Why are supply & demand important to a business?

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Why are supply & demand important to a business?
The theory of supply and demand is important to businesses of all sizes. (Hemera Technologies/AbleStock.com/Getty Images)

Supply and demand is an economic theory that looks at the relationship between the availability of and corresponding demand for a product within a given market. An understanding of the principle is important for businesses of all types and sizes as it can be used to help determine both the price that a product can be sold for under current market conditions and the amount of production that is required.

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The theory of supply and demand

Supply and demand are two of the main forces that can affect the price of a product in a particular market. Other factors such as government policies and regulations, the presence of monopolies and modern marketing techniques can also have an effect. Supply refers to the quantity of a product released into the market and demand refers to the market's appetite for and capacity to consume that product.

Effect on prices

In a competitive market that is unaffected by factors such as government regulations, the relationship between supply and demand has a direct effect on the price of a product. If supply outstrips demand, prices will tend to fall as there will be a surplus of the product available. Falling prices will usually increase demand to a certain extent. If demand outstrips supply, prices will tend to rise as there will be more people competing to buy existing stocks of the product. When supply matches demand, prices will tend to settle at what is known as an equilibrium point.

Effect on production

If supply outstrips demand, suppliers will usually reduce production until supply and demand are more closely matched. If demand outstrips supply, they will usually increase production to match. There are sometimes other factors to take into account. It may, for example, be more cost effective to create a product in bulk and sell it at cheaper prices than reducing production in order to maintain the current price. Where demand outstrips supply, some businesses may use the scarcity value of the product for marketing purposes or to maintain high prices.

Elasticity and seasonal changes

Elasticity refers to the sensitivity of demand to a change in price. Luxury goods that people can easily do without tend to be more elastic, meaning a small change in price can have a disproportionately high effect on sales. Other goods, such as basic foodstuffs, cigarettes and fuel are price inelastic. People will usually continue to buy these goods in similar amounts even if the price changes. Supply and demand can also vary seasonally. Most barbecues, for example, are sold in the summer. An extended period of exceptionally sunny weather in the autumn could cause a spike in demand that temporarily outstrips supply.

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