Why Are Supply & Demand Important to a Business?

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Simply stated, "supply and demand" is an economic theory that explains the interaction between the sellers and buyers of a resource. Supply and demand affect pricing and the volume of goods that are traded in the markets.

TL;DR (Too Long; Didn't Read)

Changes in supply and demand are hard to predict. A small business's ability to respond to changes, known as elasticity, helps determine pricing and the offering of goods and services.

The Basics of Supply and Demand

Supply and demand is one of the most fundamental principals of microeconomics, a branch of economics that studies how single-factor and individual decisions are made. (By contrast, macroeconomics is the study of how the economy works as a whole.)

In business supply and demand, it's important to understand the roles of the two players, consumers and producers. Consumers are the buyers of goods and services. They can be individuals or business units from a sole proprietorship to large corporations. Producers, as the name states, produce and sell goods and services.

Setting Prices According to Supply and Demand

The supply and demand for goods and services depend on several factors, but the most important one is price. In general, demand increases as the price falls. It's the principle on which Black Friday is based. Stores attract more customers by offering great deals on merchandise.

Producers want to make as much money as they can on what they sell. If producers make a profit selling widgets at $25 each, they may be able to increase profits by raising prices, but then fewer consumers may be willing to buy. If the price of widgets drops, more consumers can buy, but producers make less and will likely cut production, particularly if production costs near or exceed the cost of an item. Finding the right balance for pricing is called market equilibrium.

Market Equilibrium Explained

Keeping in mind the goals of consumers (lowest prices) and producers (highest profits), picture a graph in which the x-axis (horizontal) represents quantity and the y-axis (vertical) represents price. The so-named "demand curve" shows that when prices are low, demand increases, and vice versa.

The "supply curve" appears in the opposite direction on the graph because when prices are high, demand decreases, and vice versa. The point where the two lines intersect is called "market equilibrium." Producers can sell goods and services at a profit and at a price consumers are willing to pay.

The Four Laws of Supply and Demand

Once you understand the basic terminology, you can begin to understand the four basic laws of supply and demand, which are as follows:

  1. Increased shift in demand when the supply remains unchanged leads to higher equilibrium price and higher quantity. Why? Consumers are willing to pay more, leading producers to make more so they can earn more money.

  2. Decreased shift in demand when the supply remains unchanged leads to lower equilibrium price and lower quantity. Why? If consumers aren't buying, producers lower their prices to move product. They will not produce more of the goods and services that aren't selling.

  3. Increased shift in supply when demand remains unchanged leads to lower equilibrium price and higher quantity. Why? When goods or services are plentiful and easy to obtain, consumers will shop for the lowest prices and still not deplete an oversupply.

  4. Decreased shift in supply when demand remains unchanged leads to higher equilibrium price and lower quantity. Why? When supplies are low of goods and services consumers are accustomed to buying, they will pay higher prices to get what's available.

Supply and Demand Examples

A luxury clothing brand restricts supply to maintain status and keep prices high. For example, if it manufactures 10,000 units of a certain style of raincoat. Priced at $2,000 each, with a demand for 1,000 coats a month, the supply of coats would be sold out in 10 months. Priced at $100 each, the company would need to manufacture 1 million coats for the same return.

A miniature golf course has a maximum capacity of 60 people. Demand increases on evenings and weekends, decreases during the day and in periods of inclement weather. The golf course offers discounts for low-demand periods and regular pricing for high-demand periods.

A mobile app is sold to users as a month-to-month service, with supply costs virtually unchanged no matter how many are sold. Worldwide demand for the app is 2 million users, with 99% of the demand falling below $4.99 per month. At that price point and below, users are more likely to look at ratings and reviews than base their purchasing decision on cost. Developers charging above $4.99, however, must share the remaining 1% of the market.

Commodities and the Effect of Supply and Demand

A commodity is a good sold into a market that is so competitive that individual buyers and sellers have no influence on the price. Examples include soybeans, wheat, oil and gold. Price changes are triggered by economic factors (e.g., changes in interest rates), weather, government policies and speculation (futures).

When demand declines, supplies typically decline as well because companies reallocate resources, such as capital, labor and land, to more profitable uses. When demand increases, supplies also increase as existing businesses ramp up production and new businesses form to take advantage of a booming market.

Importance of Supply and Demand in Economics

Since supply and demand are interdependent, they are equally important. When consumers want a product (demand) they eventually exhaust the product or service on the market (supply).

Producers make more when consumers want to buy more. If producers cannot or do not make enough to meet demand, prices will be high because the good or service is relatively scarce. If producers increase the availability of goods or services, prices can fall when the demand is met.

Manipulating the Laws of Supply and Demand

Savvy business owners know how to make business supply and demand work to their advantage. Consider the following supply and demand examples and strategies:

Positioning yourself as a rare commodity: De Beers has vaults full of diamonds, but by limiting supply, they are able to keep prices high. Diamonds are a status symbol for which consumers are willing to pay. Advertise an item as "limited number available" or "while supplies last" to appeal to the buyers who want to be among the few to obtain hard-to-get items.

Gaining control over supply: At one time, the idea of buying shoes online seemed like a very poor one. Who would buy shoes without trying them on? Zappos is now a multi-billion dollar business because it offers consumers products and services they cannot get elsewhere, including a huge inventory, outstanding customer service and a liberal return policy. Think about how you can set yourself apart from the competition to make yourself the supplier of choice for consumers.

Manufacturing demand: Apple always announces the release of a new gadget well ahead of the actual release date. Prototypes invariably get left in a restaurant or bar and make their way into the hands of a reporter. Information is leaked. Build anticipation for a product or service in any number of ways: "teasers" on social media, pre-orders, special events, signage (such as "Coming Soon!") and video demonstrations on YouTube.