Importance of Demand and Supply Analysis for Managers

Supply and demand make market economies work. This is true for all free market economies, including the U.S. economy and many advanced economies. Therefore, managers need to complete some supply and demand analyses to understand the market structure and to make rational business decisions. Many firms fail only because their managers cannot consider current and/or expected changes and trends in markets.

If managers prefer to worry only about the details of their business without proper knowledge of future trends in prices and sales, they will be at a significant disadvantage compared to the position of their competitors. In the absence of adequate knowledge about market prices and sales, managers are likely to negotiate the wrong prices with input suppliers and customers. They may hire more or less than the necessary number of workers. They may end up with high inventory levels. Contracts for future rent payments or future supplies may ruin the profits of firms. Overall, managers must understand the functioning of markets to analyze the environment where they make their business decisions.

Supply and demand analysis is an economic tool that allows managers to see the big picture of their business environment. Supply and demand analysis allows managers to understand both current and expected developments in markets. Supply and demand are qualitative forecasting tools that managers can use to predict trends in competitive markets, including changes in the prices of their companies’ products, related substitute or complementary products, and the prices of their inputs, such as labor, capital, and technology, that are essential for their rational production decisions. Such valuable knowledge will help managers to determine how much prices would change and how much sales, revenue, and costs would change.

In this part of Lesson 1, a simple economic model will be used to explain the behavior of supply and demand and how markets work. We will establish the model of supply and demand. You will see how supply and demand for a good determine both the quantity produced and the price at which the good sells. Given that the model of supply and demand is the foundation for the discussion for the remainder of this course, this lesson is one of the most important lessons in this course. After you learn about supply and demand analysis in this lesson, Lesson 2 will add precision to the discussion of supply and demand by addressing the concept of elasticity—the sensitivity of the quantity supplied and quantity demanded to changes in economic variables. Lesson 2 will also address the impact of government policies on prices and quantities in markets.

Key Points About Supply and Demand Analysis

• Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.
• The demand curve shows how the quantity of a good demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.
• In addition to price, other determinants of how much consumers want to buy include income, the prices of substitutes and complements, consumer preference, expectations, and the number of buyers. If one of these factors changes, the demand curve shifts.
• The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.
• In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts.
• The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied.
• The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise.
• To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects equilibrium price and quantity. To do this, we follow three steps. First, we decide whether the event shifts the supply curve or the demand curve (or both). Second, we decide in which direction the curve shifts. Third, we compare the new equilibrium with the initial equilibrium.
• In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price then determines how much of the good buyers choose to consume and how much sellers choose to produce.