How Does Supply and Demand Work? (With Definitions)

By Indeed Editorial Team

Published 3 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Supply and demand are important components of an economy. It determines the ability of businesses to sell goods and services in a market and subsequently influences the impact of prices on consumers. Whether you work in business, finance or marketing, knowing how supply and demand work may enable you to better understand how the market works. In this article, we explore how supply and demand work, including definitions, the various factors that affect them and the significance of their impact on an economy.

How does supply and demand work?

To understand the answer to, 'How does supply and demand work?", it's helpful to first look at what they are and how they affect the economy:

What is supply and demand?

Supply is the quantity of goods or services that are available to consumers. A company manages their inventory in a way that provides an adequate supply of goods and services to consumers. Demand refers to consumer desires and inclination to purchase goods and services. A company usually assesses the demand for their products or services and arranges their supply. Supply and demand are dependent on each other, and their inverse relationship can affect the prices of goods and services depending on the balance of either factor.

How does it work?

The law of supply and demand is an economic principle that defines the relationship between the two factors. It explains that the price of a product or service depends on their availability and consumer demand. Increasing the price of products often decreases sales, which leads to an increase in supply. Higher prices can lead consumers to search for alternatives, which lowers demand and eventually a decrease in supply because of such lower demand.

What are the factors that influence supply?

Here are some factors that may affect supply:

Manufacturing ability

A company evaluates the demand in the market and stocks their inventory accordingly. When there is more demand, they usually increase their supply to meet it. For perishable goods with a short shelf life, a company may use measures, such as using historical market data, to determine optimal production capacity, to prevent excess supply.

Cost of production

A company typically incurs manufacturing costs such as sourcing raw materials, paying for utilities such as electricity and water and payment of salaries to employees. Higher production costs often result in higher product prices in the market. If such higher prices are agreeable with consumer demand, the supply may continue to increase to meet it until it surpasses demand.

Market competition

When a variety of the same product or service is available in the market, companies can face competition. Competition in a market allows consumers to make comparisons and choose from multiple options, usually based on affordability. Competing businesses may attempt to make their products or services more affordable by reducing costs in production or changing marketing strategies to achieve an advantage in the market.

Availability of resources

Many companies rely on the availability of resources involved in the manufacturing process. This includes sourcing raw materials at a reasonable cost and having an adequately staffed team to aid in production. When raw materials are expensive or not easily available, it results in a lower product supply to the market and increased product prices.

Supply chain

A company may spend a part of their budget to create and maintain a supply chain that's efficient, helps reduce costs, increases production output and ensures the competitive pricing of their products in the market. Having an efficient supply chain enables a company to meet the demand in the market and keeps the prices of goods consistent. Disruptions in supply chains may lead to lower supply and increased prices.

Related: What Is a Supply Chain? (With FAQs and Examples)

What are the factors that affect demand?

The following factors may affect demand:

Prices of goods

When the price of goods increases, consumers may spend less and the demand for such goods decreases. Companies price their products depending on the cost of production, margins and potential gain or loss of market share. When the price of goods is high, consumers may seek more reasonably priced alternatives.

Consumer income

A consumer's income directly affects their ability to purchase goods. When there's an increase in consumer income, it leads to a rise in demand as consumers have more purchasing power. A decrease in income can lead consumers to consider purchasing less expensive goods.

Consumer preferences and expectations

A change in market trends can affect demand as consumers determine the popularity of goods. This involves a combination of societal changes in traditions, habits and customs. While popular products can sustain demand, their demand decreases when trends change. Consumers may also drive demand if they perceive a product may be in short supply or become expensive in the future by proactively purchasing more of the product.

Substitute and complementary goods

Substitute goods are products and services that a consumer buys or uses in place of another one, such as buying flight tickets from a low-cost airline. As alternative choices to popular brands, they encourage competitive prices in the market. Some products require the use of complementary goods, such as buying fuel to power an automobile or ink for a printer. The prices and demand for complementary goods share an inverse relationship. For example, when the price of printing ink decreases, the demand for printers may increase.

Market size

This comprises the consumer population, their purchasing power and the potential revenue a business can earn from the market. The market size determines the extent to which a company can sell their goods and create a demand for a product. Market size can change because of changes in demographics. For example, an automobile company that notes an increase in the number of logistics businesses serving a variety of purposes may then manufacture vehicles catering to their needs.

Diminishing marginal utility

This refers to a gradual decrease in consumer satisfaction in a product or service as they consume or use more of it. For example, you may not be interested in buying the same shoes after wearing them for a while. As the demand for a product reduces, so does the price.

Elasticity of demand

The two kinds of demands are elastic and inelastic. Elastic demands occur when the price of goods and services change by significant amounts. For example, the cost of housing can change depending on location and type, affecting demand. Inelastic demand refers to goods or services whose change in price doesn't significantly affect demand. An example of this is utilities such as electricity and water, where a change in price may not affect the demand for such necessities.

What is equilibrium in supply and demand?

When the market reaches a balance in supply and demand, it results in a state of equilibrium. This means that prices become stable as there's ample supply of goods that adequately satisfy the market's demands. Equilibrium in a market may change because of factors such as supply chain issues. For example, the disruption in the transportation of coffee beans may cause a coffee supply shortage, which results in scarcity and higher prices.

How does supply and demand affect a business?

Here are some ways in which supply and demand affect a business:

Ability to expand

An organisation's ability to expand depends on achieving a balance in supply and demand. When there's great demand for goods and services, a business can utilise the opportunity to hire more employees, expand manufacturing resources and match production output to meet demand. When demand reduces and there's higher supply, companies may reduce costs by laying off employees or closing manufacturing facilities.

Marketing and advertising

To increase the demand for their products and services, businesses use marketing and advertising campaigns using different mediums to make consumers more aware of their brand. It results in creating a desire in the consumer, driving up the demand and allows the business to create adequate supply. For example, a company marketing a mobile phone with new features not previously seen in the market may create a demand for it.

Related: A Guide to Careers in Marketing (Plus 15 Jobs to Consider)

Managing inventory

Supply and demand significantly affect a company's inventory. A company may conduct a market study to determine the optimum production capacity that satisfies both supply and demand. An imbalance, such as oversupply and low demand, can cause significant costs, while an under-supply may prompt consumers to seek alternatives for their demands.

Related: What Is Logistics Management? (Definition and Importance)

Financing and profitability

A company's profitability benefits from strong supply and demand for their goods and services. Companies are more likely to convince lenders and investors to provide funds for expansion. When there's a lack of demand for their products or services, a business may find it difficult to attract investments.

Paying salaries

When a company benefits from strong supply and demand, it generates greater revenues. When there's increased revenue, a company may pay higher salaries that could attract better talent to grow the business. Higher salaries may improve job satisfaction and provide motivation that improves productivity and employee retention.

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