Supply and demand are fundamental concepts in a free market economy. The law of demand states that higher prices lead to lower demand, while the law of supply states that larger quantities are supplied at higher prices. The relationship between supply and demand affects the price of goods and services, and when supply and demand are equal, the economy is in a state of equilibrium.
Supply and demand is considered a basic economic concept, as well as a vital part of a free market economy. Supply is the quantity of something, such as a product or service, that a market has available. Demand is the quantity of the product or service that buyers want to purchase. The relationship between supply and demand has a great influence on the price of goods and services.
Understanding the law of demand is an important part of deciphering the relationship between supply and demand. According to the law of demand, price has a significant effect on demand. In essence, higher prices translate into lower demand for a product or service. When the price of an item or service is high, an individual must consider that purchasing the item may prevent them from affording the purchase of another, more valuable item. Therefore, the opportunity cost of that item is too high and the demand may be low.
The law of supply is also vital to understanding the relationship between supply and demand. According to the law of supply, larger quantities of a product or service are supplied at a higher price. Those who produce goods and offer services are willing to provide more at higher prices because selling their products at higher prices provides higher income.
To understand this economic relationship, consider a unique gift item priced at US$99. The company that manufactures the gift item has analyzed past sales and determines that demand for this particular item will be low if it is priced above $99. The company decides to produce and release only 100 gift items because its analysis predicts that the opportunity cost is too high to meet the high demand. However, if 200 people request the gift item, the price will increase along with the demand. As higher prices lead to increased supply, more giftware will be produced and offered.
The relationship between supply and demand affects price differently when a company has produced too much of an item. For example, if the gift company increases production to make 500 gift items, but demand remains at 200, supply exceeds demand and the price does not increase. Conversely, the company may actually lower the price in an effort to appeal to consumers who found the gift item attractive but felt the opportunity cost was too high.
It is possible that supply and demand are equal. For this to happen, the quantity of products or services supplied must equal the demand for those products and services. If this is achieved, the economy is balanced in a state of equilibrium.
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