and,
• the supply curve, which slopes upwards from left to right in accordance with the assumption (explained in the article on the theory of the firm) of the diminishing returns to scale.

The operation of the law of supply and demand in particular markets may be quantified by the use of the following concepts :

• Elasticity of demand denotes the change in demand in response to changes of price, income or the prices of substitutes.
• 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.
• Consumer's surplus denotes the amount by which consumers value a commodity over above what they have to pay for it.

The concepts associated with the law of supply and demand are among the basic tools of microeconomics and some of their applications are described in the article on that subject. They are applicable to all market activity and do not depend upon any assumptions concerning the nature of the commodities concerned. That remains true notwithstanding the fact that they can assume zero or even negative values. The concept of elasticity of demand, for example, is not invalidated by the existence of commodities that are so essential that the demand for them is insensitive to price, nor by the existence of goods that are prized simply because they are expensive. Their textbook derivations depend, however, upon assumptions about consumer behaviour that are discussed in the article on utility, and assumptions about the production function that are discussed in the article on the theory of the firm.