Supply and Demand

By Gregg Schoenberg Tuesday, September 13, 2011

In another 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.

Market Demand

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.

Market Supply

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 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.

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.

Market Equilibrium

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.

Supply & Demand

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.

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