The Law of Supply and Demand
For a market economy to
function, producers must supply the goods that consumers want. This is known as the law of supply
and demand. “Supply” refers to the
amount of goods a market can produce, while “demand” refers to the amount of
goods consumers are willing to buy. Together, these two powerful market
forces form the main principle that underlies all economic theory.
The law of supply and demand explains how
prices are set for the sale of goods. The process starts with consumers demanding goods. When demand is high, producers can charge
high prices for goods. The promise
of earning large profits from high prices inspires producers to manufacture
goods to meet the demand. However, the law of demand states that if prices are too high, only a few
consumers will purchase the goods and demand will go unmet. To fully meet
demand, producers must charge a price that will result in the required amount
of sales while still generating profits for themselves.
For example, assume that
a cell phone manufacturing company perceives demand for new cell phones. The company invests in market research to
produce the exact cell phone that consumers want. The company then produces
5,000 units and puts them up for sale at $300 each. Consumers who find the
phone to be valuable pay the full $300, and half of the units are soon sold.
Because of the high
price, however, sales gradually begin to drop off. Many consumers still want
the phone, but are unwilling or unable to pay $300 for one. Because the cell
phone company loses money on unsold products, it reduces the phone’s price to
$250 in hopes of increasing sales. Consumers begin buying again. The process
continues until a price is reached that will both meet demand and maximize the
company’s profits. That price is known as the “market-clearing price.”
When supply becomes
balanced with demand, the market is said to have reached equilibrium. At
equilibrium, resources are used at their maximum efficiency. The study of economics is largely a study in how market economies
can best achieve equilibrium, which is why economists spend a great deal of
time analyzing the relationship between supply and demand.
QUESTIONS
1.
What is supply? “Supply” refers to the
amount of goods a market can produce(at a given price).
2.
What is demand? “Demand” refers to the amount of
goods consumers are willing to buy (at a given price).
3.
What does the law of supply and demand explain? The law of supply and demand explains how
prices are set for the sale of goods.
4.
When can producers charge high prices for goods? When demand is high, producers can charge
high prices for goods.
5.
What happens if prices are set too high? If prices are too high, only a few
consumers will purchase the goods and demand will go unmet.
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