The following guide can be considered the most fundamental trading guide of all since it’s aimed at explaining the most fundamental rule of economics in modern society. The law of supply and demand is the backbone of a market economy and it is what all countries, with a few exceptions, base their financial system on. In order to invest successfully, one needs to have a good understanding of supply and demand and how this basic law controls our markets.
Market Economy vs. Planned Economy
Before we get into it, you need to understand the difference between a market economy and a planned economy. A market economy, also known as a free market, is an economic system that’s controlled by the market and the law of supply and demand. Essentially, it means that companies can produce any products and services they want and that consumer interest controls the price point and the demand. A market economy is a competitive economy where governments have little to no influence.
The opposite of a market economy is a planned economy where the government controls the supply and therefore also how consumers spend their money. This type of economy system limits the competitive nature of a marketplace and makes it nearly impossible to have free trade and make use of speculative investment opportunities. A planned economy is the backbone of a communist state.
Today, you can’t really find a complete market or planned economy anywhere. Instead, most countries have a mixed economy that’s mostly a market economy where people can trade freely and supply and demand rules, with governments having some control of certain parts of the economy in order to keep it stable.
What is Supply?
Supply is a term used to describe the quantity of a product that’s available to consumers, either at a specific price point or within a preset price range. There are many factors that can affect supply, such as related and necessary products. For example, the supply of Intel processors is affected by the supply of commodities and energy needed to produce the processors, which in turn affects the supply of Microsoft computers since they rely on the processors.
Another important factor that affects supply is technological advances that can either increase or decrease supply. You see, a new technological invention can either make it easier to produce a certain product, thus increasing the demand, or it can make the need for a product obsolete.
In an economic situation, the term supply is rarely used on its own but almost always used together with demand.
What is Demand?
Demand is a principle used to describe consumers willingness to spend a specific amount of money on a product. This concept is incredibly important to the economy since it determines how much of a product a company needs to produce and how much they can charge for it.
Compared to supply that’s affected by distinct factors, demand can be harder to calculate. For example, demand can be personal and can be based on one consumer’s current situation: how much money does the consumer have and does he or she have a need for the product? It can also be a collective demand based on what society wants. Is the general interest for these types of products high right now? On this level, companies can often use marketing to affect demand a bit, but there is one more important factor that controls demand: pricing. If a company charges too much for a product, the demand will decrease which will lead to the said company failing to make a profit.
As you might imagine, businesses spend a lot of time and resources trying to figure out demand because without demand they won’t sell anything.
Supply and Demand
As mentioned, the term supply is rarely used on its own and neither is demand. Instead, they’re used together to describe how modern-day economy works. You see demand and supply work together and they affect each other more than any of the above-mentioned factors. In fact, the law of supply and demand is a constant force that works as the foundation of our society – controlling prices, inflation, consumer trends, and much more. It’s a fundamental concept that you have to understand before you start trading.
The law of supply and demand stipulates that when the demand for a product is high but the supply is low, the price will increase. In the same respect, when the supply is high and the demand is low, the price will decrease.
Let’s say Ford launches a new electric car with a price tag of $20,000 which matches the initial demand for Ford’s first electric car. After the first rush to get the new car has died down, the demand will decrease and all of a sudden the $20,000 price tag will be too high. Now the problem is that Ford is still producing a lot of cars (high supply) and due to the limited demand (low demand) they’re not selling enough to make a profit. Because of this, Ford decides to lower the price for the car to match the demand and keep sales at a profitable level. Alternatively, Ford could lower their production rate to limit the supply and keep expenses down, but then they would have to sell more of another product.
Supply and demand is also affected by time and seasons. If you have a company that sells sandals in Europe the demand for your product will be higher in the summer than in the winter which means you have to increase production and the supply in order to match demand. On the other hand, if you start selling the sandals in a tropical part of the world, the demand will be the same all year around and you won’t have to adjust supply based on seasons.
Equilibrium and the Perfect Balance
It’s up to every company to find the perfect balance between supply and demand or the equilibrium. When equilibrium is reached supply and demand are perfectly matched and the economic situation is perfect. This means that a company is supplying exactly as many products as consumers are demanding.
The issue with a planned economy is that governments decide what the demand for a product is in advance without actually knowing. This either results in there not being enough supply or too much supply.
Supply and Demand for Investors
As an investor, you need to understand the concept of supply and demand since it affects prices in every market. For instance, when a company finds a good balance between supply and demand, the value of that company’s stock will increase.
Additionally, supply and demand can have a more direct effect on the market. For example, when the interest for Bitcoin increases but the mining rate stays the same, the price will increase: demand is high and supply is low. The same goes for other assets. When the stock market falls people tend to invest in gold which means demand for gold will increase while the supply stays the same, thus the price of gold will surge.
A Summary of the Law of Supply and Demand
The relation between supply and demand is the most fundamental economic rule in our society. It’s based on the concept that when demand for a certain product increases while the supply is low, the price will rise. However, if the demand for that same product decreases, the supply will increase and the price will drop.