Loading...

Concept: Supply and Demand (and price)

Ozier Zarouq Khan
Ozier Zarouq Khan 15 June 2021

Supply and demand is a basic economic concept, so basic that we usually talk about these things without defining them.

They can be thought of together as the governing forces of a market economy, though as we’ll see there are other forces involved. In particular, both supply and demand are moderated through prices.

Supply

Supply is the amount of a material, asset, product, or service that is available to the economy. This is a crucial point: it’s not about how much of it exists, but how much of it people can get.

Demand

Demand is the requirement for products, services and assets. It’s a measure of the number of people who want it, and the amount they’re willing to pay for it. It’s not a measure of how much of something people want to buy; it’s a measure of how much they’re willing to buy at different prices. It’s not a point, it’s a curve.

Price and price signals

Price has two main functions: rationing scarcity and signalling demand. Scarce items are more expensive, all other things being equal. And companies read consumer responses to price changes to understand demand, in a process referred to as price signalling.

Price signals are one of the most important ways information passes up from consumers to producers. Obviously, many companies sell to and buy from other businesses, so many consumers are also producers.

If a company doubles the price of its product and sales fall, price signals are telling that company to reduce the price. If a company is inundated with demand, selling everything they produce as fast as they can produce it, their options are to expand production or increase price.

Supply, demand and price curves

The first and most counterintuitive thing to grasp is that demand is not a fixed point. Suppose we turn to the humble burrito. What is the demand for burritos?

Taco Bell is the US’ biggest-selling burrito supplier; they sold $9.7 million dollars’ worth of food and drinks in 2017, most of it burritos.

U.S. Burrito

We’re going to assume all of it was their $1.79 chicken burrito and that they faced no competition, to simplify the example. That would mean our theoretical Taco Bell sold 5,418,994 burritos in 2017.

Imagine the decision-making process by which a person chooses to buy a burrito. A $1.79 expenditure isn’t too serious a matter; but $1.79 every day for a year is $653.35. Suppose you’re buying for a family: mother, father, two kids. If everyone has a burrito for lunch every day for a year, that’s a $2,500 annual burrito budget.

Still, that seems manageable for a lot of families; they were going to eat something for lunch anyway, after all.

But what if the price rose? Suppose prices doubled, making the chicken burrito $3.58. That’s a bigger expenditure. Some people have $1.79 but don’t have $3.58, so doubling the price would price some would-be purchasers out of the market.

Some people have $3.58, but they don’t have $3.58 to spend on lunch. So it would drive some others to alternative food options that were closer to the $1.79 they were planning to spend. That hypothetical, burrito-loving family has several choices: they can eat a burrito every day, in which case their lunch budget is now $5,000 a year. Or they can eat a burrito once every other day and keep their annual food budget where it was before. Or they can balance the utility they derive from their burrito-based diet with rising prices some other way. Whatever happens, we’d expect to see “demand” fall, but that’s not exactly what’s happening.

Demand more or less stays the same; roughly the same number of people still want to eat a burrito, but not as much as they want to save money, eat something they can afford to buy, or spend their money on something else. Demand in functional terms is a trade-off of quantity demanded and price.

Burrito Economy

This graph shows an imaginary effect of changing the prices of burritos on the shopping habits of a family that eats a burrito per person for lunch every day, expressed as prices in dollars vs. burritos per person per week.

Note that it isn’t a smooth slope. These people want one burrito for one meal per day; making burritos cheaper won’t make them buy more. (It might attract more new customers though.) And making them more expensive will only persuade this family to miss so many of their beloved burritos.

Real demand curves often do look like this, rather than smooth curves showing a perfect “price up, sales down” shape, because of two effects. One is diminishing marginal utility, the other is price sensitivity and elasticity.

Diminishing marginal utility

Diminishing marginal utility is a measurement of the reduced usefulness and satisfaction of additional purchases. Utility is the reason you buy something: keeping the rain off, looking good in your eyes, looking appropriate in the eyes of others and being warm are all utilities — outcomes you’d prefer to their opposites. If you can find them all in the same jacket, that’s a good purchase, but what you’re buying isn’t the jacket; it’s the utility.

Think of a train ticket. Congratulations, you’re now the proud owner of a square of card. But what matters isn’t what you get, but what you get out of it; you bought a work trip, a weekend with friends, or a ride into the city to see the big game. You bought the utility, not the ticket. Marginal utility just means more or less utility than before.

Let’s get off the burrito standard and measure diminishing marginal utility in cars. The difference between having one car and having no car is a big difference. Freed from reliance on public transport nets, you can now carry quite a lot of items anywhere you need to go. You can choose your own journey times, give friends rides, transport materials and tow trailers. (You can use your car to make money doing those things too.) Marginal utility at one car is high.

What about two cars? If you already have one, an extra car can be pretty useful. But few would choose the same car. A city runaround and a bigger machine for long distances are common two-car choices, precisely because buying another car exactly the same as the one you already have would have lower marginal utility; it wouldn’t be as useful.

How about nine cars? If you already own eight cars and buy another, the marginal utility is very low, which is why almost no-one has eight cars. Those who do are usually collectors, and for them the utility isn’t “I can drive around” but the addition of variety and quality to their collection.

This is true of most things. Diminishing marginal utility sets a (somewhat malleable) cap on sales even of items that are very price-sensitive. But it’s also determined by purchaser experience. What people want and how they feel are very strong influencers of price-demand curves.

The sharper the change in prices, the sharper this effect will be. As spending power rises or prices decrease (functionally the same thing, from the consumer’s viewpoint), new sources of demand become available to the economy which were always latent but can now be expressed. When the opposite happens and spending power falls or prices rise, demand retreats.

Aggregate supply and aggregate demand

Aggregate supply is the total supply in the economy, lumped (aggregated) together. Aggregate demand is the total amount of demand in the economy, at all possible price levels.. So when policymakers assess the economy of a country “from 10,000 feet”, they look, not at supply and demand within a single business or sector, but aggregate supply and demand. These are the big motors of the economy.

Why aggregate supply and aggregate demand matter

Low aggregate demand is the characteristic woe of developed economies, usually referred to as ‘low consumer confidence’ or ‘low consumer spending.’

Without demand, supply is not stimulated. Businesses do not produce — why should they, with no market to sell in? Employees are dismissed and their reduced spending power becomes a factor in spiralling aggregate demand that pulls supply down after it.

But low aggregate supply can be an economic problem too. In the later years of the Soviet Union, the leadership tried to transition to a ‘white goods’ consumer economy (named for appliances like fridges and ovens which tended to be white), rather than one characterized by heavy industry. This was a change the West had already gone through a generation earlier.

But to do it, Soviet workers would have had to retrain and work extra hours to increase production. The leadership reasoned they could be paid extra, and use the money to buy new consumer goods. They refused, because there was nothing for them to buy with their extra pay; of course not, because they hadn’t produced it yet.

Low aggregate supply immobilized the economy. In the US, this was not a problem and motivated factory workers frequently took on significant overtime to buy the ‘white’ consumer goods that were available to them, increasing the availability of those goods as they did so.

Elasticity in demand, supply and price

Demand elasticity is a measure of how much demand can be changed by changing another economic factor, such as supply or price. If falling prices trigger rising sales, demand is price-sensitive (self-explanatory) and elastic. If rising prices don’t reduce sales, demand is price-insensitive and inelastic.

If supply is elastic, it means more (or less) of that product can be made in response to changes in another economic factor. For instance, if demand for chicken burritos suddenly doubles, it’s not too hard to source the ingredients. They’re plentiful and not particularly specialized. Companies that make burritos can buy more wraps, more chicken, more sauce, and hire more people who are qualified to make burritos. Burrito supply is fairly elastic.

But supply of some other things is not so elastic. Computer graphics chips are in very short supply right now, because producing them requires highly-specialized production environments, specially-trained workers who can’t switch over suddenly from making burritos, and rare substances reliant on long supply chains and slow extraction processes. Graphics chip supply is fairly inelastic, so when a new use case like BTC mining is discovered, that new industry can hoover them all up and slow production of new game consoles. This example illustrates a precept: every product is part of someone else’s supply chain.

Bitcoin: supply, demand and price of scarce assets

Bitcoin fits neatly into the paradigm we’ve discussed above in two ways: it has severely restricted supply and near-unlimited demand access. Nearly anyone can buy BTC: Coinbase’s minimum purchase value is $2. But the ultimate supply of BTC is absolutely restricted: only 21 million will ever exist. And the rate at which the supply grows is throttled too.

But what about functional demand — the number of BTC that people want to buy or sell on a given day? That does fluctuate, but not as much as we might think.

Here’s BTC’s transactions over time:

BTC Transactions over time

This does move, but viewed mid-to-long-term, it’s fairly flat.

If we look at volume instead — value of transactions, not just their numbers — we get a different picture. The next graph shows BTC volume over the last twelve months. Here, you can see Bitcoin volume growing significantly, with quite radical spikes at the beginning of 2021 and again more recently.

BTC Volume

Volume doesn’t track with supply. But it does track with price:

BTC Chart

Here, you can see BTC price history since 2012. It doesn’t match up perfectly with volume, but the pattern is more or less similar. And we can see the behaviour, which is crucial: price and volume fluctuate, but transactions don’t. What about supply?

BTC Circulation

But if supply is steadily growing and price is essentially an auction, why does the price continue to rise? BTC suffers price fluctuations, to be sure, but over time the trend is unmistakable. What’s driving that?

Some of it is that BTC isn’t really available. Remember supply is how much is available in the economy, not how much exists.

BTC Liquidity

Bitcoin’s supply isn’t so simple. The majority of it is held in cold storage or wallets that seldom transact, so around 78% of total supply is illiquid. Supply is even less elastic than we thought! Maybe that’s why, when demand rises, price goes up too?

Disclaimer:

Disclaimer: This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our full disclaimer here.

Next Article