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Supply and demand: Why do you care?

supply-demand-economics

Every time you shop, you encounter the laws of supply and demand.

Supply and demand forces are what cause you to pay reasonable prices. What’s more, they cause retailers to get reasonable returns, and they make it so there are enough products for the number of buyers who want them.

But they don’t always work perfectly. If you’ve ever found something out of stock, you’ve likely been a victim of what’s called market disequilibrium. Perhaps the price was too low, causing products to fly off the shelves. (That’s why grocery stores limit you to three slabs of butter at $2.99, reg. $5.99.) Or, the store misread demand and supplied too little product.

On the other hand, when bakeries and sushi shops mark down their wares at the end of the day, it’s because they’re hoping to sell the food before it goes bad. They misjudged the demand and made too much.

Understanding the reasons behind these everyday occurrences can help you become a better shopper – and a better investor. After all, stock and bond prices are, at their most basic, set by supply and demand.

Let’s dive in.


Read the transcript for Advisor.ca explains supply and demand

 

What is supply?

Supply is how much of a good or service producers are willing to provide to the market at a given price. Economists usually express supply this way:

What is supply?

You can see that the lower the price, the lower the quantity supplied.

The blue line is called the supply curve.

Other factors that affect supply include:

  • Cost of production (e.g., wages and utilities).
  • Efficiency of production (e.g., thanks to better technology).
  • Price of inputs (e.g., for shoes, the cost of leather).
  • Number of producers (the more producers, the more supply).
  • Taxes, subsidies and regulation.
  • Weather (e.g., great weather could mean a bumper crop).
  • Expectations of future prices (e.g., if suppliers think they’ll get a better price in the future, they’ll hold off producing until later).

When any of these other factors affect supply, economists illustrate that by shifting the supply curve. When supply conditions improve, the curve moves to the right: so for the same price as before, suppliers are willing to produce a higher quantity. When supply conditions deteriorate, the curve moves to the left: so for the same price as before, suppliers are only willing to produce a lower quantity.

Supply curve

What is demand?

Demand is how much of a good or service buyers are willing to purchase on the market at a given price. Economists usually express demand this way:

What is demand?

You can see that the lower the price, the higher the quantity demanded.

The orange line is called the demand curve.

Other factors that affect demand include:

  • Income of buyers (the higher a buyer’s income, the more products she tends to demand).
  • Population of buyers (e.g., demand for lottery tickets would theoretically increase if a lot of people turned 18 one year).
  • Consumer tastes and preferences (e.g., one season skinny jeans are in; next year, it’s wide-leg pants).
  • Prices of related goods.
    • Complementary goods are purchased along with the good in question; so, salad and dressing. If the price of salad increases, demand for dressing could fall.
    • Substitute goods are purchased instead of the good in question; so, butter and margarine. If the price of butter skyrockets, demand for margarine could rise.
  • Expectations of future prices (e.g., if a customer expects gas to be cheaper tomorrow, she won’t fill up today).

When any of these other factors affect demand, economists illustrate that by shifting the demand curve. When demand conditions improve, the curve moves to the right: so for the same price as before, the quantity demanded increases. When demand conditions deteriorate, the curve moves to the left: so for the same price as before, the quantity demanded decreases.

Demand curve

How is price determined?

The optimal, or equilibrium, price is the price at which both buyers and sellers are happy.

Determining price

If the price is too high, supply will be higher than demand. Suppliers think, “We can make money!” and produce a lot; buyers think, “That’s too expensive” and don’t buy. There will be market disequilibrium.

If the price is too low, demand will be higher than supply. Suppliers think, “I can’t make money at that price!” and produce less; buyers think, “Sweet! A great deal,” and want to buy more than what’s been supplied. Again, there will be market disequilibrium.

This all sounds pretty theoretical. Can you give me real-life examples?

Here are two.

1. A supply curve shift, as illustrated by limes

Mexican food lovers keenly felt the Great Lime Shortage of 2014, which was due to a combination of poor growing weather, crop infestations and heavy “taxes” imposed on farmers by a local drug cartel.

Those factors shifted the supply curve to the left. For the same price, a producer wasn’t able to produce as many limes. Indeed, a B.C. restaurateur told CBC.ca that a case of limes had gone from $40 to $200 over a few months.

2. A demand curve shift, as illustrated by Toronto Maple Leafs tickets

The Toronto Maple Leafs’ 2014/2015 season wasn’t anything to be proud of, and fans signaled their displeasure by staying away from games. In March 2015, the Leafs recorded their lowest home-game attendance in 16 years.

The poor performance shifted the demand curve to the left: for the same price, buyers just weren’t interested. As demand fell, unofficial ticket prices did as well. Sportsnet.ca reports people were reselling tickets below face value, once unheard of for the hottest seat in town.

Cool. So what does this have to do with buying stocks?

Stock prices are based on a combination of supply and demand factors, but they’re primarily demand-driven. The main reason stock supply increases (or decreases) is when a company issues more shares (or buys shares back).

Demand for a stock might increase (or decrease) if:

  • a company has a good (or bad) quarter;
  • economic conditions have improved (or deteriorated);
  • the company hires a better (or worse) CEO or management team; or
  • competitors’ stocks/companies are doing comparatively worse (or better).

Generally, when demand increases, prices rise; when demand decreases, prices fall.

These principles apply, broadly speaking, to mutual fund units, bond prices, real estate, commodities and other traded securities.

Exceptions to the rule

Veblen goods

Imagine two bottles of wine: one priced at $9.95, the other at $25. Which do you think is higher quality – and which would you be more likely to buy? If you picked the $25 bottle, congratulations: you’ve just violated the laws of supply and demand.

This isn’t a new phenomenon. Back in the 1800s, economist Thorstein Veblen noticed that for certain luxury goods — jewelry, art, wine — raising the price actually increased demand, as the higher cost meant the good was seen as a status symbol.

Rather than rewrite the laws of economics, we now call goods that fall under this dynamic Veblen goods.

Giffen goods

Giffen goods, named after economist Sir Robert Giffen, also see higher demand when prices rice. But this time, the reason isn’t luxury – it’s poverty.

Imagine a country where rice is a staple, and the price rises quickly. The cost of buying rice becomes so high it takes over the family’s food budget. Now, they can no longer afford meat or vegetables; they can only afford rice, and they eat more of it.

In this case, rice is a Giffen good.

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