101: Supply and Demand Part I

By Gregg Schoenberg Tuesday, September 13, 2011

At the end of our last post, we discussed some of the factors affecting supply and demand in the commodities markets.  Supply and demand, of course, are not unique to the world of commodities; in fact, they are the forces that shape the market for all goods and services.  As such, it makes sense for small business owners to understand how these forces interact to affect the marketplace for their products.

We’ll start with a brief overview of supply and demand that should be familiar to those of you who made it through Economics 101.  If the thought of taking an economics course in college sounded about as appealing as taking a sharp stick in the eye, don’t worry, we’re going to keep things simple and no math will be required.

On the demand side of things, it is pretty easy to understand that price and demand have what is known as an inverse relationship.  If the price of a product falls, more people will be able to afford it, it will be more appealing compared to similar, higher-priced alternatives, and demand for it will rise.  The converse is also true, when the price of the product in questions rises, demand for it will fall.

How much demand will rise or fall given a specific change in price has to do with what economists call elasticity.  The more elastic that demand is for a particular product, the more demand for it will change given a change in price.  For a real-world example of a good with fairly elastic demand, imagine that you are a restaurant owner who regularly purchases large quantities of salt to season your food.  Given that you see very little difference in one brand of salt versus another, if one of your salt providers were to raise his prices even a little bit above what others are charging, you would be inclined to stop buying from him entirely and to switch to another provider offering similar, lower-priced salt.

The opposite of demand elasticity is demand inelasticity, which refers to the situation where even a large change in the price of a good has little effect on demand.  Health care, particularly critical care, is a classic example of an inelastic good.  No matter the price, if it will save your life, you’ll be willing to bear the cost.

The relationship between supply and price is best understood by thinking about it from the point of view of a supplier of goods.  Supplying goods to the marketplace costs money, and in order to be motivated to produce additional goods, a supplier needs to know that these goods will fetch a price that makes it worthwhile for him to supply them.  Thus as the price of a product rises, its supply will increase; this is known as a direct relationship and is the opposite of the inverse relationship that exists between price and demand.

As you might expect, the concepts of elasticity and inelasticity are also applicable to supply.   If a good is said to have highly elastic supply, then a small change in price will lead to a relatively large change in the quantity supplied.  If, on the other hand, a good has inelastic supply, then changes in price will not have as much of an effect on the quantity supplied.

In our next post, we’ll discover how supply and demand interact and look at ways that understanding this information can help you to make decisions about the quantity of goods to produce and the prices to charge in your business.

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