Supply and Demand
What is Supply and Demand?
The law of supply and demand is the economic theory which explains the relationship between the production (supply) and the buyer’s need (demand) for an item.
Supply and demand exist across pretty much everything you can get your hands on. From natural resources such as energy and metals to manufactured goods like semi-conductors chips and clothing.
The theory is simple. If there’s more demand for particular goods or services than there is supply, prices go up – known as demand-pull inflation. The opposite is true when supply outweighs demand.
To help visualise the theory, imagine a set of old-fashioned weighing scales at an equal balance. This is called the market equilibrium price – where the quantity of goods people are willing to supply are equal to the quantity of goods people demand. However, a small change in either supply or demand could throw the weighing scales out of kilter.
Understanding Supply and Demand
The law of supply and demand is a combination of the law of demand and the law of supply.
The law of demand states that demand has a negative relationship with the price for goods and services (all else being equal).
When prices rise, things become more expensive and buyers are less willing to spend. This causes demand to shift. On the other hand, if prices were to fall, people are happy to buy at a lower price which in turn boosts demand.
The relationship between demand and prices can vary across different goods and services. People are more likely to cough up for everyday essentials, such as food and water, but are less likely to fork out for non-essentials like holidays or a new car.
If an increase in price has no effect on lowering demand, it’s known to be perfectly inelastic. On the flip side, perfectly elastic means that demand is infinite at a certain price. However, if a firm increased its price by 1%, all of the demand would disappear.
The law of supply suggests that as prices for goods and services rise, so does supply.
The logic is that sellers are happy to go above and beyond to ramp up production as there’s an opportunity to make more profit per unit sold. For companies, increasing sales at a higher price means higher profits (assuming all other factors remain the same).
The relationship is the same should prices for goods and services fall. Supply will be lower as companies are disincentivised to produce more goods and services as they’re now making less profit per unit sold.
What is an example of supply and demand?
Flights are a classic example.
As demand for holidays rise and the seats for each flight start to get booked up, the remaining seats become more expensive. If the demand remains stable (even at higher prices), airlines will look to add more flights to their schedule to profit from the increased demand. Once more flights have become more readily available, prices are likely to fall as there’s now more supply to deal with the demand from holidaymakers.
It’s important to remember that other factors feed into the price for goods and services. Staying with the same example, flight prices could go up to reflect an increase in supply costs – for example higher fuel prices or staff wages.
Supply and Demand’s impact on share prices
So why do share prices go up and down? The price of a share is determined by supply and demand.
Demand for a share is the number of people who would like to buy, and supply is the number who want to sell.
This will depend on what investors think about the future prospects of the company. Are things set to improve or get worse?
If the outlook is improving, more people might want to buy the shares and the share price might increase. However if a company’s prospects are less rosy, people might look to sell shares causing the price to fall.
This is a very simplified outlook and other factors can impact supply and demand, such as the economy, corporate actions and dividends.
Remember all investments and any income they produce can fall as well as rise in value so you could get back less than you invest. If you are unsure whether an investment is right for you, you should seek advice.