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The law of supply and demand is an economic theory that explains how supply and demand are related to each other and how that relationship affects the price of goods and services. It's a fundamental economic principle that when supply exceeds demand for a good or service, prices fall. When demand exceeds supply, prices tend to rise. There is an inverse relationship between the supply and prices of goods and services when demand is unchanged. If there is an increase in supply for goods and services while demand remains the same, prices tend to fall to a lower equilibrium price and a higher equilibrium quantity of goods and services. If there is a decrease in supply of goods and services while demand remains the same, prices tend to rise to a higher equilibrium price and a lower quantity of goods and services. The same inverse relationship holds for the demand for goods and services. However, when demand increases and supply remains the same, the higher demand leads to a higher equilibrium price and vice versa. Supply and demand rise and fall until an equilibrium price is reached. For example, suppose a luxury car company sets the price of its new car model at $200,000. While the initial demand may be high, due to the company hyping and creating buzz for the car, most consumers are not willing to spend $200,000 for an auto. As a result, the sales of the new model quickly fall, creating an oversupply and driving down demand for the car. In response, the company reduces the price of the car to $150,000 to balance the supply and the demand for the car to reach an equilibrium price ultimately. Increased prices typically result in lower demand, and demand increases generally lead to increased supply. However, the supply of different products responds to demand differently, with some products' demand being less sensitive to prices than others. Economists describe this sensitivity as price elasticity of demand; products with pricing sensitive to demand are said to be price elastic. Inelastic pricing indicates a weak price influence on demand. The law of demand still applies, but pricing is less forceful and therefore has a weaker impact on supply. Price elasticity of a product may be caused by the presence of more affordable alternatives in the market, or it may mean the product is considered nonessential by consumers. Rising prices will reduce demand if consumers are able to find substitutions, but have less of an impact on demand when alternatives are not available. Health care services, for example, have few substitutions, and demand remains strong even when prices increase. While the laws of supply and demand act as a general guide to free markets, they are not the sole factors that affect conditions such as pricing and availability. These principles are merely spokes of a much larger wheel and, while extremely influential, they assume certain things: that consumers are fully educated on a product, and that there are no regulatory barriers in getting that product to them. If consumer information about available supply is skewed, the resulting demand is affected as well. One example occurred immediately after the terrorist attacks in New York City on September 11, 2001. The public immediately became concerned about the future availability of oil. Some companies took advantage of this and temporarily raised their gas prices. There was no actual shortage, but the perception of one artificially increased the demand for gasoline, resulting in stations suddenly charging up to $5 a gallon for gas when the price had been less than $2 a day earlier. Likewise, there may be a very high demand for a benefit that a particular product provides, but if the general public does not know about that item, the demand for the benefit does not impact the product's sales. If a product is struggling, the company that sells it often chooses to lower its price. The laws of supply and demand indicate that sales typically increase as a result of a price reduction – unless consumers are not aware of the reduction. The invisible hand of supply and demand economics does not function properly when public perception is incorrect. Supply and demand also do not affect markets nearly as much when a monopoly exists. The U.S. government has passed laws to try to prevent a monopoly system, but there are still examples that show how a monopoly can negate supply and demand principles. For example, movie houses typically do not allow patrons to bring outside food and beverages into the theater. This gives that business a temporary monopoly on food services, which is why popcorn and other concessions are so much more expensive than they would be outside of the theater. Traditional supply and demand theories rely on a competitive business environment, trusting the market to correct itself. Planned economies, in contrast, use central planning by governments instead of consumer behavior to create demand. In a sense, then, planned economies represent an exception to the law of demand in that consumer desire for goods and services may be irrelevant to actual production. Price controls can also distort the effect of supply and demand on a market. Governments sometimes set a maximum or a minimum price for a product or service, and this results in either the supply or the demand being artificially inflated or deflated. This was evident in the 1970s when the U.S. temporarily capped the price of gasoline around under $1 per gallon. Demand increased because the price was artificially low, making it more difficult for the supply to keep pace. This resulted in much longer wait times and people making side deals with stations to get gas. While we've mainly been discussing consumer goods, the law of supply and demand affects more abstract things as well, including a nation's monetary policy. This happens through the adjustment of interest rates. Interest rates are the cost of money: They are the preferred tool for central banks to expand or decrease the money supply. When interest rates are lower, more people are borrowing money. This expands the money supply; there is more money circulating in the economy, which translates to more hiring, increased economic activity, and spending, and a tailwind for asset prices. Raising interest rates leads people to take their money out of the economy to put in the bank, taking advantage of an increase in the risk-free rate of return; it also often discourages borrowing and activities or purchases that require financing. This tends to decrease economic activity and put a damper on asset prices. In the United States, the Federal Reserve increases the money supply when it wants to stimulate the economy, prevent deflation, boost asset prices, and increase employment. When it wants to reduce inflationary pressures, it raises interest rates and decreases the money supply. Basically, when it anticipates a recession, it begins to lower interest rates, and it raises rates when the economy is overheating. The law of supply and demand is also reflected in how changes in the money supply affect asset prices. Cutting interest rates increases the money supply. However, the amount of assets in the economy remains the same but demand for these assets increases, driving up prices. More dollars are chasing a fixed amount of assets. Decreasing the money supply works in the same way. Assets remain fixed, but the number of dollars in circulation decreases, putting downward pressure on prices, as fewer dollars are chasing these assets. Demand and Supply models are very easy to use, when there is a change in either demand or supply. However, in reality, there are number of situations which lead to simultaneous changes in both demand and supply. (I) Both Demand and Supply decrease (II) Both Demand and Supply increase (III) Demand decreases and Supply increases (IV) Demand increases and Supply decreases Let’s relate this to ridesharing businesses — Uber, Lyft, Ola — where the simultaneous shifts are seen in action. In the case of ridesharing businesses, the demand is the number of riders (Q) and the supply is the number of drivers (S). Original Equilibrium is determined at point E, when the original demand curve DD and the original supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the equilibrium price. The effect of decrease in both demand and supply on equilibrium price and equilibrium quantity can be better analyzed under three different cases: When decrease in demand is proportionately equal to decrease in supply, then leftward shift in demand curve from D to D¹ is proportionately equal to leftward shift in supply curve from SS to S¹S¹ . The new equilibrium is determined at E¹ As demand and supply decrease in the same proportion, equilibrium price remains same at OP, but equilibrium quantity falls from OQ to OQ¹. Impact: No change in Price for Riders. No change in Earnings for Drivers When decrease in demand is proportionately more than decrease in supply, then leftward shift in demand curve from D to D¹ is proportionately more than leftward shift in supply curve from S to S¹. The new equilibrium is determined at E¹, equilibrium price falls from OP to OP¹ and equilibrium quantity falls from OQ to OQ¹. Impact: Drop in Price for Riders. Drop Earnings for Drivers Case 3: Decrease in Demand < Decrease in Supply:When decrease in demand is proportionately less than decrease in supply, then leftward shift in demand curve from D to D¹ is proportionately less than leftward shift in supply curve from S to S¹. The new equilibrium is determined at E¹ equilibrium price rises from OP to OP¹ whereas, equilibrium quantity falls from OQ to OQ¹. Impact: Increase in Price for Riders. Increase in Earnings for Drivers (II) Both Demand and Supply Increase:Original Equilibrium is determined at point E, when the original demand curve DD and the original supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the equilibrium price. The effect of increase in both demand and supply on equilibrium price and equilibrium quantity is discussed under three different cases: Case 1: Increase in Demand = Increase in Supply:When increase in demand is proportionately equal to increase in supply, then rightward shift in demand curve from D to D1 is proportionately equal to rightward shift in supply curve from S to S¹. The new equilibrium is determined at E¹. As both demand and supply increase in the same proportion, equilibrium price remains the same at OP, but equilibrium quantity rises from OQ to OQ¹. Impact: No change in Price for Riders. No change in Earnings for Drivers Case 2: Increase in Demand > Increase in Supply:When increase in demand is proportionately more than increase in supply then rightward shift in demand curve from D to D¹ is proportionately more than rightward shift in supply curve from SS to S1S1. The new equilibrium is determined at E1equilibrium price rises from OP to OP¹ and equilibrium quantity rises from OQ to OQ¹. Impact: Increase in Price for Riders. Increase in Earnings for Drivers Case 3: Increase in Demand < Increase in Supply:When increase in demand is proportionately less than increase in supply, then rightward shift in demand curve from D to D¹ is proportionately less than rightward shift in supply curve from S to S¹. The new equilibrium is determined at E¹ equilibrium price falls from OP to OP¹ whereas, equilibrium quantity rises from OQ to OQ¹. Impact: Decrease in Price for Riders. Decrease in Earnings for Drivers (III) Demand decreases and Supply increases:The effect of simultaneous decrease in demand and increase in supply on equilibrium price and equilibrium quantity is analyzed in the following three cases: Case 1: Decrease in Demand = Increase in Supply:Impact: Decrease in Price for Riders. Decrease in Earnings for Drivers Case 2: Decrease in Demand > Increase in Supply:Impact: Greater decrease in Price for Riders. Greater decrease in Earnings for Drivers (IV) Demand increases and Supply decreases:The effect of increase in demand and decrease in supply on equilibrium price and equilibrium quantity is discussed in the following three cases: Case 1: Increase in demand = Decrease in supply:Impact: Increase in Price for Riders. Increase in Earnings for Drivers Case 2: Increase in Demand > Decrease in Supply:Impact: Greater increase in Price for Riders. Greater increase in Earnings for Drivers Case 3: Increase in Demand < Decrease in Supply:Impact: Increase in Price for Riders. Increase in Earnings for Drivers In this article, we just looked at the different possibilities of changes in supply and demand, and the impact on the pricing and earnings. In the next article, we look at levers such as surge pricing and incentives, which act as levers to adjust both supply and demand. |
If both supply and demand decreases but supply decreases more than demand the result would be
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