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The Basics Of Supply & Demand

If you learn economics, one of the first things you’ll be taught is the law of supply and demand.

It’s like a great big X on a graph of prices and volumes.

The demand curve slopes downwards with the basic rule that as price decreases, then demand increases. Or vice -versa – as prices increases, demand decreases.

Why is that?

Because we only buy things that we believe will give us value equal to or preferably more than the price.

At a high price, few people believe they will get value.

But as the price reduce, more people see the opportunity to gain and earn a “consumer surplus”. This is the difference between the value they receive and the price they pay.

Demand then is a function of price and perceived value.

The supply curve slopes upwards. As market price increases, then more firms are willing to step in and supply the market.

This is because no business will knowingly supply below cost. There are a few provisos here for loss-leader strategies where the business intends to profit from other items bought at the same time or later in the relationship.

Just think about it.

If you could buy apples for 20 pence each and someone comes to you and says…

“I’ll buy every apply you can get for 50p each”

then you’re going to be eager to take them up on it. You stand to make 30p profit on each apple you sell.

But if they say…

“I’ll buy every apple you can get for 18p each”

then you’re not interested.

Each apple you sell will cause you to lose 2p. And the more apples you sell, the more money you lose.

However if you could find a way to buy apples for 10p, then you’re interested in the deal.

Supply is a function of market price and cost.

As the price increases. more firms have the ability to supply at a profit and are willing to do so.

Market prices are set where the demand curve and the supply curve meet – the middle of the X.

This may be a simple lesson on the basics of supply and demand but in a world then seems to get increasingly complicated, it’s good to get back down to basics occasionally.

Supply and demand reminds you that value, market prices and costs are critical factors in your business.

The more value you create compared to the price, the better your chances are to win business.

The lower your costs are, the more you are able to supply at a profit.

It’s no wonder that value (in terms of differentiation) and low costs are the two generic competitive advantages identified by Professor Michael Porter.

It’s now time for the difficult questions.

If value, price and costs are so important, then

  • How well do you understand your value (which is a key factor in demand)?
  • How do you set prices? Guess? Copy competitors?
  • How well do you understand and control your costs? In particular, how do you know that you should be supplying that product which you’ve just cut the costs on to clinch that big deal? Are you sure that you’re not selling 20p apples for 18p each?

I’ll be going into these ideas much deeper in the strategy articles but sometimes it is useful to go back to basics and remind yourself of what’s important and why.

It’s so easy to get caught up in implementing the latest fashionable tactics (social media still looks to me like the hot topic) but if you don’t have your strategy right, then you’re in trouble.

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