Study tips: Understanding supply and demand

Have you ever wondered why you pay the price for things that you do?  Why a bottle of shampoo costs £5 one day but £5.50 the following week? And what about when things are on offer?  Why is a mobile phone that has been retailing for £300 now available at half the price?

In broad terms, the answer is micro-economics.

Understanding micro-economics

Micro-economics is the branch of economics that considers the behaviour of decision-makers in the economy, such as individuals, households and businesses. Specifically, the answer relates to a key concept that operates in the micro-economic environment called supply and demand, which explains interactions between suppliers and consumers* in a market.  A market is where sellers and buyers exchange products and services in economic transactions.

Supply and demand is important as it impacts organisations’ output, products and services, and selling prices.  Prices have to cover the cost of raw materials and production or of delivering a service.  Plus, organisations need to make a profit. However, this is only part of the pricing picture.  The reality is that prices are influenced by the market because they have to be set at an amount consumers are prepared to pay.

Supply and demand in practice

A couple of months ago I started looking for a new mobile phone.  It is a very competitive market with lots of sellers and a huge variety of products, which means there are plenty of choices.  However, I didn’t want to pay an extortionate amount and was looking for a handset which I could buy outright, with some specific functionality.

I found the ideal phone, but it was either out of stock or more expensive than normal.  It appeared that I wasn’t the only customer who wanted one and that the demand for it was high, hence the increased price.  I decided not to bother and wait.

I looked again a few weeks later, hoping the price had reduced because I’d seen that a new version of the model I wanted was about to be launched.  High demand for the latest version should result in less demand for mine.  I also knew it was likely that sellers would want to sell off excess stocks of old handsets.

Impact on pricing

Sellers continually adjust their pricing to remain competitive because of supply and demand.  When there is abundant supply but low demand, sellers have to lower prices to generate sales. 

However, if there are shortages in supply at a time of high demand, sellers will be able to put prices up.  When prices get too high, consumers will stop buying, demand will fall, and sellers will have to drop prices to try and tempt buyers back into the market.

The profit motive

When demand is high, sellers can make more profit.  A fundamental goal of most organisations is to generate profit so that pricing decisions will be underpinned by ‘the profit motive’.  This is an economic term which refers to a business’s drive to do things that result in financial gain.  Mobile phone companies often run high-profile marketing campaigns well in advance of releasing new products in order to build demand.  Some products may be limited, either in terms of their quantity or the time for which they are available, in an attempt to make them exclusive and, therefore, capable of selling for a higher price.  However, as technology advances rapidly, products like mobile phones become obsolete quickly, and as demand and prices fall, so do profits.

Impact on production levels

Supply and demand not only has an impact on pricing, but they affect production as well.  The manufacturer of the handset that I wanted, probably reduced or stopped making the old version as it started manufacturing the new one.  The company will have had to carefully anticipate the market’s reaction to its launch.  If its marketing successfully generates high demand it will be able to increase both production and prices.  However, if the new handset receives poor reviews after its launch, maybe consumers think the old version was better, the pricing and production of both mobiles will need to be adjusted.

Increases in income generally lead to increases in demand

Most people think of a mobile phone as a necessity these days, just as we do food, utilities and housing costs.  However, they can also be seen as a luxury depending on the brand, version or functionality.   Demand for necessity goods is not as sensitive to price increases as demand for luxury goods is.  If the price of food goes up, we still have to eat, so demand will not fall but we might buy less or swap to cheaper alternatives.  However, the demand for necessities does fluctuate in line with income.  Generally, as our income increases, we buy more.  Plus, as it goes up, we spend a larger proportion of it on luxury goods, such as a high spec mobile phone rather than a basic model.

So if there is an increase in a household’s income it is likely to result in increased demand, which will lead to price rises and encourage businesses to increase supply (the opposite will happen if income decreases).  I’m still looking for a new phone by the way and keeping my eye out for a good deal.

*  A consumer is similar to a customer however, there is a difference.  A customer always purchases a product or service, but might not be the end user. A consumer is always the end user of a product or service, but might not have purchased it.  So for example, if I buy shampoo for my daughter I am the customer and she is the consumer.  If I buy it for myself, I am both the customer and the consumer.

• Study tips: Understanding supply and demand curves (advanced level)

Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.