Why Are Supply & Demand Important to a Business?

by John Lister; Updated September 26, 2017

Although supply and demand is an economic theory, it is directly relevant to any company competing in a market. Understanding the specific supply and demand issues affecting both the sales and purchases a business makes can help it make more informed and smarter business decisions. Some businesses may find supply and demand varies on a seasonal basis.

Concept

Supply and demand are the two factors that determine pricing in the big picture of a competitive economic market. The two factors can be thought of as two forces. Both the absolute levels of supply and demand, and the relative levels of the two in comparison to one another, are important. The principle of supply and demand is that if one or both changes, there will be a temporary imbalance in the quantity of product manufacturers are prepared to sell and the quantity that consumers (as a whole) are prepared to buy. This imbalance will cause the market price to rise or fall as needed until the quantities are equal.

Effect on Business

The effects of supply and demand mean that businesses have to keep an eye on two different "forces" that can affect the prices they will be able to command. On the demand side, an increase in demand (such as a product becoming popular) will raise the price, and vice versa. On the supply side, an increase in supply (such as new competitors entering the market) will force the price downward, while a reduction in supply (such as a competitor going out of business) will push prices upward.

Production

Although supply and demand is usually seen in the context of consumer sales, it can also affect a company's expenses. Most of the money it spends, including on raw materials, machinery and labor, is spent in a market that contains its own supply and demand. For example, if a widget factory is staffed mainly by the spouses of soldiers posted to a nearby military base and the base then closes, the supply of labor would fall. This would, all other things being equal, mean the company had to pay more for labor.

Elasticity

The effects of changes in supply and demand are not always proportional. Some goods are known as price elastic, meaning a small change in price can have a disproportionately high effect on sales. These tend to be luxury goods that people can do without. Other goods are known as price inelastic, meaning a big change in prices has little effect on sales. These tend to be "staple" goods that people need to buy whatever the price, such as basic goods or cigarettes. A well-run business needs to understand how price elastic its goods are so that it can judge the effect of potential price changes.

Seasonal Demand and Supply

In some industries, demand for goods varies greatly during the year. For example, demand for ice creams sold from vans is usually high during the summer and low during the winter. This will usually mean that sellers can command higher prices during the summer. From the other perspective, supply can also vary seasonally. For example, some types of fish may be harder to catch during the winter, raising the price a restaurant has to pay for them. This can create an interesting effect as demand among customers for fish dishes may not be seasonal. This means restaurants may find it difficult to raise prices for these dishes in the winter, leaving them to choose between taking a lower profit margin and only offering the dishes at certain times of year.

About the Author

A professional writer since 1998 with a Bachelor of Arts in journalism, John Lister ran the press department for the Plain English Campaign until 2005. He then worked as a freelance writer with credits including national newspapers, magazines and online work. He specializes in technology and communications.