Law of Supply and Demand

Have you ever wondered what drives the prices of your favourite products? While it may seem as simple as adding a profit component to cost, what determines the profit margin?

Imagine yourself as an entrepreneur looking to launch a product. Do you know what it takes to get your product into the market? While infrastructure and capital may be obvious responses, have you estimated how much you’d need?

Yes, you are right!

It will depend on the number of units you wish to produce. But how do you determine that number? No, budget cannot be the only criterion! 

What happens if you have a substantial budget but not so many takers for the product? Or conversely, what do you do when you have a shoestring budget but an overwhelming number of people interested in buying?

Navigating the delicate balance between production volume, pricing, and demand in business can indeed be tricky. Producing a large quantity or setting high prices might leave you with unsold stock, which is a monetary loss for business and thus undesirable. On the other hand, if you produce too little or price your products too low, fearing unsold inventory, you might end up with insufficient profits. Both these scenarios can cause unwelcome stress.

Enter the concept of demand and supply!

Understanding Supply and Demand

Supply and demand are fundamental microeconomic concepts that form the backbone of market economics. They determine the relationship between the availability of products, consumer interest in purchasing them, and the prices that consumers are willing to pay.

Supply refers to the quantity of a product that is available for sale in the market. Factors such as manufacturing capabilities, raw material availability, and logistical considerations determine the supply of a product.

Demand, on the other hand, represents the consumer's desire to purchase a product and their willingness to pay for it. It's not just about wanting something; it's also about being able and willing to pay for it. Consumer preferences, income levels, and the price of the product itself are key factors influencing demand.

Price is a significant factor in both supply and demand. It acts as a guide for both producers and consumers. 

The key to making manufacturing decisions lies in understanding the product's market demand and identifying the price point at which customers are willing to purchase, which is also viable for you. 

Understanding the ‘Law of Supply’ and the ‘Law of Demand’ 

The law of supply and the law of demand are two fundamental concepts in economics that explain how market dynamics work. The interplay between them drives prices and, in turn, the economy:

1. The Law of Supply:

   This law suggests a direct relationship between the price of a good and its supply. Basically, as the price of a product increases, suppliers are more inclined to produce and sell more of it, assuming they can achieve a profit margin that exceeds the production cost. This scenario often attracts new suppliers to the market, chasing potential profits. So,

• Increased Supply with Constant Demand Leads to Price Drop:

When a product's supply increases while the demand remains constant, businesses often face a surplus. To mitigate the risk of overstocking, suppliers may lower prices to encourage increased sales, effectively clearing out excess inventory.

• Decreased Supply with Constant Demand Results in Higher Prices:

When the supply of a product decreases, but the demand stays the same, the prices of these products tend to increase. Consumers are often willing to pay more for goods that are in short supply. Supply chain issues are a common cause of reduced supply, and once these issues are resolved, prices typically return to normal levels.

For example, the increasing demand for electric vehicles, which are more environmentally friendly, has led to a rise in the price of lithium batteries. This price hike motivates mining companies to expand their lithium extraction operations and explore new sources, thereby increasing the supply of lithium to meet the growing market demand.

1. The Law of Demand:

   This law states that there is an inverse relationship between the price of a commodity and the quantity demanded by consumers. So, demand generally falls in light of increasing prices. The possibility of this happening is especially higher if cheaper alternatives are available. So,

• Decreased Demand with Constant Supply Causes Price Drop:

In scenarios where the demand for a product decreases, but the supply remains unchanged, overstocking becomes a concern. Suppliers, in such cases, tend to reduce prices to sell off excess stock and prevent inventory buildup.

• Increased Demand with Constant Supply Leads to Price Rise:

An example of this was observed with hand sanitisers during the COVID-19 pandemic. As demand surged due to heightened health concerns, but supply remained constant or even decreased, prices for sanitisers increased significantly. This scenario highlighted how sudden spikes in demand can lead to substantial price increases for certain products.

For instance, let’s assume a new model of a popular smartphone is launched at premium pricing. The law of demand suggests that the quantity demanded might be lesser than other variants. This is because many brand loyalists may find the higher price less attractive. Some potential buyers may even choose not to purchase, especially if there are other models with the same features available at a lesser cost. However, in the same setting, should the manufacturer announce an introductory offer or special discount as part of promotional sales, the demand for the model may spike as many may be willing to buy this model from the brand! 

Both these laws operate together in a market and determine the movements of pricing, production, and consumption. Understanding these laws helps to understand how markets adjust to changes in supply and demand and thus form the foundation of the microeconomic theory. 

Factors Impacting Supply and Demand

Every product in the market comes at a price. When buyers and sellers agree on a price, the transaction takes place. The law of supply and demand establishes just this. 

Below are the factors that impact the supply and demand of products in the market:

• Environmental factors:

Environmental factors play a crucial role in production. For instance, untimely rain can ruin certain food crops in a particular area. This will hamper the availability of these crops, while the demand for the product remains the same. 

• Consumer trends:

The rate at which consumer preferences change can be mind-boggling. The story of the Stanley Quencher cup, where a simple repositioning transformed the cup from a functional item to a fashion accessory, is the perfect example of demand being driven by consumer trends. Primarily driven by influencer marketing, the cup became a viral trend, and the manufacturers received an overwhelming demand despite a high price compared to similar cups.

• Price of the product:

When a product experiences a sudden surge in demand, it often leads to a short-term decrease in supply and an increase in prices. However, if high prices persist, demand may eventually decline as consumers seek more affordable alternatives. This situation forces brands to make a critical decision: either reduce prices to maintain market share or risk losing it by keeping prices high. 

• Population:

A growing population typically leads to increased demand for food, transportation, and other life necessities. Similarly, a declining population may result in reduced demand for various products and services.

• Income levels:

Higher income levels generally increase consumer affordability, leading to increased demand for better-quality products and services. As consumers' purchasing power grows, they tend to seek out products that offer more facilities and amenities.

• Competitor Pricing:

In a market with multiple companies manufacturing similar products, pricing strategies play a critical role. If one company raises its prices, consumers may shift their demand to competing products that offer better value. Conversely, suppose a company successfully introduces a comparable product at a lower price, gaining consumer acceptance. In that case, other companies may feel compelled to lower their prices to stay competitive and retain their customer base.

• Market Trends and Analysis:

Digital transformation and globalisation significantly shape market dynamics. For example, the expansion of e-commerce has revolutionised retail, affecting global supply chains and consumer buying habits. This digital shift has caused an increase in both demand and supply, thereby helping businesses grow.

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• Government Policies and Regulations:

Government actions, such as implementing tariffs or trade policies, might either open up new markets or restrict access, directly affecting both supply and demand.

• Technological Advancements:

Technological progress, especially in automation and digital tools, helps to improve production efficiency and thus the supply. If the quality improves, consumer demand most likely improves.

• Global Economic Indicators:

Macroeconomic factors like GDP growth and unemployment rates play a critical role in shaping market conditions. For instance, a strong economy often boosts consumer spending power, affecting the demand for various products and services.

• Seasonal Variations:

Seasonal changes can shape both production and consumer demand. For example, the demand for certain clothing items increases in winter, affecting both manufacturers' supply strategies and consumers' purchasing patterns.

• Sustainability and Ethical Considerations:

Growing consumer awareness of sustainability and ethics has started to impact demand. For example, a shift towards eco-friendly products has led many companies to adopt more sustainable practices in production.

Stock Market and the Law of Supply and Demand

The law of supply and demand significantly impacts the stock market, particularly the pricing of individual stocks. Stock prices generally rise when demand is high, but availability is low and decrease in scenarios of low demand and high availability.

Below are the key factors that influence stock demand. Professionals closely monitor these factors to analyse and predict stock market trends and demand.

• Interest Rates:

Higher interest rates can lead to a decrease in stock demand due to an increase in the risk-free rate of return. However, when the economy improves and rates rise, this can stimulate demand for stocks.

• Economic Data:

The state of the economy, as reflected in economic data, directly influences the stock demand. A better-performing economy often leads to increased stock demand due to the potential for improved earnings.

• Corporate Results:

Sales figures, profit margins, and the overall outlook of a company can affect the demand for its shares. Positive corporate forecasts and profit results can lead to a short-term increase in stock demand. This is because these make the investors perceive the stocks as profitable.

• Market Sentiment and Investor Behavior:

Investor sentiment, swayed by market news and global events, plays a quintessential role in the stock market. Reactions to political upheavals, economic updates, and international incidents can lead to rapid shifts in stock demand. 

• Foreign Exchange Rates:

Fluctuations in foreign exchange rates significantly impact the stock prices of multinational corporations. Since these changes can alter a company's profitability and financial stability, they affect investor interest and demand for their stocks, especially in globally oriented sectors.

• Technological Sector Trends:

Emerging trends in the technology sector, like breakthroughs in artificial intelligence or developments in renewable energy, are key drivers of investor interest. Advances in these areas often create new investment opportunities and can lead to increased demand for stocks in innovative tech companies.

• Demographic Shifts:

Changes in population demographics, such as ageing populations in certain regions, shape the demand for stocks in specific sectors. For instance, an increase in the elderly population can boost demand for healthcare and retirement services stocks, reflecting the changing needs of society.

• Environmental, Social, and Governance (ESG) Factors:

The growing emphasis on ESG factors is increasingly influencing investor decisions. There's a rising demand for stocks of companies with strong records in sustainability, social responsibility, and ethical governance, as investors seek not only financial returns but also social and environmental impact.

Summing It Up

The law of supply and demand is a fundamental concept in microeconomics that describes how the availability of goods (supply), the desire for these goods (demand), and their prices interact. This understanding is crucial for market participants to assess the current state of the market, gauge their position, and make informed predictions about future market trends and conditions.