Supply and demand – how they control the market

A free market economy is influenced by supply and demand more than virtually any other factor. If supply exceeds demand, prices fall. In the worst case, companies then find it difficult to sell their goods and services profitably. Conversely, if supply is too low, prices rise and consumers can no longer afford the products they want. In both cases, the market normally regulates itself. The exact relationship can be clearly seen by constructing a supply and demand graph.

What is supply and demand? Definition and explanation

“Supply” is the economic term for all goods and services available on the free market, which trading partners can acquire in exchange for money, physical goods or other services. We often think first of consumer goods (such as those typically found displayed in stores), but the term is used in a much broader sense and also covers labor, transportation of goods, currencies, raw materials, etc.

Definition

Supply is the total amount of goods and services available on the free market. Demand, on the other hand, is the total amount of available goods and services that is necessary to cover the actual requirement on the free market.

“Demand” is the complementary concept to supply. If refers to the actual requirement for particular goods or services among potential trading partners such as companies and households.

Before starting to develop a product, you should identify the basic requirement for it, as this ultimately determines the demand. The idea that a requirement can be artificially created by marketing is a fallacy. If there is no requirement, your supply will not earn you any profit. If is important to differentiate between a basic requirement for something and a preference for a specific product.

Tip

Example: Drinking is a basic requirement. A specific expression of this requirement (“I'd like some tasty XYZ brand soda”) is a preference. Only if a basic requirement already exists can you can use the tools in the marketing mix to influence consumers’ actual preferences.

Interaction of supply and demand

There is a direct relationship between supply and demand, as supply usually rises when demand is high. Initially there is what is known as excess demand when the currently available supply is unable to fully meet requirements. This leads to a rise in the market price, which in turn causes more companies to offer the relevant good because they can earn a lot of money by doing so (at least at that point in time).

As a consequence of this, the effect is frequently reversed, as the more expensive a product or service is, the less demand there is for it, as potential buyers look around for cheaper alternatives. This results in excess supply. The market price falls until the relevant good is sufficiently affordable that buyers’ interest – and thus demand – rises again.

The relationship between supply and demand is illustrated by the graph below:

At the point where the supply curve and the demand curve intersect, the relationship between supply and demand is perfectly balanced. Exactly as much is produced as is required, and both the market price and production quantity remain stable. This is known as market equilibrium, although it is merely a theoretical figure. In reality, there is always alternating excess demand and supply. This phenomenon is often described with the phrase “the market regulates itself.”

Importance of supply and demand in everyday business

Supply and demand are hugely important to companies’ future planning. Regardless of whether they want to offer new products or services, or whether they are putting together the business plan for a new company – the current needs of the market (demand) and the actual situation (supply) determine their success or failure.

Tip

The business plan for setting up a new company should always be based on a thorough market analysis. Accurately estimating supply and demand is the basis for a promising business idea.

There are various methods of analysing the two variables for a particular product. Market research studies, customer surveys and economic analysis of price trends and production figures have all proven effective.

Tip

Developing a minimum viable product (MVP) means designing the relevant product in such a way that it is precisely tailored to the needs of the target group. Demand is identified in parallel to (ongoing) development through communication with users.

The MVP has proven to be particularly effective for start-ups and technology companies who prefer to work with their potential customers rather than conducting laborious analyses. The MVP is a product that is developed just enough to function properly (so it should satisfy the anticipated requirements, but not yet be designed to exceed expectations). Once it is available on the market, it becomes clear whether it has been accepted by the target group. Customers can then review it and provide suggestions for improvements and other preferences, which can be used to perfect the product and tailor it to the demand as much as possible.

Please note the legal disclaimer relating to this article.


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