Law of demand and supply: an easy introduction
More often than we like it to happen, we ask ourselves “Why does it cost so much?” or “How is it possible that the price has increased so much?”
Well, if you want to look smart and, in most cases, be right, the answer is “it depends on the law of demand and supply!”
In order not only to look smart, but TO BE smart, we need to answer the following questions:
- What does it mean?
- What is the demand?
- What is the supply?
- What is this law?
Definition
Demand:
how many people are willing to pay for that product or service
Supply:
the amount of a product or service available
Brutally, the law of demand and supply says that the demand for a product and supply of a product are linked.
One of the consequences is that if the demand for a product is high, but the supply is low, the price is high. This is due to more people wanting the same product than the number of units available, and willing to pay more to get it, even more than the “fair” price. This can be intuitively understood by considering the following situation.
A simple example: high demand, low supply
Let’s consider a product A, for which only 1000 pieces are produced and brought to the market. On the contrary, the product has been well advertised and there are 100.000 people that want it.
What would be its price? How the company that produced the product can maximize its earnings?
The management of the company decides to run a survey to understand how to set the prize. They ask 100.000 people if they would buy the product at a certain prize and include 15 options. In the following there is first the prize and after the number of people willing to pay for it at that prize.
- 50 euros, 95970 people.
- 75 euros, 94634 people.
- 100 euros, 91930 people.
- 125 euros, 88751 people.
- 150 euros, 80740 people.
- 175 euros, 72901 people.
- 200 euros, 44103 people.
- 225 euros, 31949 people.
- 250 euros, 25948 people.
- 275 euros, 18442 people.
- 300 euros, 11485 people.
- 325 euros, 6784 people.
- 350 euros, 2801 people.
- 375 euros, 896 people.
- 400 euros, 378 people.
The previous list shows that at 50 euros almost 100% of customers would buy the product, all the products will be sold, the potential revenues would be 1000*50=50.000 euros, a good amount but the company knows that it can push more the price to increase the revenue since there will be still a great number of people willing to pay for the product a higher price.
At 75 euros all the units would be sold, the revenues would be 1000*75=75.000 euros, a better value but there are more people that want the product, and we know that they are willing to spend more, so the price can still be pushed.
Consider the 350 euros price. All the units would still be sold, with the revenue of 1000*350=350.000 euros, a far better amount compared to 75 euros price. Still, there are other people wanting the product, let’s try to push a little more the price.
At 375 euros only 896 units would be sold, generating revenue of 896*375=336.000 euros, a lower amount than the 350 euros situation. This is due mainly to the fact that, at this price, we are not able to extract value from the sold units that compensates for the lost money of the unsold units.
This survey suggest that the optimal price can be something between 350 and 375.
A simple example: low demand, high supply
Another consequence of the law of demand and supply is that if the demand of a product is low and the supply is high, the price is low. This is due to a lower number of people wanting the product than the number of units available and leads the company to reduce the price to make it more appealing and increasing the number of people buying it. This can be intuitively understood by considering a situation similar to the one before, but with few changes.
Let’s consider a product B, for which 100.000 pieces are produced and brought to the market. On the contrary, because of various causes (bad advertising, similar product into the market, high inflation etc) it seems the number of units sold would be lower than 100.000. What would be its price? How the company that produced the product can maximize its earnings?
The management of the company runs a similar survey than the one before, asking 100.000 people if they would buy the product at a certain price and include 15 options. In the following there is first the prize and after the number of people willing to pay for it at that prize.
- 400 euros, 1050 people.
- 375 euros, 1408 people.
- 350 euros, 2301 people.
- 325 euros, 4110 people.
- 300 euros, 5900 people.
- 275 euros, 13042 people.
- 250 euros, 18084 people.
- 225 euros, 22581 people.
- 200 euros, 31039 people.
- 175 euros, 50310 people.
- 150 euros, 62097 people.
- 125 euros, 75042 people.
- 100 euros, 87414 people.
- 75 euros, 94062 people.
- 50 euros, 110415 people.
The previous list shows that at 400 euros only 1050 people are willing to buy the product, generating a revenue of 1050*400=420.000 euros. However, most of the produced units (99%) remains unsold, do not generate revenues but account for inventory and maintaining cost. The company should lower the prices to try to sell more.
At 375 more people are willing to buy the product, generating revenue of 1408*375=528.000 euros, a better situation but still most of the produced units remains unsold.
At 350 the revenues are 350*2301=805.350 euros, better than before but customers are not responding as well as hoped to the new price, it should be lowered more.
At 175 there are 50310 people willing to buy the product, the strategy is working and generates revenues of 8.804.250, which compared to the revenue related to 400 euros price (420.000) is amazing (21 times more!!).
At 75 there are 94062 customers, generating revenue of 7.054.650, which is actually lower than the situation at 175 euros price.
At 50 we sold all the units, generating revenues of 5.000.000 euros. In this case, even if we sell all the units, it seems it is not convenient choosing the price to sell it all.
In this simple case the optimum price is not in correspondence with the one where all the units would be sold, but it will be higher (if the main goal of the company is to maximize the revenues).
However, the choice of the price depends on the company’s strategy, which can choose a lower value in the following scenarios:
- It can be a launch campaign, so the company is aiming at having the biggest market penetration.
- It can be a sale aiming to sell all the units remained in the inventory.
- Simply the company wants to kill the market and tackle the competition aggressively.
Conclusion
The law of demand and supply is at the base of most of the price changes we see and is one of the main factor in the world economy.
There are many real life examples to better understand its implications, but the main takeaways are:
If many wants a limited product, the price demanded for it will be high
If a low number of customers are willing to buy a product with no problem of quantities, the price will be low.
Having this clear in mind, you will be able to understand and explain most of what happens in the world!
