Supply & Demand

This is the first post in a series of articles focused on deconstructing the economic forces behind the operative performance of a business. 

 

Economic Articles

 

Supply & Demand

Profit Theory

Profit Maximization

Cost Theory

Unit Econometrics

Labor

(Links Coming Soon)

 

Supply & Demand

 

Underlying any and all economic activities, policies, and theories of business and economics is the concept of supply and demand. 

To determine whether or not a specific solution will be positively received by a population of buyers in the marketplace, entrepreneurs must be aware of the forces that drive supply and demand. 

Here, we examine the fundamental aspects of supply and demand. 

Demand refers to how much a specific product or service is desired by a population of buyers. The quantity demanded by buyers is the amount of a product or service individuals are willing to buy at a certain price. The relationship between the quantity of a product or serve and it’s price is commonly referred to as the demand relationship. 

Supply represents how much of a product or service a company or provider is willing to offer buyers in exchange for a certain price. The relationship between sully and price is referred to as the supply relationship. 

Price, is therefore a reflection or consequence of supply and demand. 

The relationship between demand and supply illuminate the economic forces behind the allocation of resources in a market economy. In theory, the forces of demand and supply aim to allocate resources in the most efficient way possible. 

Efficient in this case really means to the satisfaction of all parties; producers, suppliers and buyers. When a marketed solution is deemed efficient, all parties are satisfied. When a product or service is deemed inefficient, it means that one or more parties of the equation is not satisfied and will likely take specific measures to improve their economic situation.

Understanding how the difference forces of supply and demand impact each party, requires a closer examination of the law of demand and the law of supply. 

 

Law of Demand

 

The law of demand proposes that, given all other factors that affect decision making remain equal, the higher the price of a good or service is, the less people will demand the good or service. 

Simply put, the higher the price, the lower the quantity of a solution is demanded.  

Buyers are less willing to purchase a good at a higher price because of the opportunity cost associated with buying that specific good or service. The higher the price, the higher the opportunity cost, the lower the price, the lower the opportunity cost.

Opportunity cost is defined as the loss of potential gain from alternative solutions when one solution is purchased. In other words, when a buyer spends $200.00 on a new mobile phone, he or she looses the opportunity to spend that $200.00 on a new pair of shoes. 

Therefore, individuals within the market economy will naturally avoid purchasing products or services that force them to forgo the purchasing of alternative solutions they potentially value more. 

 

Demand Function

 

 
 

The chart above illustrates the downward sloping or negative relationship demand has on price and quantity. 

Points on the slope represent a direct correlation between a specific quantity demanded (Q) at a specific price (P). The chart demonstrates that the higher the price of a good or service, the lower the quantity of the solution is demanded (A), and the lower the price of a good or service, the more the good or service will be in demand (C). 

For most business, Demand is often determined by the following economic and personal factors relating to individual buyers:

 

  1. Income

  2. Taste and preferences

  3. Prices of complementary products and/or services

  4. Expectations about future prices and income

  5. Number of potential buyers

 

Examining how these factors affect the demand, production and sales of a particular product or service requires utilizing the demand function formula.

 

Demand Function Formula

 

The demand function allows entrepreneurs to make astute assumptions about the amount of units of a product or service that is likely to be demanded by a market of buyers. 

The Demand Function is represented by the following equation;

 

π(Q Demand) = f { P1(Q), P2(Q), I, X, etc..}

 

Where:

π(Q Demand) = The change in quantity of units demanded

f = function of {…}

P1= price of a good or service

P2 = Price of an alternative good or service

I = Income

X = Any and all other variables that affect demand

Q = Quantity

 

With this formula, entrepreneurs can determine what quantity of a product or solution will likely be demanded by a population of buyers, and subsequently how much of the product or service their company should produced and sell for a given price to generate a profit.

 

Law of Supply

 

The law of supply demonstrates the quantities of a good or service that will be sold at a certain price. The law of supply proposes that the higher a solution is priced, the greater it’s quantity will be supplied in the marketplace. 

Simply put, the higher the price, the greater the quantity of a solution is supplied.

The logic is that producers are inclined to supply more of an expense good or service because selling a higher quantity of the solution will increase their revenues, and therefore positively impact their profit. 

In this way, the law of supply is represented by an upward slope that juxtaposes the law of demand. 

 

Supply Function

 

 
 

 

The chart above illustrates the upward sloping or positive relationship supply has on price and quantity. 

Points on the slope represent a direct correlation between quantity supplied (Q) and price (P). The chart demonstrates that the higher the price of a good or service, the greater the quantity of the solution will be supplied (C), and the lower the price of a good or service, the less the solution will be supplied (A). 

Another important consideration entrepreneurs should not about the law of supply is taking into account time. Unlike the demand relationship of price and quantity, the supply relationship is a factor to time because suppliers must react to a change in demand and price.  

Therefore, a supplier’s primary objective is to react as quickly as possible to any market change, and determine whether or not a change in price caused by an evolution in demand represents a temporary or permanent event. 

 

For Example: 

Consider a sudden increase in the demand and price of ski jackets during an unusually snowy season in the Colorado Rockies. Suppliers may elect to accommodate to the market change in demand by utilizing their production capabilities to a maximum.

But, if the snowy season is the consequence of a significant long term change in the Colorado climate, suppliers will be forced to expand their production capabilities in order to meet the new and long-term levels of demand. 

 

For most business, Supply is often determined by the following economic and social factors relating to the market:

 

  1. Production Cost

  2. Labor

  3. Capital

  4. Energy

  5. Resources & Materials

  6. Expectations about future prices

  7. Number of Suppliers in the Market

 

Examining how these factors affect the production, supply and sales of a particular product or service requires utilizing the supply function formula. 

 

Supply Function Formula

 

The supply function allows entrepreneurs to make astute assumptions about the amount of units of a product or service their company can produce at a specific price and with certain costs. 

The Supply Function, is represented by the following equation;

 

π(Q Sold) = P (Q) - C (Q)

 

Where:

π(Q Sold) = The change in quantity of units sold

P = Price

C = Cost 

Q = Quantity 

 

With this formula, entrepreneurs can determine what quantity of a product or solution their company can produce and sell with defined costs, at a certain price, and with the aim of generating a profit.

 

Supply & Demand Relationship

 

The relationship between supply and demand is such that should any scarce product or service experience a high level of demand, suppliers will react to that demand by elevating the price of the solution and increasing the production of the product or service in order to maximize profits.

Suppliers will continue this pattern until the supply of the solution saturates the market and demand diminishes. 

Simply put, scarcity can elevate the perceived value of a product or service. 

Similarly, should a solution experience a low level of demand because of an excess supply of the product or service, suppliers will react to the circumstance by lowering the price associated to the solution in order to increase sales, maximize profits and diminish the supply.

Lowering the price of a solution will increase the demand because of the lower opportunity cost associated to the product or service. 

Simply put, overabundance can reduce the perceived value of a product of service. 

 

Equilibrium

 

When the supply and demand of a solution are equal, the economy of that product or service is considered to be at equilibrium.

At equilibrium, the allocation of resources or goods reaches its point of maximum efficiency because the amount of goods being supplied meets exactly the amount of goods being demanded. 

In this event, individual buyers, producers and communities experience satisfaction with the state of their economy because prices are reflective of the shared and relatively equal opportunity costs between suppliers, producers and buyers. 

 

Market Equilibrium

 
 

The chart above illustrates the two slopes; demand and supply, in relation to price and quantity. 

The supply slope, often referred to as the Supply Schedule, shows the relationship between the price of a good or service at various supplied quantities. Similarly, the demand slope, often referred to as the Demand Schedule, shows the relationship between the quantity buyers are willing to purchase at various prices. 

As demonstrated by the chart, equilibrium occurs when the demand and supply functions intersect.

At this point, the economy is fully efficient with a price and quantity that satisfies both the demand and the supply of that solution. 

But, in practical terms, market equilibrium is never actualized.

The factors of time, change and human perception are too powerful. In the real economy prices constantly fluctuate in relation to changes in the demand, supply and perception of a specific product or service. 

The reason why equilibrium is important and desired, particularly by producers and suppliers is because it represents the most efficient allocation of a companies capital resources. 

When a company produces a solution that has no demand, the business will suffer from tying up too much of it’s capital in inventory. And, if the low level of demand never changes, the inventory can become a serious liability for the company. 

Conversely, if a company fails to produce enough supply for it’s product or service that is highly demanded by the marketplace, it misses out on additional revenues. 

In addition, the failure of the company to provide adequate supply of it’s solution will invite competitors enter their space and provide a similar product or service. 

In this case the competitor will reap the economic rewards that the company should have positioned itself to take advantage of in the first place. 

Business leaders are therefore heavily invested in discovering the right equilibrium of producing enough supply to meet potential demand. When entrepreneurs miscalculate, it is there responsibility to react quickly in order to maintain their business’s position in the market and profitability.

 

Disequilibrium

 

When equilibrium is not achieved, which happens to be the normal state of affairs, an economy can be viewed as being in disequilibrium.

This means that the price (P) and quantity (Q) do not intersect on the supply and demand curves. 

Disequilibrium can therefore be attributed to two circumstances; excess supply, and excess demand. 

 

A. Excess Supply

When the price of a product or service is to high, the result will be an excess of supply which represents an allocative inefficiency for the economy of that solution.

Simply put an excess of supply means that resources have been poorly allocated and expectations of demand overstated, which results in surplus inventory. 

 

 
 

 

The chart above demonstrates that at price (P1) the quantity of a product or service producers wish to supply the market is (Q2), however the quantity of the solution desired by buyers is much less, at (Q1). 

Because (Q2) is greater than (Q1) we can conclude that suppliers are producing an excess supply of a product or service because the supply far outpaces the demand. 

This chart also reveals that while suppliers attempt to supply a solution at a certain price, the buyers perceive the product or service to be unattractive because the price is too high.

In other words, buyers consider the opportunity cost of the solution to be too great, and therefore look to alternatives. 

 

B. Excess Demand

When the price of a product or service is set below the equilibrium price on the supply and demand curves the result is an excess of demand.

With a price perceived by buyers as too low, individuals in the marketplace will desire the solution more than suppliers are capable of providing the product or service. 

 

 
 

 

The chart above demonstrates that at price (P1) the quantity of a product or service demanded by buyers is (Q2), but producers are supplying the solution at quantity (Q1).

In this case, the marketed solution is not being supplied at a level that would satisfy the demand from buyers. 

When this occurs, buyers are compelled to compete with one another to purchase the solution. Over time, the demand will elevate the price, and suppliers will be encouraged to produce more of the solution in order to maximize profits and elevate the price closer to its market equilibrium. 

 

Shifts & Movements

 

When changes in price and quantity occur on the demand and supply curve, they are commonly referred to as shits and movements.  

 

A. Movements

A movement refers to a change along the demand or supply curve.

On the demand curve a movement represents a consistent change in both the price of a solution and the quantity demanded of it. 

 

Demand Movement

 

 
 

 

Simply put, a movement occurs when a change in the quantity of a solution demanded is caused only by a change in price, and vice versa. 

Similarly, a movement along the supply curve represents a consistent change in both the price of a good or service and the quantity demanded of it. 

 

Supply Movement

 

 
 

 

Simply put, a movement occurs when a change in the quantity of a solution supplied is caused only by a change in price, and vice versa.

 

B. Shifts

A shift refers to a change of the demand and supply curves when the quantity of a product or service demanded or supplied changes, but the price remains the same.

A shift in the demand curve represents a change in the quantity demanded of a solution caused by a factor other than the price of the solution. 

 

Demand Shift

 

 
 

 

This often occurs when a particular product or service becomes a monopoly. With no competitors, the demand of a solution will naturally increase irrespective of it’s price. 

Similarly, a shift in the supply curve represents a change in the quantity supplied of a solution caused by a factor other than the price of the solution. 

 

Supply Shift

 

 
 

 

A shift of the supply curve often happens when a particular resource, product or service becomes scarce due to an unexpected and atypical event or circumstance. 

 

Conclusion

 

By understanding the forces behind supply and demand, entrepreneurs can make very calculated decisions on the types of products and services their company can produce and market to generate a profit.

In basic terms, an entrepreneur's goal is create a solution people are willing to buy, and at a price that can yield a profit.

Examining the different ways supply and demand are affected can illuminate how impactful different constraints like labor and raw materials are to the viability of developing a specific product or service. 

There are instances where the demand of a solution exists, but the costs associated with supplying the solution far exceed any reasonable price that can be attributed to the solution. In such cases, entrepreneurs are typically forced to wait until new technologies are developed to lower to production costs, or look to alternative markets to produce their solution. 

With the right perspective, business leaders can make astute assumptions about the demand their solution will likely generate, and the capability of the company to supply their solution to meet such a  demand. 

The best approach entrepreneurs can adopt is to carefully and cyclically study their market economy to understand how and why changes in demand and supply occur, and routinely update the economic model of their specific product or service, and more broadly their company. 

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