Supply and demand is considered a basic economic concept, as well as a vital part of a free market economy. Supply is the amount of something, such as a product or service, that a market has available. Demand is the amount of the product or service that buyers want to purchase. The relationship between supply and demand has a good deal of 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. Essentially, higher prices translate into less demand for a product or service. When the price of an item or service is high, an individual must consider that buying the item may prevent him from being able to afford the purchase of another, more valuable item. As such, the opportunity cost of that item is too high and demand for it may be low.
The law of supply is also vital to understanding the relationship between supply and demand. According to the law of supply, higher quantities of a product or service are supplied at a higher price. Those who produce goods and offer services are willing to supply more at higher prices because selling their wares at higher prices provides increased revenues.
To understand this economic relationship, consider a unique gift item that is priced at 99 US Dollars (USD). The company that makes the gift item has analyzes past sales and determines that demand for this particular item will be low if it is priced higher than 99 USD. The company decides to produce and release just 100 gift items because its analysis predicts that the opportunity cost is too high to provide for high demand. However, if 200 people demand the gift item, the price will rise along with the demand. Since higher prices lead to increased supply, more of the gift item will be produced and offered.
The supply and demand relationship affects price in a different manner when a company has produced too much of an item. For example, if the gift company increases production to create 500 gift items, but the demand stays at 200, the supply outstrips the demand and the price will not rise. By contrast, the company may actually lower the price in an attempt to attract consumers who considered the gift item attractive, but thought the opportunity cost was too high.
It is possible for supply and demand to be equal. In order for this to happen, the amount of supplied products or services must equal the demand for those products and services. If this is attained, the economy is balanced in a state of equilibrium.