The law of supply and demand is the basic principle on which a market economy is based. This principle reflects the relationship that exists between the demand for a product and the quantity supplied of that product, taking into account the price at which the product is sold.
Thus, depending on the market price of a good, the bidders (those who sell) are willing to manufacture a certain number of that good. Like the plaintiffs (those who buy) they are willing to buy a certain number of that good, depending on the price.
The point where there is an equilibrium because the demanders are willing to buy the same units that the suppliers want to manufacture, for the same price, is called the market equilibrium or equilibrium point.
According to this theory, the law of demand establishes that, keeping everything else constant (ceteris paribus), the quantity demanded of a good decreases when the price of that good increases. On the other hand, the law of supply indicates that, keeping everything else constant (ceteris paribus), the quantity supplied of a good increases as its price increases.
Thus, the supply curve and the demand curve show how the quantity supplied or demanded varies, respectively, as the price of that good varies.
How do you break even?
To understand how to reach the point of equilibrium, we must talk about two situations of excess:
- Excess supply: When there is an excess supply, the price at which the products are being offered is higher than the equilibrium price. Therefore, the quantity supplied is greater than the quantity demanded. Consequently, bidders will lower prices to increase sales.
- Excess demand: On the other hand, when there is a shortage of products, it means that the price of the good offered is lower than the equilibrium price. The quantity demanded is greater than the quantity supplied. So the suppliers will increase the price, since there are many buyers for few units of the good so that the number of demanders decreases, and the equilibrium point is established.
Graphical representation of the law of supply and demand
Translating the supply and demand behaviors that we have just explained to a graph, it is understood that the supply curve (O, blue line) is increasing and the demand curve (D, red line) is decreasing. The point where they intersect is known as market equilibrium.
If we start from the initial point at which the quantity Q1 of a good is demanded at the price P1, and due to some external cause there is an increase in demand up to the quantity Q2, the price of the good will increase until it reaches P2.
If, on the contrary, it happens that sellers for some reason decrease their production (for example, floods cause wheat production to decrease), in the graph we will observe a movement of the supply curve (O) to the left and therefore, it increases the price of the good in question and with it the demand will be reduced.
How does competition affect the law of supply and demand?
As we have seen in the examples above, depending on the movement of supply and demand, prices can be affected. In some cases, if the supply or demand for a good is very strong, it can affect the price of that good.
Types of competition
- Perfect competition: It is an almost ideal economic situation and unlikely in reality. It is a market in which the market price arises from the interaction between companies or people who demand a product and others who produce and offer it. None of the agents can influence the price of the good or service, that is, they are price-takers.
- Imperfect Competition : Individual sellers have the ability to significantly affect the market price of their products or services. We can distinguish according to the degree of imperfect competition:
- Monopolistic competition: There is a high number of sellers in the market, although they have a certain power to influence the price of their product.
- Oligopoly: The given market is controlled by a small group of companies.
- Monopoly: A single company dominates the entire market for a type of product or service, which usually translates into high prices and low quality of the monopolized product or service.
- Oligopsony: It is a type of market in which there are few applicants, although there may be a large number of suppliers. Therefore, control and power over prices and purchasing conditions in the market resides with the applicants or buyers.
- Monopsony: It is a market structure where there is a single plaintiff or buyer. While there may be one or more bidders.
Let’s see graphically when the competition is not perfect and sellers can affect the price of the good. For example, if the supply (O) reduces its production forcibly, it will cause an increase in the price of the good in question, and the demand for that good will decrease.
See the law of demand and the law of supply.
Producer surplus and consumer surplus
Through the law of supply and demand, producers and consumers can know at what price they are willing to buy a good or service. The difference between the market price and what they are willing to pay or charge is known as consumer surplus and producer surplus, respectively.
The surplus graph is as follows:
Example of the law of supply and demand
Suppose we own a company that manufactures wooden chairs. We start from the market equilibrium point that we mentioned above. We make one case for supply and another for demand.
In the case of supply, imagine that a tax is imposed on producers of wood goods. In this way, the supply will shift to the left, modifying the price and reducing the number of seats sold.
On the demand side, suppose that customers change their consumption preferences. From this moment they will prefer to buy plastic chairs due to their lightness and low cost. In this case, the quantity demanded will be reduced and the price will fall.