Supply and demand are economic concepts that are used to determine a price and output level that is not likely to change. This is known as equilibrium.
Changes in demand can cause the price to rise or fall. If a product has an increase in demand the price tends to rise. If we take the example of an early MP3 music player we can see why this occurs. When the product was introduced to the market, its price may have been $100. As people were introduced to this product and could see the benefit of it, the demand for it grew. When a situation exists where there are many buyers in the market and the supply is relatively low, the price will rise as retailers realize that people will pay above the initial price of $100 to be able to consume the product. The reason the price rises is that retailers all have the “profit motive”: that desire to maximize profits. A situation now exists where demand is greater than supply.
As producers take note of market actions, it diverts its productive resources away from products that are not being demanded (such as portable cassette players in the case of the MP3 player), into the production of those products that are being demanded. The supply of MP3 players increased as producers tried to take advantage of the high level of demand. The shortage of MP3 players that did exist gradually disappears. The result is that the price will then fall as supply begins to match demand. The point at which the quantity supplied matches the quantity demanded is known as equilibrium, where there is little propensity to change.
This change in supply and demand and the consequent change in price is known as the price mechanism. It can therefore be seen that the price mechanism is the agent that returns markets to the situation where demand equals supply.