Supply & Demand Trading Strategy - Free Online Course

What Is Supply and Demand?

Supply and demand is a fundamental subject in microeconomics. It is the study of how buyers and sellers interact to determine transaction prices and quantities.

Demand refers to how much of a product or service is desired by buyers. The quantity demanded is the amount of product people are willing to buy at a certain price.

Supply refers to how much the market can offer for a desired product. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price.

Law of Supply

To understand how prices are determined, you have to look at both demand and supply - the willingness and ability of producers to provide goods and services at different prices in the market. The law of supply states that as the price rises for a good, the quantity supplied generally rises, and as the price falls, the quantity supplied also falls.

With supply, a direction relationship exists between the price and quantity supplied. A direct relationship means that when prices rise, quantity supplied will rise too. When prices fall, quantity supplied by sellers will also fall. Thus, a larger quantity will generally be supplied at higher prices than at lower prices. A smaller quantity will generally be supplied at lower prices than at higher prices.

Law of Demand

The law of demand explains how people react to changing prices in terms of the quantities demanded of a good or service. There is an inverse, or opposite, relationship between quantity demanded and price. The law states that as price goes up, quantity demanded goes down, and as price goes down, quantity demanded goes up.

Several factors explain the inverse relation between price and quantity demanded, or how much people will buy of any item at a particular price. These factors include real income, possible substitutes, and diminishing marginal utility.

Equilibrium vs Disequilibrium

In the real world, supply and demand operate together. As the price of a good goes down, the quantity demanded rises and the quantity supplied falls. As the price goes up, the quantity demanded falls and the quantity supplied rises. Is there a price at which the quantity demanded and the quantity supplied meet? Yes. This level is called the equilibrium price. At this price, the quantity supplied by sellers is the same as the quantity demanded by buyers. One way to visualize equilibrium price is to put supply and demand curves on one graph, as shown in figure 20.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curves. Which indicates no allocative inefficiency. At this point, the price of the goods will be P and the quantity will be Q, these figures are referred to as equilibrium price and quantity.

However, in real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.

Disequilibrium occurs whenever the price or quantity is not equal to P or Q.

Excess Supply:

If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high.

Excess Demand:

Excess demand is created when the price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it. Thus, there are too few goods being produced to satisfy the wants of the consumers. However, as consumers have to compete with one another to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.