Foundations
Supply & Demand
How the price of anything gets set: buyers competing for a limited supply, and sellers competing for buyers, meeting at a price both sides can live with.
Definition
Demand is how much of something people want to buy at a given price — and how that amount changes as the price changes. Usually, the lower the price, the more people want to buy.
Supply is how much of something sellers are willing to offer at a given price. Usually, the higher the price, the more sellers are willing to produce or sell.
The price a good actually trades at is the point where the amount buyers want to buy matches the amount sellers want to sell — often called the equilibrium price.
Why this exists
Because of scarcity, there's rarely enough of any good for everyone to have as much of it as they'd want for free. Something has to determine who gets it and how much. Price is that mechanism: it rations a scarce good among everyone who wants it, without anyone having to decide by hand who deserves it.
Supply and demand describe the two forces that push price toward a specific level. If a price is set too low, more people want to buy than sellers are willing to provide — buyers compete for the limited amount, and price gets bid upward. If a price is set too high, sellers have more to offer than buyers want — sellers compete for the scarce buyers, and price gets pushed down. Price keeps moving until the amount offered and the amount wanted line up.
This is why prices carry information: a rising price is usually a signal that a good has become more scarce relative to how much people want it, and a falling price usually signals the opposite — without anyone needing to announce why.
Worked example
You're running a lemonade stand on a hot day. At $1 a cup, you sell out of your 20 cups within an hour — demand at that price is higher than your supply for the day.
The next weekend you make 40 cups instead, still at $1 — but it's a cooler day and you only sell 15. Supply now exceeds demand at that price, and cups go to waste.
On the next hot day, you raise the price to $1.50: fewer people buy per cup, but you still sell all 20 and earn more per cup, because demand at the higher price still roughly matches your supply.
Common misconceptions
“Sellers can charge whatever they want.”
Charging more than buyers are willing to pay just means fewer or no sales. Price is constrained by demand, not freely chosen — a seller can set a price, but the market decides whether anyone buys at it.
“More demand always means higher prices.”
Only if supply doesn't rise to meet it. If sellers can easily produce more, higher demand can be satisfied without the price moving much at all.
“Supply and demand only apply to physical goods like lemonade or gas.”
The same forces set wages (the price of labor) and interest rates (the price of money) — see What an Interest Rate Fundamentally Is.
Also in the Glossary: Demand, Equilibrium Price, Supply