Supply and demand is a fundamental factor in shaping the character of the marketplace, for it is understood as the principal determinant in establishing the cost of goods and services. The availability, or "supply," of goods or services is a key consideration in determining the price at which those goods or services can be obtained. For example, a landscaping company with little competition that operates in an area of high demand for such services will in all likelihood be able to command a higher price than will a business operating in a highly competitive environment. But availability is only one-half of the equation that determines pricing structures in the marketplace. The other half is "demand." A company may be able to produce huge quantities of a product at low cost, but if there is little or no demand for that product in the marketplace, the company will be forced to sell units at a very low price. Conversely, if the marketplace proves receptive to the product that is being sold, the company can establish a higher unit price. "Supply" and "demand," then, are closely intertwined economic concepts; indeed, the law of supply and demand is often cited as among the most fundamental in all of economics.
FACTORS IMPACTING SUPPLY AND DEMAND
When using the term "demand" most people think the word means a certain volume of spending, as when we say that the demand for cars has fallen off or the demand for paper is high. But that is not what economists mean when using the term. For economists, demand means not just how much we are spending for a given item, but how much we are spending for that item at its price, and how much we would spend if its price changed.
The demand for products and services is predicated on a number of factors. The most important of these are the tastes, customs, and preferences of the target market, the consumer's income level, the quality of the goods or services being offered, and the availability of competitors' goods or services. All of the above elements are vital in determining the price that a business can command for its products or services, whether the business in question is a hair salon, a graphic arts firm, or a cabinet manufacturer.
The supply of goods and services in the marketplace is predicated on several factors as well, including production capacity, production costs (including wages, interest charges, and raw materials costs), and the number of other businesses engaged in providing the goods or services in question. Of course, some factors that are integral in determining supply in one area may be inconsequential in another. Weather, for example, is an important factor in determining the supplies of wheat, oranges, cherries, and myriad other agricultural products. But weather rarely impacts on the operations of businesses such as bookstores or auto supply stores except under the most exceptional of circumstances.
"When we are willing and able to buy more, we say that demand rises, and everyone knows that the effect of rising demand is to lift prices," summarized Robert Heilbroner and Lester Thurow in their book Economics Explained: Everything You Need to Know About How the Economy Works and Where It's Going. "Of course the mechanism works in reverse. If incomes fall, so does demand, and so does price." They point out that supply can also dwindle as a result of other business conditions, such as a rise in production costs for the producer or changes in regulatory or tax policies. "And of course both supply and demand can change at the same time, and often do," added Heilbroner and Thurow. "The outcome can be higher or lower prices, or even unchanged prices, depending on how the new balance of market forces works out."
SUPPLY AND DEMAND ELASTICITY
The demand for goods depends on the price for those goods, as well as on consumer income and on the prices of other goods. Similarly, supply depends on price, as well as on variables that affect production cost. How much the supply and demand will rise or fall is often difficult to predict. This measurement of a product or service's responsiveness to market changes is known as elasticity. Elasticity is a measure of the responsiveness of one economic variable to another. For example, price elasticity is the relationship between a change in the supply of a good and the demand for that good. Economists are often interested in the price elasticity of demand, which measures the response of the quantity of an item purchased to a change in the item's price. A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in demand for the product or service. Products and services that are highly elastic are usually more discretionary in nature—readily available in the market and something that a consumer may not necessarily need in his or her daily life. On the other hand, an inelastic good or service is one for which changes in price result in only modest changes in demand. These goods and services tend to be necessities.
The quality and degree of marketplace reaction to price changes depend on several factors. These include: 1) the presence or absence of alternative sources for the product or service in question; 2) the time available to customers to investigate alternatives; 3) the size of the investment made by the purchaser. Elasticity, then, is an important factor for small business owners to consider when entertaining thoughts about changing the prices of the goods or services that they offer.
Hall, Robert Ernest. Microeconomics: Principles and Applications. Thomson South-Western, January 2004.
Heilbroner, Robert, and Lester Thurow. Economics Explained: Everything You Need to Know About How the Economy Works and Where It's Going. Revised Edition. Touchstone, 1998.
Langabeer II, Jim R. "Aligning Demand Management with Business Strategy." Supply Chain Management Review. May 2000.
"No Conspiracy: Law of Supply and Demand At Work." Paducah Sun. 5 May 2006.