A good understanding of the laws of supply and demand and market equilibrium is very empowering. It helps us predict what prices will do which also affect decisions like where to invest our money, what skills to learn and when to buy things.
Households and firms interact in two basic kinds of markets. In output markets firms supply products and services to households. To produce these products and services, firms must buy resources from households in input markets. When firms decide how much to produce, it must also determine how much and what type of input it needs to produce the desired level of output.
On the other hand, households must decide how much products and services to buy. Most households earn its income by supplying labour to firms (the labour market). Households may also decide to lend its accumulated savings to firms in exchange for interest or sharing profits (the capital market). Households may also supply land in exchange for rent (the land market). Household income is determined by its decisions on what types and how much input to supply… decisions like what kind and how much training to get, whether to start a business, how much hours to work, how to invest savings.
In short, firms determine the quantity and character of output produced as well as the quantity and type of inputs needed. Households determine the output demanded and the quantities and types of input supplied.
In a free market system, prices are generally determined by the interaction between suppliers and demands.
- When prices fall, households will demand more of the item and when prices increase, households will demand less (Law of demand). However, this is limited on the one hand by income and wealth and on the other hand by time and diminishing marginal utility. (You cannot buy more than you can pay for. And even at zero price, there is a limit to how much you can use).
- Supply is determined by profit potential. Firms must be able to sell their products for more than it cost to produce it. When a firm get a higher price for its products, it will increase the quantity supplied and if it gets a lower price, it will reduce the quantity supplied (Law of supply). This is limited by the cost of production and profit potential of related products.
Market equilibrium is at the point where quantity supplied is equal to quantity demanded at the current price.
- When there is a shortfall (excess demand) prices will tend to increase because available products will go to those who are able to pay the most. When the price increases, supply will go up and demand will go down until equilibrium is reached where quantity demanded is equal to quantity supplied.
- When there is a surplus (excess supply) prices will tend to fall because suppliers want to encourage buyers to buy the surplus. When the price falls, quantity supplied will fall and quantity demanded will go up until equilibrium is reached where quantity supplied is equal to the quantity demanded.
These market forces are not only interesting, but it is also very useful. For example, when there is a drought, food prices is likely to rise because supply is affected. When the banks wants a higher deposit on home loans, house prices tend to fall because it affects demand. These rules are also relevant when it comes to financial markets (share prices, exchange rates, the price of gold). It also applies to labour markets. When we decide which skills to learn, we should definitely find out if the skill is in demand and at what price level.
Karl E. Case, Ray C.Fair, Principles of economics. Seventh Edition, Pearson Prentice Hall, 2004, Chapter 3