[An updated version of this article can be found at Supply in the 2nd edition.]
The most basic laws in economics are those of supply and demand. Indeed, almost every economic event or phenomenon is the product of the interaction of these two laws. The law of supply states that the quantity of a good supplied (that is, the amount that owners or producers offer for sale) rises as the market price rises, and falls as the price falls. Conversely, the law of demand says that the quantity of a good demanded falls as the price rises, and vice versa. (For reasons unknown, economists do not really have a "law" of supply, though they talk and write as though they did.)
One function of markets is to find "equilibrium" prices that balance the supplies of and demands for goods and services. An equilibrium price (also known as a "market-clearing" price) is one at which each producer can sell all he wants to produce and each consumer can buy all he demands. Naturally, producers always would like to charge higher prices. But even if they have no competitors, they are limited by the law of demand: if producers insist on a higher price, consumers will buy fewer units. The law of supply puts a similar limit on consumers. They always would prefer to pay a lower price than the current one. But if they successfully insist on paying less (say, though price controls), suppliers will produce less and some demand will go unsatisfied.
Economists often talk of supply "curves" and demand "curves." A demand curve traces the quantity of a good that consumers will buy at various prices. As the price rises, the number of units demanded declines. That is because everyone's resources are finite; as the price of one good rises, consumers buy less of that and more of other goods that now are relatively cheaper. Similarly, a supply curve traces the quantity of a good that sellers will produce at various prices. As the price falls, so does the number of units supplied. Equilibrium is the point at which the demand and supply curves intersect—the single price at which the quantity demanded and the quantity supplied are the same.
Markets in which prices can move freely are always in equilibrium or moving toward it. For example, if the market for a good is already in equilibrium and producers raise prices, consumers will buy fewer units than they did in equilibrium, and fewer units than producers have available for sale. In that case producers have two choices. They can reduce price until supply and demand return to the old equilibrium, or they can cut production until supply falls to the lower number of units demanded at the higher price. But they cannot keep the price high and sell as many units as they did before.
Why does supply (the quantity that sellers produce) rise as the price rises and fall as the price falls? The reasons really are quite logical. First, consider the case of a company that makes a consumer product. Acting rationally, the company will buy the cheapest materials (not the lowest quality, but the lowest cost for any given level of quality). As production (supply) increases, the company has to buy progressively more expensive (i.e., less efficient) materials or labor, and its costs increase. It has to charge a higher price to offset its rising unit costs.
Or consider the case of a good whose supply is fixed, such as apartments in a condominium. If prospective buyers suddenly begin offering higher prices for apartments, more owners will be willing to sell and the supply of "available" apartments will rise. But if buyers offer lower prices, some owners will take their apartments off the market and the number of available units drops.
History has witnessed considerable controversy over the prices of goods whose supply is fixed in the short run. Critics of market prices have argued that rising prices for these types of goods serve no economic purpose because they cannot bring forth additional supply, and thus serve merely to enrich the owners of the goods at the expense of the rest of society. This has been the main argument for fixing prices, as the United States did with the price of domestic oil in the seventies and as New York City has fixed apartment rents since World War II.
Economists call the portion of a price that does not influence the amount of a good in existence in the short run an "economic quasi-rent." The vast majority of economists believe that economic rents do serve a useful purpose. Most important, they allocate goods to their highest-valued use. If price is not used to allocate goods among competing claimants, some other device becomes necessary, such as the rationing cards that the United States used to allocate gasoline and other goods during World War II. Economists generally believe that fixing prices will actually reduce both the quantity and quality of the good in question. In addition, economic rents serve as a signal to bring forth additional supplies in the future, and as an incentive for other producers to devise substitutes for the good in question.
Al Ehrbar is a partner of Stern, Stewart and president of EVA Institute. He formerly was editor of Corporate Finance magazine and a senior editor of Fortune magazine.