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 inter-twined economic concepts; indeed, the law of supply and demand is often cited as among the most fundamental in all of economics.
"When we speak about demand," wrote Robert Heilbroner and Lester Thurow in Economics Explained, "most people think the word just means a certain volume of spending, as when we say that the demand for automobiles has fallen off or the demand for gold is high. But that is not what the economist has in mind when he defines demand as part of his explanation of markets. 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 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 Heilbroner and Thurow. "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."
Robert Pindyck and Daniel Rubinfeld observed in their book Microeconomics that "the demand for a good depends on its price, 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…. Often, however, we want to know how much supply or demand will rise or fall." This measurement of a product or service's responsiveness to market changes is known as elasticity. Todd G. Buchholz, writing in his book From Here to Economy: A Shortcut to Economic Literacy, used an example from the world of sports business to provide an example of economic elasticity: "Will football fans buy the same number of tickets if the team jacks up the prices? If they do, then demand is inelastic. If higher prices lead the fans to cut back their attendance, then demand is elastic, or sensitive to change."
The quality and degree of marketplace reaction to price changes depends 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.
Buchholz, Todd G. From Here to Economy: A Shortcut to Economic Literacy. Dutton, 1995.
Heilbroner, Robert, and Lester Thurow. Economics Explained: Everything You Need to Know About How the Economy Works and Where It's Going. Revised ed. Touchstone, 1994.
Langabeer II, Jim R. "Aligning Demand Management with Business Strategy." Supply Chain Management Review. May 2000.
Pindyck, Robert S., and Daniel L. Rubinfeld. Microeconomics. 2d ed. Macmillan, 1992.