Supply & Demand Don’t Affect Price The Way Most People Think They Do
By David Grace (www.DavidGraceAuthor.com)
Supply Surplus
The quantity of a product available for sale can become materially greater than the amount of the product that people wish to purchase at the current price if either the supply of the product materially increases or the demand for product materially decreases.
For the sake of simplicity let’s call either an increase in supply or a decrease in demand a “supply surplus.”
The lower the industry-wide ratio of orders & sales/production capacity & inventory the greater the supply surplus.
Supply Shortage
The quantity of a product available for sale can become materially less than the amount of the product that customers wish to purchase at the current price if either the supply of the product materially diminishes or the demand for product materially increases.
For the sake of simplicity let’s call a either reduction in supply or an increase in demand a “supply shortage.”
The higher the industry-wide ratio of orders & sales/production capacity & inventory the greater the supply shortage.
Changes In Supply & Demand Effect On Price Depends On the Product, The Seller And The Buyer
Most people have a simplistic, and wrong, idea that when supply goes up there is always a proportionate decrease in price and an increase in demand, and when supply goes down that there is always a proportionate increase in price and a decrease in demand.
That’s usually not true.
Simple-minded formulas appeal to simple minds, but a modern economy servicing hundreds of millions of people with millions of products is not simple and those simple-minded, comic-book-level notions are usually wrong.
In the real world any change in price that may occur because of a change in supply or demand will not be proportional to the percentage increase or decrease in that supply or demand.
Changes In Supply & Demand Only Affect Price By Changing Bargaining Power
Instead, any change in price will be proportional to the change that the supply surplus or the supply shortage causes to the relative bargaining power of the sellers versus the bargaining power of the buyers.
A supply surplus or a supply shortage are only two of the many factors that make up a buyer’s and a seller’s bargaining power.
The effect of the interaction between Supply, Demand and Price varies widely from product to product and seller to seller because the bargaining power of the sellers versus that of the buyers varies widely from product to product and seller to seller.
What Is Bargaining Power?
Seller
Sellers always want to charge the highest price they can get while still making the sale.
Buyers always want to pay the lowest price they can get while still making the purchase.
A seller’s bargaining power is the measure of the seller’s power to get the buyer to pay a higher price.
The more the seller’s bargaining power exceeds the buyer’s bargaining power the higher the price the seller will be strong enough to get the buyer to pay.
Buyer
The buyer’s bargaining power is the measure of the buyer’s power to get the seller to accept a lower price.
The more the buyer’s bargaining power exceeds the seller’s bargaining power the lower the price the buyer will be strong enough to get the seller to accept.
This result of the conflict between the buyer’s bargaining power and the seller’s bargaining power, the price, is dependent on the unique facts of the transaction — how badly the buyer needs to buy, how badly the seller needs to sell, how many other buyers are competing to purchase the product, how many other sellers are competing to sell it, etc.
The result of that conflict between the seller’s desire for a higher price and the buyer’s desire for a lower price will be the actual price that is agreed to by the sellers and the buyers who actually make a deal.
Some sellers may not agree to sell at the lower price that some buyers may insist on and some buyers may not agree to buy at the higher price the seller insists on.
In those instances those sellers lose a potential sale and those buyers lose a potential purchase.
The Components Of Bargaining Power
Seller
How Badly The Seller Needs To Sell
One of the principal components of the seller’s bargaining power is how badly the seller needs to sell that product at that time. The magnitude of the seller’s need to sell is dependent on:
- 1) How Perishable The Product Is.
The more perishable the product — agricultural products, event tickets, airplane seats, certain pharmaceuticals, etc. — the more the seller will need to lower the price in order to make a sale or get nothing when the product rots or expires.
The farmers have to sell their peaches at whatever price they can get because they will soon spoil and be worth nothing.
- 2) How much the seller needs the sales revenue now
The more the seller needs the sales revenue now in order to remain in business the more the seller will be motivated to lower prices in order to get whatever sales revenue it can .
The importer or manufacturer has incurred substantial costs in purchasing or manufacturing the goods and he may need to sell them now at whatever price he can get to avoid going out of business.
- 3) Is there a supply shortage or a supply surplus?
The smaller the ratio of current orders & sales/production capacity & inventory (“Orders to Inventory”) the greater is the supply surplus and the more the seller will be motivated to lower prices in order to increase sales in order to clear excess inventory and increase sales to exploit unused production capacity.
The greater the ratio of orders to inventory the greater is the supply shortage and the less the seller will be motivated to sell at the current price because he already has more orders than he has product available.
In the chart below, the more that orders exceed inventory (supply shortage) the more negative the number in the range of 0 to -50; the more that inventory exceeds orders (supply surplus) the more positive the number in the range of 0 to 50.
The -10 below means that orders slightly exceed inventory.
NOTE: The charts in the column are only illustrative. The value ranges are merely guesses as to the magnitude of the value of each with regard to top line component. The point is to illustrate the relationship between the factors, not to claim to show a specific real-world value range in each category.
Buyer
How Badly The Buyer Needs To Buy
One of the principal components of the buyer’s bargaining power is how badly the buyer needs to buy that product at that time. The magnitude of the buyer’s need to buy is dependent on:
- 1) How Vital The Product Is To The Buyer, and
- 2) How Many Acceptable Substitute Products Are Available At The Current Price
The Other Components Of The Seller’s Bargaining Power
The sellers’ bargaining power is dependent on several components:
- 1) How badly the seller needs to sell
- — — How Perishable The Product Is
- — — How much the seller needs the sales revenue now
- — — The ratio of orders & sales per unit of time/production capacity & inventory per unit of time (ratio of “Orders to Inventory”).
- 2) How united a negotiating front the sellers can present.
The more unified the sellers are, the more power they have to hold out for a higher price. Sellers who are a cartel or a monopoly present the maximum united sellers’ front.
- 3) How cheap the product is compared to the buyer’s wealth
If the price of the product is extremely low compared to the wealth of the buyers then a material increase in the price will cause a smaller reduction in demand than if the increase in price represented a larger proportion of the buyer’s wealth.
If pencils are two cents each then the seller might be able to double the price to four cents and see only a moderate reduction in the demand for pencils because the additional amount that the consumer will spend for a box of pencils is trivial in comparison to the consumer’s wealth .
On the other hand, if the price of a new Honda Civic is $20,000 and Honda doubled it to $40,000, the magnitude of the new price compared to the wealth of most of the people who would otherwise buy a new Honda Civic would cause a huge reduction in demand.
[NOTE: The more the seller needs to sell, the less bargaining power the seller has. In order to show the seller’s bargaining power, the value for how badly the seller needs to sell must be inverted so that the less he needs to sell, the higher his bargaining power, and the more he needs to sell, the lower his bargaining power.]
The Other Components Of The Buyer’s Bargaining Power
The buyers’ bargaining power is dependent on several components:
- 1) How badly the buyer needs to buy
- — — How Vital The Product Is
- — — How Many Substitute Products There Are At The Current Price
- 2) Is there a supply shortage or a supply surplus?
The greater the ratio of orders to inventory, the greater is the supply shortage and, all other things being equal, the more the buyer will be willing to pay a higher price in order to get the product quantity he needs, but the buyer’s willingness to pay a higher price is strictly dependent on how badly the buyer needs the product.
In the chart below, the more that orders exceed inventory the more negative the number in the range of 0 to -50; the more inventory exceeds orders the more positive the number in the range of 0 to 50.
The -10 means that orders are slightly greater than inventory.
- 3) How united a negotiating front the buyers can present
A union, a buyer’s cooperative, or a single customer for the product can present the maximum united buyers’ front and thus have more ability to pressure the seller to accept a lower price in exchange for selling a larger quantity with the alternative of selling nothing at all.
How Bargaining Power Affects Price
A price agreed upon between the buyer and the seller is determined by the strength of the bargaining power of the seller compared to the strength of the bargaining power of the buyer.
Some Examples Of A Supply Surplus’ Effect On Price
A 25% supply surplus may cause:
- A huge decrease in the seller’s bargaining power and therefore on the price of perishable, relatively non-vital products with several substitutes that are being sold by a large, competitive group of sellers to a small, unified group of buyers.
For example certain fruits and vegetables or cruise tickets.
- A large decrease in the seller’s bargaining power and therefore on the price for ordinary items being sold by a relatively large group of competitive sellers to a relatively small group of buyers and whose price is high compared to the wealth of the buyers.
For example, home exercise equipment.
- A small or no decrease in the seller’s bargaining power and therefore on the price for extremely vital products with no substitutes that are being sold by a small, unified group of sellers to a large, competitive, group of buyers.
For example, life-saving generic medicines.
There are several situations where a 25% supply surplus will not cause a seller to choose to materially reduce the price:
- If the product represents only a small portion of the seller’s business the seller may instead choose to close down production rather than sell the product at an unacceptably low profit level.
- If the product is not perishable and the sellers are not under strong financial pressure to sell they may simply inventory the unsold units.
- If the low-price sellers do not have the capacity to meet the entire market demand, one or many other sellers may elect to reduce production to match the current, lower sales level and keep selling at the original higher price to those customers whose needs cannot be met from the inventory of the low-price sellers.**
**For an example of how this would work, skip ahead to the end of this column.
Some Examples Of A Supply Shortage’s Effect On Price
A 25% supply shortage may cause:
- a huge increase in the seller’s bargaining power and therefore on the price for vital items without substitutes that are being sold by a small, united group of sellers to a non-unified group of buyers,
For example, life-saving medicines.
- a large increase in the seller’s bargaining power and therefore on the price for important items without exact substitutes that are being sold by a relatively small group of sellers to a non-unified group of buyers and whose price is small compared to the wealth of the buyers ,
For example, coffee.
- a small or no increase in seller’s bargaining power and therefore on the price for extremely non-vital items with many substitutes that are being sold by a large, competitive group of sellers to a small, group of buyers.
For example, chocolate-covered cherries, decorative glass paperweights.
Summary: Supply & Demand Are Only Two Of The Components Of Bargaining Power
As we’ve seen, supply and demand are only two of the several components of the seller’s bargaining power along with how much the seller needs money, how perishable the product is, how price competitive the sellers of this product are, and how cheap the product is in relation to the buyer’s wealth.
Supply and demand are only two of the several components of the buyer’s bargaining power along with how vital the product is to the buyer, how many substitute products are available at the same or lower price, and how united or competitive the buyers are.
Variations in supply and demand will only affect price to the extent that they materially change the relative bargaining powers of the product’s buyers and sellers.
The less that a variation in supply and demand will affect the relative bargaining powers of that product’s sellers and buyers, the less it will affect the price for that product or service.
By David Grace (www.DavidGraceAuthor.com)
**An Example Of When An Increase In Supply Will Not Lower The Price
EXAMPLE — Suppose:
- Three manufacturers supply all the insulin sold in the U.S.
- Their total cost including overhead and marketing to supply a month’s supply for a diabetic is $10
- The price they charge for a month’s supply is $100
- They sell 1,250,000 month’s supplies every month
A new company, NewCo, that is able to produce 125,000 month’s supplies/month has just entered the market. In order to gain market share NewCo is pricing its insulin at $50 for a month’s supply.
Almost immediately NewCo has orders for all of the 125,000 units that it can manufacture.
If the other three manufacturers reduced their prices from $100/month to $50/month to match NewCo’s price they would each make 1,250,000–125,000 = 1,125,000/3 = 375,000 units X $40 profit = $15,000,000 profit/month.
Or, they could continue to sell 1,250,000–125,000=1,125,000/3 = 375,000 units/month for $90 profit each and make $33,750,000 profit/month.
The management of the original three companies would have to be incredibly stupid to lower their prices to match NewCo’s price.
NewCo Increases it capacity from 10% to almost 30% of market volume.
Suppose NewCo spent a few billion dollars to expand its capacity to 350,000 units/month.
If NewCo upped its sales to 350,000 units/month it would be making 350,000 X $40 =$14,000,000 profit/month.
Each of the other three would be selling 1,250,000–350,000 = 900,000/3=300,000 units/month X $90 = $27,000,000/month.
If they dropped their price to match NewCo’s price and if each of the four companies each ended up with 25% of the market then each of the original three would be making 1,250,000/4 = 312,500 units/month X $40 profit/unit = $12,500,000 profit/month.
The original three would have to be morons to drop their price to compete with NewCo because that price drop would reduce their profits from $27 million/month to only $12.5 million/month.
An increase in supply by 10% or even almost 30% would not cause any intelligent seller to reduce their price.
In fact, NewCo would need to have the capacity to sell a bit over 825,000 units/month, about 66% of the total market consumption, in order for the existing sellers to make about as much money by lowering their price and taking 25% of the market at $40 profit/unit as each keeping only about 11% of the market each and earning $90 profit/unit.
1,250,000–825,000 = 425,000/3 = 141,667 X $ 90 profit = 12,750,000 profit vs 312,500 X $40 profit = $12,500,000 profit.
Because the executives running NewCo and the three existing firms are not idiots, what would actually happen is that after NewCo got its ten percent of the market it would raise its price to someplace around $96/unit, thus guaranteeing that it would keep its existing customers while increasing its profits from $40/unit to $86/unit or from 125,000 X $40 = $5 million profit/month to 125,000 X $86 = $10,750,000 profit/month.
In short, in the real world even a 65% increase in the supply of a vital product could result in no reduction in the price charged by existing sellers because those sellers would make more money by dividing up the remaining 35% of the market at the current high price than they would make by dividing up 100% of the market at the new lower price.
