Law of supply and demand

From CEOpedia | Management online

The law of supply and demand is an economic theory stating that the price of a product or service is determined by the relationship between the quantity of the product or service available and the amount of it that people are willing to purchase. This relationship is also affected by the perceived value of the product or service, as well as external factors such as taxes and subsidies. The law of supply and demand governs the prices of goods and services, the wages of workers, and the interest rates of investments. It is the foundation of a market economy and the driving force behind decision-making for businesses and consumers.

Example of law of supply and demand

  • The law of supply and demand can be seen in action when a product is in high demand and short supply. For example, when a new tech device is released, such as the iPhone 12, the demand for the product will be high and the supply will be low. This will cause the price to increase, as people are willing to pay more to get their hands on the product.
  • On the other hand, when a product is no longer in demand, the supply will exceed the demand and the price will drop. For example, when a new version of a product is released, such as the iPhone 13, the demand for the previous version will decrease and the price will drop.
  • The law of supply and demand also applies to wages. When jobs are in high demand and short supply, employers must offer higher wages to attract qualified candidates. For example, when the economy is booming and there is a shortage of skilled workers, employers must offer higher wages to compete with other employers for the best candidates.
  • Similarly, when there is an oversupply of workers and a decrease in demand for jobs, wages may decrease. For example, when the economy is slow and there is an oversupply of workers, employers may not have to offer as much money to fill positions.

When to use law of supply and demand

The law of supply and demand is an economic theory that is used to explain the relationship between the quantity of a product or service available and the amount of it that people are willing to purchase. It can be used in a variety of situations, such as:

  • When setting prices for goods or services - understanding the law of supply and demand can help businesses determine the optimal price for their products or services.
  • When analyzing the wages of workers - the law of supply and demand states that when the demand for a certain type of labor is high and the supply is low, wages will increase.
  • When deciding how to allocate resources - businesses use the law of supply and demand to determine the most efficient use of their resources.
  • When determining the interest rates of investments - the law of supply and demand can be used to predict the interest rate at which investors are willing to invest in a certain project.
  • When examining the effects of taxes and subsidies - taxes can increase the cost of goods and services, while subsidies can make them more affordable. The law of supply and demand can help businesses and consumers understand these effects.

Types of law of supply and demand

The law of supply and demand is an economic theory that states that the price of a product or service is determined by the relationship between the quantity available and the amount of it that people are willing to purchase. There are several types of supply and demand laws:

  • The Law of Diminishing Marginal Utility states that as more units of a product or service are consumed, the utility of additional units will diminish.
  • The Law of Supply states that the quantity of a product or service supplied by a producer will increase as the price increases, and vice versa.
  • The Law of Demand states that the quantity of a product or service demanded by consumers will increase as the price decreases, and vice versa.
  • The Law of Equilibrium states that in a competitive market, the price of a product or service will eventually settle at a level where the amount supplied is equal to the amount demanded.
  • The Law of Elasticity states that the demand for a product or service is affected by the price of related goods and services, as well as the prices of substitutes and complements.
  • The Law of Substitution states that when the price of a product or service increases, consumers will substitute it for other goods or services that are either cheaper or of greater perceived value.

Advantages of law of supply and demand

One of the main advantages of the law of supply and demand is that it can help to create an efficient market, allowing resources to be allocated in an optimal way. This can result in reduced prices for consumers and increased profits for businesses. Additionally, the law of supply and demand helps to keep prices relatively stable by creating a balance between supply and demand. Lastly, it can act as a guide for decision-making, allowing businesses to adjust their production and pricing strategies in order to remain competitive.

  • It can create an efficient market, allowing resources to be allocated optimally.
  • It can help to keep prices relatively stable.
  • It can act as a guide for decision-making, allowing businesses to adjust their strategies.

Limitations of law of supply and demand

The law of supply and demand is an important economic theory, but it is not without its limitations. The following list outlines some of the key limitations of the law of supply and demand:

  • The law of supply and demand assumes that buyers and sellers have perfect knowledge of all relevant factors, such as the availability of a product, its price, and its quality. In reality, this is rarely the case, and buyers or sellers may make decisions based on incomplete information.
  • The law of supply and demand also assumes that buyers and sellers are rational and will make decisions in their own best interest. In reality, buyers and sellers may make decisions based on irrationality or emotion, which cannot be accounted for by the law.
  • The law of supply and demand assumes that all prices are determined by the interaction between supply and demand. In reality, external factors such as taxes, subsidies, and government regulations may have an effect on prices.
  • The law of supply and demand does not account for the long-term effects of certain economic decisions. For example, a decrease in demand for a product may cause its price to fall in the short term, but it could have a long-term impact on the viability of the industry.

Other approaches related to law of supply and demand

In addition to the law of supply and demand, there are several other approaches related to how the market price for goods and services are determined. These include:

  • Market equilibrium: This approach states that the market price of a good or service will be determined by the intersection of the supply and demand curves. At this point, the quantity of the good or service supplied is equal to the quantity demanded.
  • Marginal utility: This theory states that the price of a good or service is determined by the utility it provides to the consumer. This means that the more utility a good or service provides, the higher its price will be.
  • Auction markets: This approach states that the price of a good or service is determined by the auction process. In an auction, the market price of a good or service is determined by the highest bidder.
  • Bargaining: This approach states that the price of a good or service is determined by negotiation between the buyer and the seller.

Overall, these approaches are used to explain how the market price for a good or service is determined. While the law of supply and demand is the most common, the other approaches can also be used to explain the market price of a good or service.


Law of supply and demand — recommended articles
Competitive equilibrium — Market mechanisms — Hicksian substitution effect — Supply curve — Monopson — Short run aggregate supply curve — Underconsumption — Short run equilibrium — Change In Supply

References

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