essay on demand and supply in market economy

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• Introduction

Demand curve

Supply curve.

• Market equilibrium, or balance between supply and demand

supply and demand

supply and demand , in economics , relationship between the quantity of a commodity that producers wish to sell at various prices and the quantity that consumers wish to buy. It is the main model of price determination used in economic theory. The price of a commodity is determined by the interaction of supply and demand in a market . The resulting price is referred to as the equilibrium price and represents an agreement between producers and consumers of the good. In equilibrium the quantity of a good supplied by producers equals the quantity demanded by consumers.

The quantity of a commodity demanded depends on the price of that commodity and potentially on many other factors, such as the prices of other commodities, the incomes and preferences of consumers, and seasonal effects. In basic economic analysis, all factors except the price of the commodity are often held constant; the analysis then involves examining the relationship between various price levels and the maximum quantity that would potentially be purchased by consumers at each of those prices. The price-quantity combinations may be plotted on a curve, known as a demand curve , with price represented on the vertical axis and quantity represented on the horizontal axis. A demand curve is almost always downward-sloping, reflecting the willingness of consumers to purchase more of the commodity at lower price levels. Any change in non-price factors would cause a shift in the demand curve, whereas changes in the price of the commodity can be traced along a fixed demand curve.

The quantity of a commodity that is supplied in the market depends not only on the price obtainable for the commodity but also on potentially many other factors, such as the prices of substitute products, the production technology, and the availability and cost of labour and other factors of production . In basic economic analysis, analyzing supply involves looking at the relationship between various prices and the quantity potentially offered by producers at each price, again holding constant all other factors that could influence the price. Those price-quantity combinations may be plotted on a curve, known as a supply curve , with price represented on the vertical axis and quantity represented on the horizontal axis. A supply curve is usually upward-sloping, reflecting the willingness of producers to sell more of the commodity they produce in a market with higher prices. Any change in non-price factors would cause a shift in the supply curve, whereas changes in the price of the commodity can be traced along a fixed supply curve.

3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services

Learning objectives.

By the end of this section, you will be able to:

• Explain demand, quantity demanded, and the law of demand
• Explain supply, quantity supplied, and the law of supply
• Identify a demand curve and a supply curve
• Explain equilibrium, equilibrium price, and equilibrium quantity

First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.

Demand for Goods and Services

Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a person who does not have a drivers license has no effective demand for a car.

What a buyer pays for a unit of the specific good or service is called price . The total number of units that consumers would purchase at that price is called the quantity demanded . A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand . The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.

We can show an example from the market for gasoline in a table or a graph. Economists call a table that shows the quantity demanded at each price, such as Table 3.1 , a demand schedule . In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like Figure 3.2 , with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical axis. While economists often use math, they are different disciplines.)

Table 3.1 shows the demand schedule and the graph in Figure 3.2 shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded.

Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.

Confused about these different types of demand? Read the next Clear It Up feature.

Clear It Up

Is demand the same as quantity demanded.

In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to a (specific) point on the curve.

Supply of Goods and Services

When economists talk about supply , they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service . A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply . The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.

Still unsure about the different types of supply? See the following Clear It Up feature.

Is supply the same as quantity supplied?

In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that we can illustrate with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to a (specific) point on the curve.

Figure 3.3 illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like Table 3.2 , that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.

The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.

Equilibrium—Where Demand and Supply Intersect

Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.

Figure 3.4 illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 3.2 . The supply curve (S) is identical to Figure 3.3 . Table 3.3 contains the same information in tabular form.

Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in Figure 3.4 , is called the equilibrium . The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity . At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.

In Figure 3.4 , the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.

The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.

Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in Figure 3.4 illustrates this above-equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.

Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus .

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.

Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in Figure 3.4 shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.

When the price is below equilibrium, there is excess demand , or a shortage —that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which has been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model.

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• The Law of Supply and Demand
• How It Works

The Law of Demand

The law of supply, equilibrium price, factors affecting supply, factors affecting demand, the bottom line, law of supply and demand in economics: how it works.

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What Is the Law of Supply and Demand?

The law of supply and demand combines two fundamental economic principles that describe how changes in the price of a resource, commodity, or product affect its supply and demand. Supply rises while demand declines as the price increases. Supply constricts while demand grows as the price drops.

Levels of supply and demand for varying prices can be plotted on a graph as curves. The intersection of these curves marks the equilibrium or market-clearing price at which demand equals supply and represents the process of price discovery in the marketplace.

Key Takeaways

• The law of demand holds that the demand level for a product or a resource will decline as its price rises and rise as the price drops.
• The law of supply says that higher prices boost the supply of an economic good and lower ones tend to diminish it.
• A market-clearing price balances supply and demand and can be graphically represented as the intersection of the supply and demand curves.
• The degree to which changes in price translate into changes in demand and supply is known as the product's price elasticity.
• Demand for basic necessities is relatively inelastic. It's less responsive to changes in their price.

Investopedia / Alex Dos Diaz

Understanding the Law of Supply and Demand

It may seem obvious that the price satisfies both the buyer and the seller in any sale transaction, matching supply with demand. The interactions between supply, demand, and price in a free marketplace have been observed for thousands of years.

Many medieval thinkers distinguished between a "just" price based on costs and equitable returns and one at which the sale was transacted, just like modern-day critics of market pricing for select commodities.

Our understanding of price as a signaling mechanism matching supply and demand is rooted in the work of Enlightenment economists who studied and summarized the relationship.

Supply and demand don't necessarily respond to price movements proportionally. The degree to which price changes affect the product's demand or supply is known as its price elasticity.

Price discovery based on supply and demand curves assumes a marketplace in which buyers and sellers are free to transact or not depending on the price.

Products with a high price elasticity of demand will see wider fluctuations in demand based on the price. Basic necessities will be relatively inelastic in price because people can't easily do without them so demand will change less relative to changes in the price.

Factors such as taxes and government regulation, the market power of suppliers, the availability of substitute goods, and economic cycles can all shift the supply or demand curves or alter their shapes. However, the commodities affected by these external factors remain subject to the fundamental forces of supply and demand as long as buyers and sellers retain agency.

The law of demand holds that demand for a product changes inversely to its price when all else is equal. The higher the price, the lower the level of demand.

Buyers have finite resources so their spending on a given product or commodity is limited as well. Higher prices reduce the quantity demanded as a result. Demand rises as the product becomes more affordable.

Changes in demand levels as a function of a product's price relative to buyers' income or resources are known as the income effect .

But some exceptions exist. One is Giffen Goods . These are typically low-priced staples also known as inferior goods . They're those who see a drop in demand when incomes rise because consumers trade up for higher-quality products.

The substitution effect turns the product into a Giffen good when the price of an inferior good rises and demand goes up because consumers use more of it in place of costlier alternatives.

Veblen goods are at the opposite end of the income and wealth spectrum. They're luxury goods that gain in value and consequently generate higher demand levels as they rise in price because the price of these luxury goods signals and may even increase the owner's status.

Veblen goods are named for economist and sociologist Thorstein Veblen who developed the concept and coined the term "conspicuous consumption" to describe it.

The law of supply relates price changes for a product to the quantity supplied. The law of supply relationship is direct, not inverse. The higher the price, the higher the quantity supplied . Lower prices mean reduced supply all else being equal.

Higher prices give suppliers an incentive to supply more of the product or commodity, assuming their costs aren't increasing as much. Lower prices result in a cost squeeze that curbs supply. Supply slopes are upwardly sloping as a result.

As with demand, supply constraints may limit the price elasticity of supply for a product. Supply shocks can cause a disproportionate price change for an essential commodity.

Also called a market-clearing price, the equilibrium price is that at which demand matches supply, producing a market equilibrium that's acceptable to buyers and sellers.

Supply and demand in terms of the quantity of the goods are balanced at the point where an upward-sloping supply curve and a downward-sloping demand curve intersect leaving no surplus supply or unmet demand.

The level of the market-clearing price depends on the shape and position of the respective supply and demand curves, which are influenced by numerous factors. 

Supply will tend to decline toward zero at product prices below production costs in industries where suppliers aren't willing to lose money.

Price elasticity will also depend on the number of sellers, their aggregate productive capacity, how easily it can be lowered or increased, and the industry's competitive dynamics . Taxes and regulations may matter as well.

Consumer income, preferences, and willingness to substitute one product for another are among the most important determinants of demand.

Consumer preferences will depend in part on a product's market penetration because the marginal utility of goods diminishes as the quantity owned increases. The first car is more life-altering than the fifth addition to the fleet. The living room TV is more useful than the fourth one for the garage.

What Is a Simple Explanation of the Law of Supply and Demand?

Higher prices cause supply to increase as demand drops. Lower prices boost demand while limiting supply. The market-clearing price is one at which supply and demand are balanced.

Why Is the Law of Supply and Demand Important?

The law of supply and demand is essential because it helps investors, entrepreneurs, and economists understand and predict market conditions. A company that's considering a price hike on a product will typically expect demand for it to decline as a result and will attempt to estimate the price elasticity and substitution effect to determine whether to proceed.

What Is an Example of the Law of Supply and Demand?

Gasoline consumption plunged with the onset of the COVID-19 pandemic in 2020 and prices quickly followed because the industry ran out of storage space. The price decline in turn served as a powerful signal to suppliers to curb gasoline production. Crude oil prices in 2022 then provided producers with additional incentive to boost output.

The law of supply and demand reflects two central economic principles that describe the relationship between price, supply, and demand.

The law of demand posits that demand declines when prices rise for a given resource, product, or commodity. Demand increases as prices fall. On the supply side, the law posits that producers supply more of a resource, product, or commodity as prices rise. Supply falls as prices fall.

The price at which demand matches supply is the equilibrium, the point at which the market clears. The law of supply and demand is critical in helping all players within a market understand and forecast future conditions.

SSRN. " The First Laws in Economics and Indian Economic Thought – Thirukkural ."

JSTOR. " The Concept of the Just Price: Theory and Economic Policy. "

Thorstein Veblen, via The Mead Project. " Conspicuous Consumption ." Chapter 4 in The Theory of the Leisure Class: An Economic Study of Institutions.  The Macmillan Company, 1899, pp. 68-101.

Trading Economics. " Crude Oil ."

U.S. Bureau of Labor Statistics. " From the Barrel to the Pump: the Impact of the COVID-19 Pandemic on Prices for Petroleum Products ."

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Page One Economics ®

The science of supply and demand.

"A body in motion tends to stay in motion unless acted on by an out-side force."  

—Isaac Newton

Science Is Everywhere

We live in a world governed by the laws of science. From gravity, to electromagnetism, to sound waves, our lives are filled with scientific phenomena that structure and affect every facet of our daily routine. As a species, we have attempted at every turn to channel the laws of science to our own benefit, constantly working to build better products and to develop improved means of manufacturing. However, sometimes science unveils itself in unanticipated ways—ways that often force its will on the distribution of goods in markets.

Figure 1 Personal Consumption Expenditures

SOURCE: FRED ® , Federal Reserve Bank of St Louis; https://fred.stlouisfed.org/graph/?g=r60z , accessed January 2021.

Few events demonstrate this fact better than the COVID-19 pandemic of 2020. As this new viral strain spread around the globe, many businesses in the United States closed or reduced workers' hours, sometimes by the choice of businesses—to prevent employees from catching the virus—and sometimes due to government stay-at-home orders. 1 In the early months of the pandemic, virtually no industry or market remained unaffected as the economy declined: Consumer spending on goods and services dropped by 6.7 percent in March and 12.7 percent in April (Figure 1) and the unemployment rate rose from a 50-year low of 3.5 percent in February to a post-Great Depression record of 14.7 percent in April (Figure 2). 

Figure 2 Unemployment Rate

SOURCE: FRED ® , Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/graph/?g=r5AM , accessed January 2021.

Supply and Demand

COVID-19 affected markets the same way they are affected by any outside force—through supply and demand . In competitive markets , supply and demand govern the ways that buyers and sellers determine how much of a good or service to trade in reaction to price changes.

The law of demand describes the behavior of buyers in markets: As the price (P) of a good or service rises, the quantity demanded (Q D ) of that good or service falls. Likewise, as the price of a good or service falls, the quantity demanded of that good or service rises. Consider your favorite snack food. A downward sloping demand curve indicates that as the price of the snack increases, you would be able and/or willing to buy a smaller amount. This relationship is demonstrated by the downward sloping demand curve in Figure 3. When the price increases from P 1 to P 2 , the quantity demanded decreases from Q 1 to Q 2 .

Similarly, the law of supply describes the behavior of sellers in markets: As the price of a good or service rises, the quantity supplied of that good or service rises. Like­wise, as the price of a good or service falls, the quantity supplied of that good or service falls. Therefore, as the price (as determined by the market) of your favorite snack rises, firms are willing to produce more units. This relationship is demonstrated by the graph of the upward sloping supply curve in Figure 4. When the price increases from P 1 to P 2 , firms are willing to supply a greater quantity. That is, the quantity supplied increases from Q 1 to Q 2 .

Market prices are constantly adjusting to bring into balance the amount desired by buyers and the amount sold by sellers. This balance is found at the equilibrium price , where supply and demand intersect (Figure 5). At this point we have our equilibrium price (P e ) and equilibrium quantity (Q e ).

Scientific Events

Biology: COVID-19

The COVID-19 pandemic and the associated lockdowns hit the Leisure and Hospitality sector particularly hard (Figure 6). A recent study looked at hours worked by sector in the immediate aftermath of stay-at-home orders—March 2020. 2 As shown in Figure 6, the effects on hours worked are separated into supply factors (red bars) and demand factors (blue bars) and measured as the percent change in historical growth rates of hours worked in each sector. Supply factors are related to businesses partially or fully shutting down. Demand factors are related to reduced consumer spending, such as from customers not shopping, to avoid catching the virus, or simply cutting back on spending due to income loss. 3 For most sectors, hours worked dropped compared with historical trends due to both supply and demand factors.

When a factor other than price affects supply or demand, it is modeled by shifting the supply or demand curve, respectively, rather than moving along the curve. For increases in supply or demand, the curves are shifted to the right to higher quantities. For decreases, the curves are shifted to the left to lower quantities.

Although supply factors contributed to most of the almost 10 percent drop in the Leisure and Hospitality sector in March 2020 compared with historical growth, demand factors also contributed (see Figure 6). The change in this sector is demonstrated in Figure 7: Demand decreases (shifts to the left) and supply decreases more (also shifts to the left), resulting in a lower quantity of goods sold at the new equilibrium (Q 2 ). 4

Meteorology: Hurricane Sandy

In the fall of 2012, Hurricane Sandy hit New York City and surrounding regions, with millions of citizens and thousands of businesses losing power. In New Jersey, only 40 percent of gas stations tracked by AAA had power and were operational in the immediate aftermath of the hurricane. 5 As a result, consumers faced a severe shock to the supply of gasoline.

Applying the laws of supply and demand, one can predict how this event would change the quantity and price of gasoline at the pump: Assuming unchanged demand, 6 the supply curve would shift to the left (Figure 8). The equilibrium quantity would decrease from Q 1 to Q 2 , with the price increasing from P 1 to P 2 .

Did this occur? Not exactly. New Jersey Governor Chris Christie promised to punish gas stations that significantly increased prices above their pre-hurricane levels (P 1 ). 7 As a result, prices remained low because they were not allowed to reach equilibrium, so oil firms had no incentive to bring extra gasoline to the market at the lower price, long lines of vehicles formed, and many stations sold out due to limited supply. 

Chemistry: The Ethanol Fuel Boom

In the late 2000s, ethanol experienced a boom as an alternative fuel. Compared with gasoline, ethanol was believed to be cleaner burning (produce less carbon dioxide) and could be produced from renewable crops such as corn and sugar cane. 8 With subsidies provided by the U.S. government to produce fuel ethanol, production facilities sprouted up across the Midwest and supply increased in this growing industry. 9

With more and more ethanol being blended into gasoline for use in everyday car engines, many believed that yearly production would continue to grow for years to come. Then, consumers began noticing that their gas engines were being damaged by gasoline mixtures with large percentages of ethanol. 10 As it turns out, the chemical nature of ethanol makes it very attractive to water. When water gets into an engine's fuel, it increases the corrosion of metal and degrades the engine. As a result, regulators decided that gasoline for normal car engines could only contain up to 10 percent ethanol by volume. 11,12

Using supply and demand to analyze fuel ethanol markets is a little tricky due to the volume ethanol limit. In Figure 9, the desire of producers to increase the supply of ethanol is indicated by the rightward shift of the supply curve. Producers would expect ethanol buyers to continue increasing their demand as ethanol becomes more and more popular. However, all else being equal, once buyers are running their vehicles with gasoline with 10 percent ethanol, their desire to purchase more would dramatically decrease and the demand curve would become a nearly straight vertical line. 13 That is, the quantity demanded wouldn't increase much beyond this limit even if the price of ethanol were to decrease because people won't use gasoline with more than 10 percent ethanol. Thus, no matter how much producers wish to increase supply, buyers would not buy much more ethanol and increased production of ethanol would drive down prices.

Figure 10 U.S. Fuel Ethanol Consumption and Percent of Motor Gasoline Consumption, 1981-2019 (June 24, 2020)

Figure 10 confirms this analysis of supply and demand. Fuel ethanol consumption increased dramatically during the 2000s and then flattened out when it reached about 10 percent of motor gasoline consumption. 14

Markets provide a means by which individuals and businesses can trade goods and services. Though goods and services come in many shapes and sizes, they are all governed by the laws of supply and demand. Of course, unanticipated scientific events, such as pandemics and hurricanes, can alter the course of markets. Yet, the same laws that make markets function every day will exert their will—the laws of supply and demand.

https://www.sciencemag.org/news/2020/03/modelers-weigh-value-lives-and-lockdown-costs-put-price-covid-19 .

2 Brinca, Pedro; Duarte, Joao B.  and Faria-e-Castro, Miguel. "Is the COVID-19 Pandemic a Supply or a Demand Shock?" Federal Reserve Bank of St. Louis Economic Synopses , 2020, No. 31; https://research.stlouisfed.org/publications/economic-synopses/2020/05/20/is-the-covid-19-pandemic-a-supply-or-a-demand-shock .

3 Some sectors such as Wholesale Trade and Information were positively impacted by demand factors. In the case of the Information sector, the increase may have been caused by families increasing their demand for goods and services to work, communicate, and/or enjoy entertainment from home.

4 Figure 7 depicts price increasing, but price could decrease depending on the size of the supply and demand shifts and how responsive supply and demand are to price changes. 

5 Smith, Aaron. "Gas Shortage Continues in Areas Hit By Sandy." CNN Business, November 2, 2012; https://money.cnn.com/2012/11/02/news/economy/gas-shortage-sandy/index.html .

6 There could actually have been an increase in demand from individuals using gas powered electric generators during the power outage.

7 Futrelle, David. "Post-Sandy Price Gouging: Economically Sound, Ethically Dubious." Time , November 2, 2012; https://business.time.com/2012/11/02/post-sandy-price-gouging-economically-sound-ethically-dubious/ .

8 U.S. Energy Information Administration. "Biofuels Explained: Ethanol and the Environment." December 7, 2020, update; https://www.eia.gov/energyexplained/biofuels/ethanol-and-the-environment.php .

9 Byrge, Joshua A. and Kliesen, Kevin L. "Ethanol: Economic Gain or Drain?" Federal Reserve Bank of St. Louis Regional Economist , July 1, 2008; https://www.stlouisfed.org/publications/regional-economist/july-2008/ethanol-economic-gain-or-drain .

10 Johnson, M. Alex. "Mechanics See Ethanol Damaging Small Engines." NBC News, August 1, 2008; https://www.nbcnews.com/id/wbna25936782 .

11 Tyner, Wallace E.; Brechbil, Sarah l. and Perkis, David. "Cellulosic Ethanol: Feed­stocks, Conversion Technologies, Economics, and Policy Options." Congressional Research Service, October 22, 2010; http://nationalaglawcenter.org/wp-content/uploads/assets/crs/R41460.pdf .

12 Specialty vehicles with anti-corrosive engine parts were sold to accommodate fuel with higher concentrations of ethanol, including E85, a fuel mixture containing 85 percent ethanol. However, such vehicles and fuel types have yet to gain mass popularity.

13 The demand curve would likely not be fully vertical, as decreases in any fuel component's price, like ethanol's, would increase the quantity demanded of fuel. However, because ethanol makes up a small percentage of fuel, the demand curve is assumed to be nearly vertical.

14 U.S. Energy Information Administration (2020). See footnote 8.

© 2021, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Biology: The study of living organisms.

Chemistry: The branch of science that deals with the identification of the substances of which matter is composed.

Competitive markets: Markets in which there are generally many buyers and many sellers so that each has a negligible impact on market prices.

Demand: The quantity of a good or service that buyers are willing and able to buy at all possible prices during a certain time period.

Equilibrium price: The price at which quantity supplied and quantity demanded are equal. The point at which the supply and demand curves intersect.

Meteorology: The branch of science concerned with the processes and phenomena of the atmosphere, especially as a means of forecasting the weather.

Subsidies: Payments made by the government to support businesses or markets. No goods or services are provided in return for the payments.

Supply: The quantity of a good or service that producers are willing and able to sell at all possible prices during a certain time period.

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Home — Essay Samples — Economics — Finances — Supply and Demand

Essays on Supply and Demand

If you struggling to come up with a topic for your essay, look no further because we're here to help you explore the fascinating world of supply and demand. Understanding the concept of supply and demand is crucial in various fields, from economics to business, and even in everyday life. So, it's no wonder why you're interested in writing an essay about it!

Choosing a Topic

When it comes to choosing a topic for your supply and demand essay, the possibilities are endless. You could explore the impact of supply and demand on pricing, the relationship between supply and demand and consumer behavior, or even the role of supply and demand in a specific industry. The key is to choose a topic that interests you and allows you to delve into the complexities of supply and demand.

Argumentative Essay Topics

If you're leaning towards an argumentative essay, you may want to consider topics such as the effects of government intervention on supply and demand, the pros and cons of price ceilings and floors, or the impact of supply chain disruptions on supply and demand.

Cause and Effect Essay Topics

For a cause and effect essay, you could explore the causes and effects of supply and demand imbalances, the impact of technological advancements on supply and demand, or the effects of globalization on supply and demand.

Opinion Essay Topics

If you prefer expressing your opinion, consider topics like the role of supply and demand in shaping market trends, the ethical implications of supply and demand fluctuations, or the impact of supply and demand on income inequality.

Informative Essay Topics

And if you're more inclined towards an informative essay, you could explore the basics of supply and demand, the factors that influence supply and demand, or the relationship between supply and demand and market equilibrium.

Thesis Statement Example

Let's take a look at a thesis statement example for a supply and demand essay: "The interaction between supply and demand is the driving force behind market dynamics and pricing strategies." This statement sets the tone for an essay that delves into the intricate relationship between supply and demand.

In your , you could start by providing a brief overview of the concept of supply and demand, followed by a discussion of its significance in various industries. For example, you could highlight the impact of supply and demand on pricing strategies, consumer behavior, and market equilibrium. This sets the stage for a comprehensive exploration of the topic in your essay.

When it comes to the , you could summarize the key points discussed in your essay, reiterate the significance of supply and demand, and perhaps offer some insights into future developments in the field. Remember to leave your readers with a lasting impression that reinforces the importance of understanding supply and demand in today's dynamic market environment.

Final Thoughts

As you can see, supply and demand is a rich and complex topic that offers a plethora of possibilities for exploration in your essay. Whether you're aiming for an argumentative, cause and effect, opinion, or informative essay, the key is to choose a topic that ignites your curiosity and allows you to delve deep into the fascinating world of supply and demand. So, roll up your sleeves and get ready to unravel the intricacies of supply and demand in your essay!

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The Importance of Supply and Demand – With Examples

Understanding Supply and Demand gives you access to one of the most powerful tools in all of economics.

You’ll be able to understand:

• Foreign exchange (Forex) and currency prices
• How wages are determined
• How the unemployment rate responds to various market conditions
• Prices of assets in the stock market
• How interest rates are adjusted by central banks
• How bond prices work
• How something is priced: from fruits at your local grocery store to the cost of your kitchen remodel
• Why some industries thrive and others die

We’ll learn how supply works, and why the amount supplied of something tends to increase as price increases. We’ll learn how demand works, and why the amount demanded tends to decrease as price rises.

More importantly, you’ll obtain a framework for making sense of how various events will affect important economic variables.

Why Amount Supplied Increases With Price:

Would you collect garbage for $100k per year how about $1 million per year.

Think of a job that you really wouldn’t want to do, say garbage collection or janitorial services. Suppose you were offered a salary of $100K per year to do the job. Would you take it? Maybe not, but what if you were offered $1 million per year? If you’re not already a millionaire, you probably would take the job.

This example illustrates the basic idea of supply. As the price offered for anything increases, there are more and more people who are willing to provide that thing. That goes for jobs, it goes for products, it even goes for financial assets, it goes for anything.

More Expensive Apples = More Farmers

You get the idea with jobs. But how about something like the supply of apples? As the price of apples in the market goes up, more farmers decide to grow apples instead of pears and cherries. Perhaps some people that otherwise would have gone into other professions decide to become apple farmers.

This means supply has a positive relationship with price. As the price offered for something increases more of that thing is provided.

Graphically, supply looks like an upward sloping line:

Why the Demand For Anything Decreases With Price

Demand has the opposite property, mainly because everyone has a budget, and if something is really expensive you can usually just not have it, buy less of it, or buy something else that’s almost as good.

More Expensive Labor = Less Jobs

In the section on supply, we discussed receiving an exorbitantly high salary to do some unpleasant job like picking up garbage. What would this mean for the firm that hired you? Well they could raise their prices somewhat to negate the cost – but this would probably cost them some of their customers. More likely, they would lay off some of their employees and invest in more technology like dump trucks that substitutes for humans.

The higher the wages they must pay, the less labor they would hire.

More Expensive Apples = Less Apples Purchased

How about apples? If you go to your local grocery store and you discover that apple prices have become twice as high overnight, would you still buy some? Maybe but you would probably buy less. You might instead buy more of some other fruit like oranges or pears. If apple prices rise by 10 times, you would move away from apple buying even more.

You can summarize this by saying that demand has a negative relationship with price.

If we were to show this graphically, we would draw a downward sloping line for demand .

How the Market Price of Apples is Determined

By combining the supply and demand lines into one graph, we now can show what the market price for apples will be:

With this last graph, we are starting to see the power of supply and demand. Together, they tell us what the market price of apples will be and how many apples are bought in the market. And this is only the beginning.

How Various Changes Affect the Price

Suppose a deep freeze hits apple producers causing 25% of the apple crop to be destroyed. What will this do to the price of apples or amount sold?

The supply and demand lens gives us a framework to logically think through the effects. Does the destruction of apple crops have any effect on demand for apples? Nope. Consumers don’t change their demand for apples because of the freeze.

Does the freeze have any effect on the suppliers? Of course. The amount of apples farmers can provide to the market has declined. One way to think about it is, that at every price, the farmer now has less apples to sell. How do we add this information to the graph?

It’s a leftward shift of the supply line:

What are the effects of the decreased supply? The market price of apples has increased, and as a result, less apples are bought and sold.

Now I understand that most people aren’t interested in apple pricing, but this example serves as a template for understanding how various goods and services are priced: from forex to interest rates.

Quick Check

Before we go on, here’s a quick quiz to check your understanding:

• Suppose the USDA recommends everyone have at least an apple a day for health reasons. How would you represent this on the supply and demand graph? What would be the final effects on the price of apples and the quantity bought and sold?
• Suppose a new technology is developed that allows apples to be grown and harvested more efficiently, lowering the costs of producing apples. How would you represent this on the supply and demand graph? What would be the final effects on the price of apples and the quantity bought and sold?
• The announcement would have the effect of increasing demand for apples at every price. This means the demand line shifts to the right. The final effect would be higher prices and more apples consumed.
• Since apples cost less to produce, at every price, farmers would be able to supply more apples. This means the supply line shifts to the right. This would have the effect of lowering the price of apples and increasing the amount sold.

Summary of How Supply and Demand Works

So far we have covered the supply line, and why supply tends to increase as prices increase (upward sloping). We’ve covered the demand line and why demand for anything tends to decrease the more expensive it gets (downward sloping). We’ve shown how when the demand and supply curves are combined, the market price and quantity are determined.

Most importantly, we’ve created a framework to think about the effect a million different things will have on the final market price and quantity bought and sold. This framework is the shifting of the demand and supply curves in response to different “shocks”.

Make sure you understand this before we go on, since this is THE vital tool in utilizing supply and demand to the fullest extent.

Constructing Supply and Demand Curves Step by Step

Foreign exchange markets (forex).

In the context of foreign exchange we have the price of one currency with respect to the price of another. A typical case is the price of the dollar ($) with respect to the euro (€), which is referred to as the exchange rate. The exchange rate can be thought of as the price, since if you are a European looking to exchange your euros into dollars, the rate of $/€ is the price of dollars.

When the exchange rate is higher, the dollar is cheaper and relatively the euro is more expensive. Vice versa when the exchange rate is low.

What Goes on the Horizontal and Vertical Axes?

So on the vertical axis, we will have the price of euros, represented as the exchange rate of $/€.

What about the horizontal axis, any guesses about what goes there?

It’s simply the amount of euros.

Note: It’s important that if we have $/€ as the price, the amount is to be measured in euros, on the horizontal axis. Why is that? Because the vertical axis has price per unit, and the amount of units always goes on the horizontal axis. So if we had €/$ on the vertical axis, we would need to have $ on the horizontal axis. 

The shape of Demand and Supply Lines

What shape will the demand line take?

Again it will be downward sloping. Why is that? It’s because when the exchange rate is high and a European can get a lot of $ per euro, that’s when euros are the most expensive. Thus, at high exchange rates Europeans will relatively demand less euros, and as the exchange rate decreases they will be willing to take on more and more euros.

What about supply, what shape will it take?

It will be upward sloping, as usual. Why? Because when the exchange rate is low, the dollar is very valuable while euros are cheap. In this kind of environment, not many investors will want to sell their euros into the market. At higher exchange rates, when the euro is relatively more valuable, much more people will be willing to sell euros.

For practice, try to combine this information into a graph and you can compare it to mine below.

How Will Economic Conditions Affect the Exchange Rate?

With this simple graph, we now have a powerful framework to determine what will happen to the exchange rate as economic conditions change.

Suppose a financial crisis occurs in Europe such as the Greek Crisis of 2009, and suddenly investors find themselves wanting to get rid of Euro bonds due to concerns of defaults. What would happen to the exchange rate?

Investors rushing to get rid of euro bonds and fleeing to safer assets like dollar bonds implies that across the board (for every exchange rate) supply of euros has increased. This is represented graphically as a rightward shift of the supply of euros line.

As shown by the graph, the exchange rate falls, meaning the dollar has become stronger, and the amount of euros traded on the market increases.

It should be apparent how this simple supply and demand graph can be used to analyze the effects of various economic conditions on the exchange rate and trade in currency.

Interest Rates

What about the case of interest rates, one of the most important drivers of economic activity in any country. What can supply and demand teach us about how these work?

The interest rate is really a price: the price of holding money. As interest rates increase it becomes more expensive to hold money, and people invest it instead of holding onto it as cash.

Thus we will have the interest rate on the vertical axis and the amount of money on the horizontal axis.

The Shape of Demand and Supply Lines

The demand line for money will be downward sloping, because the higher the interest rate, the less money people will want to hold on to.

How about the supply of money? In this case, it wouldn’t be downward sloping, since the money supply is determined by the government, apart from interest rates. This is not to say that the government doesn’t consider interest rates when setting the money supply, just that they arbitrarily choose what the money supply is.

Because of this, the money supply is simply a vertical line.

All together, the graph looks like this:

How Will Economic Conditions Affect the Interest Rate?

This gives us a good framework for understanding how interest rate changes under various economic conditions.

Just some of the cases:

The government decides interest rates are too high and wants to lower them. How can it do this? By printing more money and increasing the money supply, shifting the Money Supply (orange line) to the right and lowering interest rates.

Suppose economic activity increases, this means more transactions are happening, meaning demand for money has increased. This can be represented as the Money Demand line shifting to the right, meaning the final market interest rates will be higher than before. This tells us that as as economic activity increases, we can expect interest rates to also increase.

Wrapping It Up

With these several examples, you should have a pretty good idea of why supply and demand is one of the most important tools in economics and how it can help you make sense of all kinds of economic conditions.

Just remember, the price goes on the vertical axis, the quantity of units goes on the horizontal axis. Demand is generally downward sloping, and supply upward sloping. Once you draw these you obtain the initial market equilibrium. Then if you want to simulate the effects of some scenario, just think about whether it’ll affect supply and demand, and how.

With some practice, you’ll be thinking in terms of supply and demand intuitively.

Work through these practice problems to increase your understanding:

• Suppose there is a large influx of low skilled immigrant labor into the US . According to supply and demand, what effect would this have on the wages of low-skilled workers?
• Suppose that due to the popularity of bitcoin and alternative investments, people start investing less in the stock market than they used to. According to supply and demand, what effect will this have on average stock prices?

Have a comment or another example to share? Leave it below.

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Demand And Supply - Free Essay Examples and Topic Ideas

Demand is the amount of a particular good or service that people are willing and able to buy at a certain price. It is often influenced by factors such as income levels, consumer preferences, and changes in the economy. On the other hand, supply refers to the quantity of a product that businesses are able and willing to offer for sale at a given price range. This is determined by factors such as input costs, technology, and the availability of resources. The interaction between demand and supply ultimately determines the market price of a product or service. When demand exceeds supply, prices tend to go up, whereas when supply exceeds demand, prices tend to go down.

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Economics: Demand and Supply, Essay Example

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Demand and Supply

• Law of Demand: According to the law of demand, there is an inverse relationship between the price and quantity demanded of a good and/or service. As I think about it, I have been applying the law of demand all my life, even without realizing it because it seems so natural. Like every person, I only have limited financial resources and several choices. Money spent on one particular item leaves me with fewer financial resources for other goods and if the price goes up, I may have to forego even more of my other needs and desires. As a result, I will be less willing to buy the good if it becomes more expensive and vice versa.
• Other determinants of demand: This concept teaches me that demand for goods and services is also influenced by non-price factors. One of the factors that leads to change in demand is price of alternatives. Last year, I wanted to buy a video game console and my first choice was PS3. But I also considered the prices of other video games consoles such as Xbox 360 and Wii. I eventually went with PS3 but I might have chosen Xbox 360 if the console was priced at least 20 percent lower.
• Law of Supply: According to this law, there is a positive relationship between price and quantity supplied. I still remember reading in the newspaper few years ago when oil prices were a serious concern that higher prices of hybrid vehicles were encouraging automakers to increase supply of hybrid vehicles. It makes sense because higher prices increase the profit potential and if I open up my own business, I may also do the same.
• Other determinants of supply: According to this concept, supply is also influenced by non-price factors. This concept helps me make better sense of the economic news I read about agricultural products. I still remember how poor orange plantations yield in Florida due to adverse weather conditions resulted in an increase in Tropicana’s orange juice prices.
• Equilibrium: After reading about this concept, I realized I see it at work at almost every retail outlet I visit. Goods that sell slow often go on sale because quantity supplied exceeds quantity demanded and as a result, retail outlets low prices to boost demand. Similarly, items that are in high demand sometimes go up in prices because the outlets can still sell all their stock at higher prices.
• Price system: I find the price system as a reflection of changes in demand and supply really fascinating. I myself use the price system when buying and selling online. Sometimes I buy items online to sell back for profit and the prices of items on sale give me a good idea of which items are in scarce quantity or in demand and may be easier to sell for profit.
• Transaction costs: The concept of transaction costs helps me understand the importance of information and efficient market systems. I realize I obtain lower prices through internet shopping because of lower transaction costs. If I go to mall, the high transaction costs discourage me from doing price-comparisons but internet doesn’t pose same problem.
• Change in Supply and Demand: This concept helps me understand why the housing bubble occurred before the recent financial crisis. Housing supply increased due to lower production costs such as cheaper access to funding but prices still continued to rise. This is because the demand for housing increased at even greater pace due to rising income levels as well as optimistic future outlook among buyers.
• Price Ceilings: Price ceiling refers to the highest price that can be set for a good or service. I went to New York City which is quite expensive but I learnt there that many city-owned public apartments have rents that cannot exceed a certain upper limit. I believe this is a good policy to help low-income people in big cities with high cost of living since housing can consume a considerable proportion of one’s income. Price ceilings may lead to black markets but in some instances they can also help reduce poverty.
• Price Floors: Price floors refers to the lowest price that can be set for a good or service. I read in a newspaper that the U.S. agriculture industry supports price floors. While it may offset some of the competitive disadvantage faced by U.S. agriculture industry against developing countries, I believe overall this is a bad policy because the better alternative is international trade which may result in low prices for Americans. Price floors artificially keep the prices higher which are not supported by the forces of demand and supply.

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Cocoa hits 4-month low as demand predicted to weaken, supply grows

Sustained elevated prices will likely impact demand and result in a slowdown in grindings

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Article content

Cocoa futures fell to the lowest in more than four months as traders weigh improved supply in the next season against the prospects of weaker demand.

Cocoa hits 4-month low as demand predicted to weaken, supply grows Back to video

The most-active contract fell as much as 4.4 per cent to US$6,650 a tonne in New York , the lowest price since early March. Futures are down about 13 per cent this month after more than doubling earlier this year, as the end of the El Niño weather pattern and a potential shift to La Niña is set to boost production.

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An improving outlook for the next season has weighed on prices, with some analysts seeing the market flipping to a surplus in the upcoming 2024-2025 season after three consecutive years of deficit. Still, analysts at Fitch Solutions’ BMI unit said they “remain cautious” about rebounding production in top producers Ivory Coast and Ghana, and forecast a small 110,000-tonne deficit for the season.

A sustained period of elevated cocoa prices, which is expected to continue, will likely impact demand and result in a slowdown in grindings, the analysts said. Chocolate companies have already warned margins could come under pressure in the second half of the year as they purchase beans at higher prices following this year’s rally.

KitKat maker Nestle SA flagged a “tough consumer environment” in an earnings call last week, as customers seek cheaper goods. Lindt & Spruengli AG said the global chocolate market was seeing a slowdown for some products.

Bloomberg.com

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Demand, Supply and Market Equilibrium Essay

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Demand is the quantity of products customers are willing to buy at a particular price while supply is the quantity of products firms are willing to offer for sell. There is an inverse relationship between demand and supply when all other factors remain constant. On the other hand, market equilibrium is attained at the point of contact between the equilibrium quantity on offer and the equilibrium price in the market. Here, the market is defined as buyers and sellers. The demand and supply for a product influence each other.

When equilibrium is attained, no changes in price occur. However, if the price of the product falls below the equilibrium price, the demand for the product is in excess creating a shortage. Here, shortage occurs when the quantity in supply is lower than the in demand. At this point, sellers provide fewer products than the quantity consumers are willing to buy.

When the price of a product is increased, positive changes in supply and demand occurs. Raising prices decreases excess demand for a product and cancels out the demand and supply differences, restoring the supply and demand equilibrium.

If supply exceeds demand, and the price reaches above the equilibrium point, the price is reduced by excess supply and causes the demand for the product to reduce. In this case, the gap between the quantity in demand and the quantity supplied reduces. An equilibrium point is attained when the demand and supply are the same. As exemplified in figure 1 below, when changes in quantity of the product in demand changes, there are changes in the supply of the product, shown in the movement of the arrow between points a and b.

There is a change in the quantity in demand as the line shifts from a to b and a change in demand as the graph in B above shifts toward the right direction. There is also a change in the product prices when the variables that cause changes in demand are factored into the graph shown above.

Factors such as increase in income, increase in the price of substitute goods, decrease in income, and changes in complementary factors cause changes in the curve. Complimentary factors include inferior, normal, preference, and substitute goods. A shift to the right influences the demand, supply, and product pricing positively.

The change is caused by increase in population, decrease in the prices of complimentary goods, expectation of higher future prices, and changes in consumer preferences. Therefore, a decrease in demand decreases the equilibrium price as mentioned above. A decrease in equilibrium price is caused by excess supply underpinned by decrease in the price of substitute goods, decrease in income, population decrease, and price increases of complimentary goods.

The changes in supply and demand have simultaneous effects on the market equilibrium. As illustrated in figure 2 below, the market equilibrium shifts to point b from point a, because demand exceeds supply. Here, a large increase in demand causes a sharp increase in prices. On the other hand, quantity increases with an increase in demand and supply.

Market equilibrium is attained when the quantity in demand equals the quantity being supplied as shown in figure 3 below. At this point, prices do not increase.

Contact point

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IvyPanda. (2018, December 19). Demand, Supply and Market Equilibrium. https://ivypanda.com/essays/demand-supply-and-market-equilibrium/

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IvyPanda . 2018. "Demand, Supply and Market Equilibrium." December 19, 2018. https://ivypanda.com/essays/demand-supply-and-market-equilibrium/.

1. IvyPanda . "Demand, Supply and Market Equilibrium." December 19, 2018. https://ivypanda.com/essays/demand-supply-and-market-equilibrium/.

Bibliography

IvyPanda . "Demand, Supply and Market Equilibrium." December 19, 2018. https://ivypanda.com/essays/demand-supply-and-market-equilibrium/.

What is a housing bubble?

Signs of a housing bubble, how housing bubbles burst, what is a housing bubble signs & how it bursts.

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• Housing bubbles are sharp price increases driven by a temporary surge in demand that isn't rooted in basic fundamentals.
• Fundamentals are determined by the factors that affect supply and demand, such as costs of building houses and changes in population demographics.
• Though experts often disagree on the existence of a housing bubble, you can look at housing prices compared to rent and income as a good indicator.

Housing bubbles can be devastating. Just look to the one in the late aughts, which saw millions of Americans enter foreclosure, losing their homes and much of their wealth in the process.

Want to prevent the same from happening to you? Then understanding housing bubbles (and when they might burst) is critical. Here's what to know about this market phenomenon — and the signs that might indicate whether we're in one right now.

A housing bubble is a steep run-up in home prices. It's defined by its ability to "pop." Eventually, whatever is driving demand will collapse, and suddenly there is no demand, which means that housing prices will begin dropping rapidly. 

There is no one cause for a housing bubble (it varies from bubble to bubble). However, they're always caused when the housing market moves away from the fundamentals that it's based on, usually by some temporary external pressure on the housing market that boosts demand. Here's a look at the conditions that typically lead to a housing bubble.

Rapid rise in home prices 

A housing bubble is primarily marked by a sharp price increase in prices in the real estate market. 

According to Logan Mohtashami , lead analyst at Housing Wire, housing bubbles occur when "prices are disconnected from fundamentals, and the demand that's being pushed by housing is of a speculative nature." 

Let's take an example: the housing bubble in the mid-2000s. At that time, lending standards were incredibly slack, and it was easy to get a housing loan , which created unsustainable demand for housing. When credit standards tightened, demand shrunk and prices fell.

Speculative buying and FOMO

Speculation can further drive the housing market away from fundamentals, though it doesn't have the force to create a housing bubble on its own. 

When real estate prices start climbing, speculators might see an opportunity to ride that wave and buy into the real estate market. These property investors limit the housing supply and raise prices even higher and further away from the fundamentals. 

Unsustainable demand

High demand leads to a run-up in prices and often encourages more housing construction. While that's good for satisfying demand at the time, once that demand eventually wanes — as it always does — it makes the subsequent crash even worse.

There is then a glut of supply and not enough buyers, leading to even steeper declines in home prices.

There are typically signs you can watch for that indicate a housing bubble may be happening — or is at least in the works. These include:

Skyrocketing prices outpacing income growth

One concerning indicator is if housing prices are rapidly outpacing income. Housing demand grows when income grows because people have more disposable money to put toward a down payment on a house . 

If income isn't growing but housing prices are, then something else other than buying power is pushing demand. That could mean a housing bubble is afoot.

Loosening lending standards

Looser lending standards can also be a big red flag. The housing bubble that crashed housing prices in the 2000s, for example, was largely a result of loose lending practices — or what Mohtashami calls exotic loan debt structures. 

These risky loans were given to borrowers who wouldn't have been able to buy a house otherwise, opening the possibility of home ownership to a whole section of the population. Unfortunately, many of these borrowers were unable to make their mortgage payments, so they lost their homes as credit standards tightened.

"We no longer have any exotic loan debt structures in the system," Mohtashami says. "Hence, we have created the best homeowner loan profiles ever in our history."

Increased construction activity

A jump in home construction can also be a sign of a housing bubble. As demand increases, builders increase construction to capitalize on it. 

If they overbuild, though — or demand falls off quickly — that upsets the balance, ultimately driving home prices downward.

Compared to other economic bubbles, housing bubbles are uncommon. This is primarily because housing is so expensive, so it's not subject to a great deal of impulsiveness. 

When they do burst, though, the consequences can be huge and far-reaching. Here's how this typically happens and what it means for consumers. 

Triggers (interest rate hikes, economic downturns)

Anything that would hurt demand can trigger a housing bubble to burst. Rising mortgage interest rates , for example, could be a trigger, as they make buying a home more expensive and may discourage buyers from entering the market.

General downturns in the economy, widespread layoffs in one industry or market, or other issues can trigger a burst, too. 

Price corrections and falling demand

A housing bubble pops when whatever was pushing demand suddenly evaporates. Signs of a housing bubble bursting include a sudden abundance of supply compared to demand, exacerbated by both speculation and new houses on the market. 

"That causes a drop in home prices because people are willing to sell their home for lower and lower. Eventually, demand and supply reach an equilibrium," says Nik Shah, founder of Home.LLC . 

When a housing bubble pops, the general consensus is that if you're able to hold onto your house, you should wait to sell it until after the market has stabilized.

Foreclosures and economic impact

When a housing bubble bursts, the aftershocks can be huge. In the mid-2000s, it caused millions of Americans to lose their homes. Foreclosures doubled from nearly 720,000 in 2006 to 2.3 million in 2008. Six trillion dollars in wealth was lost as a result.

These losses reverberate throughout the economy, leading to less consumer spending and increased layoffs and unemployment. 

Is the housing market going to crash? It's impossible to predict — though not likely anytime soon. While home prices have risen quite a bit in the past few years, demand is still much higher than supply. This keeps prices from crashing. 

When a housing bubble bursts, it can have ripple effects on the broader economy. Spending typically falls, and as a result, companies lay off workers and unemployment rises.

To protect yourself should a bubble ever burst, always buy within your means and avoid taking on excessive debt. And if housing does crash while you own a home, keep up with your payments and avoid selling unless you absolutely need to. In this scenario, selling may leave you upside down on your mortgage — owing more on the home than you can get for it on the current market.

If you buy early in the bubble and then sell your house at the peak, before the bubble can burst, you may be able to net a significant profit from your investment. With that said, though, timing a real estate purchase this perfectly can be challenging, as it's not always clear if a housing bubble is in the works.

There's no way to predict when a housing bubble will burst perfectly, but there are signs you can watch for. These include home price growth that exceeds income growth, increasing home construction, and loosening lending standards. 

A housing bubble forms when home prices rise steeply, often faster than incomes can keep up. SIgns of a housing bubble include loosening lending standards, increased construction, and higher home prices.

A housing bubble is when home prices rise rapidly due to some external force driving up demand. In the mid-2000s, a housing bubble was created when mortgage lenders loosened standards, allowing less creditworthy borrowers to buy homes. This is just one of several examples of housing bubbles in U.S. history. 

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