The Definition and Importance of the Supply and Demand Model
Forming the basis for introductory concepts of economics, the supply and demand model refers to the combination of buyers' preferences comprising the demand and the sellers' preferences comprising the supply, which together determine the market prices and product quantities in any given market.
In a capitalistic society, prices are not determined by a central authority but rather are the result of buyers and sellers interacting in these markets.
Unlike a physical market, however, buyers and sellers don’t have to all be in the same place, they just have to be looking to conduct the same economic transaction.
It’s important to keep in mind that prices and quantities are the outputs of the supply and demand model, not the inputs.
It’s also important to keep in mind that the supply and demand model only applies to competitive markets — markets where there are many buyers and sellers all looking to buy and sell similar products.
Markets that don’t satisfy these criteria have different models that apply to them instead.
The Law of Supply and The Law of Demand
The supply and demand model can be broken into two parts: the law of demand and the law of supply.
In the law of demand, the higher a supply's price, the lower the quantity of demand for that product becomes.
The law itself states, "all else being equal, as the price of a product increases, quantity demanded falls; likewise, as the price of a product decreases, quantity demanded increases."
This correlates largely to the opportunity cost of buying more expensive items wherein the expectation is that if the buyer must give up consumption of something they value more to buy the more expensive product, they will likely want to buy it less.
Similarly, the law of supply correlates to the quantities that will be sold at certain price points.
Essentially the converse of the law of demand, the supply model demonstrates that the higher the price, the higher the quantity supplied because of an increase in business revenue hinges upon more sales at higher prices.
The relationship between supply in demand relies heavily on maintaining an equilibrium between the two, wherein there is never more or less supply than demand in a marketplace.
Application in Modern Economics
To think of it in modern application, take the example of a new DVD being released for $15.
Because market analysis has shown that current consumers will not spend over that price for a movie, the company only releases 100 copies because the opportunity cost of production for suppliers is too high for the demand.
However, if the demand rises, the price will also increase resulting in a higher quantity supply.
Conversely, if 100 copies are released and the demand is only 50 DVDs, the price will fall to attempt to sell the remaining 50 copies that the market no longer demands.
The concepts inherent in the supply and demand model further provide a backbone for modern economics discussions, especially as it applies to capitalist societies.
Without a fundamental understanding of this model, it is almost impossible to understand the complex world of economic theory.