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Supply And Demand & Calculating Your Price

Author: 
Daniel Rizk
Last Updated: 
September 22, 2021

Supply And Demand A Business Owners Guide

In the article, we break down the fundamentals of supply and demand and how to use this knowledge in your business.

Having a good understanding of supply and demand can assist in developing a price point for your products or services.

Supply and demand is a concept in economics that explains price fluctuations and trade. It is the idea that the number of goods offered for sale will affect the price of those goods.

Are you starting a business? Check out our step by step: How to set up a business.

What Is Supply And Demand?

Supply and demand are the two primary market forces that drive price within a marketplace.

The relationship between:

  • The amount of a product that producers want to sell
  • The quantity that customers want to purchase

This is known as supply and demand in economics.

The combination of supply and demand in a market determines the price of a product or service.

The resultant price is known as the equilibrium price, and it symbolises a deal between the good's producers and customers.

If the number of items provided by producers equals the quantity requested by consumers, we have what is known as a "balanced market".

Price Influences On Supply And Demand

The volume of a product desired is affected by its price, as well as other factors such as the pricing of other commodities, consumer income and preferences, and seasonal effects.

This is tested in what is known as fundamental economic research, firstly all factors except the product's price are typically held constant.

The study then examines the relationship between multiple price levels and the maximum quantity that may be purchased by customers at each of those prices.

A demand curve, which has a vertical axis for price and a horizontal axis for quantity, may be used to show the price-quantity combinations (see graph below).

Simply put:

Customers typically want to purchase more of a product the lower the price of the product is set.

It's also important to consider this from the producer's financial standpoint.

A business may be less motivated to produce products or services at a lower price point even with the increased market appetite.

And inversely that same business will be much more motivated to produce more products or services at a higher price point due to the increase in profit margin per product.

Those price-quantity combinations may be displayed on a supply curve, which has the vertical axis representing price and the horizontal axis representing quantity (see graph below).

Supply and demand curve graph
A supply and demand curve graph.

Other Influences

The amount of a commodity provided in the market (the supply) is determined by its price and several other factors, including:

  • The pricing of alternative items
  • Manufacturing technology
  • The availability and cost of labour
  • Other production factors such as raw materials

Non-price variables would cause the supply curve to vary, but changes in the commodity's price may be tracked along a stable supply curve. 

What Is Equilibrium?

A product is in equilibrium quantity when there is no shortage or surplus on the market.

When supply and demand collide, the quantity of an item that buyers want to buy is equal to the quantity that producers are willing to make.

To put it another way – it's when the market has reached a condition of perfect equilibrium, with prices stabilising at levels that are acceptable to all stakeholders involved.

Let's look at an example.

Herbs are sold by Company XYZ and during the winter, there is a lot of demand and an equal amount of supply. As a result, the markets are in a state of equilibrium.

After the winter season, supply will begin to decline, while demand may stay stable. To take advantage of and manage demand, Company XYZ will raise prices.

Once prices are high, demand will gradually decline, putting the markets back into balance.

Increase In Price (1)
This graph shows that when the price increases from $100 to $200, demand for the product decreases from 10 units to 5.

Supply And Demand Laws That Affect Equilibrium

As discussed earlier the unit price for a specific item will fluctuate until it reaches a price where the quantity requested by consumers equals the quantity provided by producers.

This results in price and quantity economic equilibrium. to expand in this there are some basic economic laws that can affect the equilibrium price.

The basic supply and demand laws are:

  • If demand rises while supply stays unchanged, the equilibrium price and quantity rise as well.
  • Demand falls while supply remains constant, resulting in a lower equilibrium price.
  • If supply rises while demand stays constant, the equilibrium price falls.
  • If supply falls but demand stays constant, the equilibrium price rises.

The customer is assumed to be a rational decision-maker and therefore, if a product's price rises and the buyer is aware of all relevant facts, demand for that product will fall.

Contrastingly, demand would grow if prices dropped.

Example: supply influencing market prices

Example One: Grain harvests are plentiful throughout the year, and there is more grain on the market than most people would buy.

To get clear of the surplus supply of maise, farmers must lower the price of the grain, which lowers everyone's price.

Example Two: There are a limited number of apples available due to the drought. There is a greater demand for apples than there are apples available. Apples get more and more costly.

Example: Demand influencing market prices

Example One: A popular item falls out of favour and is no longer deemed trendy. As a result, demand for the item plummets since it is no longer a must-have item for the season.

Example Two: A new restaurant in town, for example, has opened to excellent reviews. Even though the restaurant only has 10 tables, everyone wants to make a reservation.

Increase in demand
This graph illustrates that when demand increases (represented by demand 2) price will also rise to maintain equilibrium.

How Can This Help My Business?

Understanding supply and demand is a very valuable tool to any business owner regardless of industry. One of the main uses of this knowledge is to be able to set a price for your products or services.

Let's use another example:

Let's say that you're a petrol supplier and you want to sell your petrol at high prices. You'll be facing a market that wants to buy their petrol as cheap as possible.

If you try and sell your petrol at, for instance, $2.10 per litre, it probably wouldn't sell very well. 

But if you lower the price to $1.00 the litre, you'll get many happy customers. The problem then is: you're not satisfied because you haven't seen a profit.

The key to resolving this dilemma, as alluded to above, is finding the sweet spot: that market equilibrium.

You can also use supply and demand to determine if your pricing is relevant to the market in which you operate.

If you have launched a new product into the market that already has thriving competition.

Through your marketing efforts manage to gain lot's of exposure to potential customers, yet no one buys your product, this could indicate your price is too high and needs to be reduced.

Other Important Questions

Do supply and demand laws apply to all industries?
Answer: No, there are certain industries in which price is regulated by a third party.
Should I use supply and demand theory in a new business?
Answer: Yes, however, it is recommended that you test multiple price points to a large number of consumers in an effective market analysis.
What are ceiling & floor prices? 
Answer: This is when there is a mandated maximum and minimum price for a product or service.
How often should I revise my pricing?
Answer: Best practice is to be continually monitoring your market, customers, and financial goals and adjust in regular intervals that make sense to your industry.

Final Words

Now that you have an understanding of supply and demand and the basic principles, you can apply the knowledge to your business and hopefully, this will assist with your pricing strategy.

Important note: If you are just starting out as a sole trader or small to medium enterprise it's very important that you understand your pricing may be influenced by the fact you are new to the market.

In these cases the more customer feedback and research you can do, the better your understanding will be and the more accurate your market penetration strategy will become.

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