In the first of our two-part post on supply and demand, we looked at the relationships that supply and demand have to the price of goods, and we defined the concept of elasticity. Now let’s move on to see how supply and demand interact in order to create the prices for all of the goods and services that we produce and consume.
While we promised that no math would be involved in this discussion, we didn’t say anything about charts, and the following one is rather instructional so let’s take a look at it.
A quick glance at the demand curve (the red line) confirms what we stated in our last post: as the price of a good falls, demand for it increases. Looking at this relationship visually helps us to understand why a demand curve is often referred to as a downward-sloping curve.
The opposite, as you will remember, can be said of the supply curve (the blue line). As the price of a good rises, its supply increases, resulting in a curve that is upward sloping.
The point where the supply and demand curves intersect generates a tremendous amount of excitement among economists, and makes the rest of us think that maybe economists should get out of the house a little more often.
In this case, however, economists’ excitement is justified, as the intersection of the supply and demand curves represents something with great importance to all of us: the point of market equilibrium. At market equilibrium, the quantity that suppliers are producing exactly matches the quantity that consumers are demanding, and the price that suppliers are charging is equal to the price that consumers are willing to pay. These equilibrium prices and quantities are known as the market price and the market quantity, and they represent the amount of goods that actually get produced and the price paid for these goods, when a market is in equilibrium.
While we may struggle to find equilibrium in our lives, markets always gravitate toward it and can thus be said to be self-correcting. A quick look at our chart demonstrates why this is so. Pick any price in the chart that is above the equilibrium price, then draw a line from that price to see where it hits the supply and demand curves, and you should notice the following: at any price above the market price, supply is greater than demand. If suppliers are left with excess product, it is pretty easy to imagine what happens next: they have a sale, so to speak, and drive prices down until they reach the equilibrium point. If, on the other hand, prices start out below the equilibrium price, then demand will be greater than supply and buyers will bid up prices until they reach equilibrium.
As a small business owner it is important to understand how supply and demand interact to create market prices. While you cannot dictate the market price for the goods and services you produce, you can and should pay close attention to what the market tells you any time you change either the amount of goods you produce or the prices you charge. It can really pay off to keep detailed records of how your sales and profitability change for any given change in the prices you charge or the quantity you produce. Doing so will allow you to see how the forces of supply and demand affect your specific business, and should help you determine your optimal quantities to produce and prices to charge.