Introduction to Supply and Demand

The law of supply and demand is a fundamental concept of economics and a theory popularized by Adam Smith in 1776. The principles of supply and demand are effective in predicting market behavior. Whether an individual is a manufacturer or a consumer, the supply and demand equilibrium is relevant in daily market transactions.

Consumer Demand

Consumer demand for a good commonly decreases as its price rises. The figure below depicts the relationship between the price of a good and its demand from the consumer's standpoint. The demand curve is portrayed from the view of the consumer, whereas supply graphs are drawn from the producer's perspective.

If televisions were priced at $5 each, then consumers would purchase them and probably buy more TVs than they need based on price. The demand will remain high. If the price is $50,000, this good would likely be considered a luxury good, and demand would be low.

This example assumes that product differentiation does not exist. There is only one type of product sold at a single price to every consumer. In this closed scenario, the item is not an essential human necessity such as food or shelter, does not have a substitute, and consumers expect prices to remain stable. 

Explaining Supply

The supply curve considers the relationship between the price and available supply of an item from the producer's perspective rather than the consumer's.

When prices of a product increase, producers are willing to manufacture more of the product to realize greater profits. Falling prices depress production as producers may not recover input costs. If the costs to produce a TV are $50, production would be unprofitable when the selling price of the TV falls below $50.

If television prices are $1,000, manufacturers will focus on producing television sets over ventures and provide incentives to build more TVs. The behavior to seek maximum profits forces the supply curve to be upward-sloping. 

An underlying assumption of the theory lies in the producer taking on the role of a price taker. Rather than dictating the prices of the product, this input is determined by the market, and suppliers only face the decision of how much to produce, given the market price. Optimal scenarios are not always the case, such as in monopolistic markets.

Finding Equilibrium

Consumers typically look for the lowest cost, and producers test their products at the highest price. When prices become unreasonable, consumers change their preferences and move away from the product.

A proper balance must be achieved where both parties engage in ongoing business transactions to benefit consumers and producers. In supply and demand theory, the optimal price that results in producers and consumers achieving the maximum combined utility occurs where the supply and demand lines intersect.

The Bottom Line

The market theory of supply and demand was popularized by Adam Smith in 1776. Consumer demand for a good decreases as its price rises. As prices rise, producers manufacture more to gain more profits. The optimal price that shows an equilibrium between supply and demand is where the supply and demand lines intersect on a graph.