Definition of law of supply & demand: A framework used by economists to describe the tendency of free markets to settle at a market price at which quantity demanded equals the quantity supplied.
What is the law of supply & demand?
The law of supply & demand is a model of how a free market works. It’s the first topic that the best economics books for beginners tend to start on.
I’ll explain the logic of this model in a brief summary:
First, consider how the quantity demanded by customers will change as price increases. Of course, demand will fall, as fewer customers will be able to afford the product or will feel it is still worth the price on offer.
Next, consider how the quantity supplied by vendors will change as the price reduces. Supply should rise because at higher prices, it becomes more profitable to produce the good which will attract more firms into the marketplace.
Consider now how these two forces interact in a market place.
If the market price is too low, plenty of goods will be demanded, but the size of the market will be constrained as few vendors will want to produce goods at that price.
If the market price is too high, plenty of goods will be supplied (as vendors will make a large profit on each), but the number of goods changing hands will also be constrained by the fact that only a small proportion of potential buyers may be willing to pay a high price.
Buyers and sellers act independently and pursue their own self-interest. But taken together, buyers will want to consume as much as possible and sellers want to sell as much as possible.
If an opportunity arises in which a vendor believes they will be able to sell more and still make a higher profit, then they will discount their price.
If a buyer is frustrated by the short supply of goods at lower prices, they may increase their offered price in order to secure a supply and satisfy their need.
Because of market price participants making these types of decisions, the price will naturally adjust until market equilibrium is reached, at which point the price results in an equal number of buyers and sellers willing to trade. This is the price point at which the maximum number of goods will change hands.
Economist Adam Smith referred to this process as the invisible hand, eluding to the almost magical way in which equilibrium is reached automatically, as if being directed by a central authority.
How is the phrase law of supply and demand used in a sentence?
What else you should know about law of supply and demand
The law of supply and demand is a very flexible model which can be adjusted and complicated with many additional assumptions and constraints.
- What would happen if a new VAT tax was introduced?
- What would happen if a supplier suddenly shutdown?
- What would happen if buyers needed to pay commission to an agent to make a purchase in the market?
All of these events can be modelled using a chart to determine how the market equilibrium price would be affected.
The demand curve, (see our demand definition page), is a downward sloping curve, representing the reducing demand as price increases.
The supply curve is an upward sloping curve which represents the increasing quantity of goods the market could supply as price increases.
The market equilibrium is the price point at which the two lines intersect.
Because this chart technique is so visible and intuitive, it’s a very helpful way to learn basic micro economics and learn about the behaviour of markets under a variety of conditions.
How does the definition of law of supply and demand to investing?
When you invest in shares or invest in property, you are participating in a market. Modern financial markets might not be entirely ‘free’ in the academic sense, but they do still operate under the law of supply and demand.
- As a buyer, you’d be prepared to invest more if share prices were lower.
- As a seller, you’ll feel more encouraged to sell your shares when prices have risen.
This is the invisible hand nudging you into trading on the market in real life!
Investing books and investment courses, of course, would argue that you should only buy and sell shares when the trade lines up with your personal investment strategy, rather than purely after price movements.
This could be a buy and hold approach, where you invest in a cheap equity ETF each month. Or you could follow a value investing or growth investing strategy, where you pick stocks only when they meet your extensive criteria.