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Supply and Demand Effects on Price

Posted in Money

What is Price?

Price is the true reflection of value. The price is where sellers and buyers meet. Some may still feel cheated no matter what the price is negotiated at, like at a car dealership. Others feel the price is overvalued, as in athletes who sign huge contracts and then underperform in years to come. In stocks, the true value of a public company is in the stock price. No matter what the fundamentals may be saying, the value of the company is reflected in its price. Opinions matter as one may perceive a company is undervalued, like Buffett and Munger way of trading. Or in real estate, no matter what the agents may say about “market value,” what they are really trying to say that at a certain price, the house will sell quickly. If it’s too high, then the house will not sell, no matter how the seller feels about the value of the home. It is often a guessing game and requires a bit of negotiation skills to sell at an optimal price.

Supply and Demand

In economics, the price is reflected with a supply vs demand curve. In theory, the law of demand depicts the demand curve as a downward slope. With the price in the y-axis, and the quantity of goods in the x-axis. As the price decreases, the quantity of goods increase along the demand curve. Conversely, the law of supply depicts the supply curve as an upward slope. As the price increases, the quantity of goods increase along the supply curve. Ideally, the two curves intersect at the most efficient price with the optimal amount of goods available. [1]

fintekneeks_econ_supplydemand

In reality, I believe the price does not dictate supply and demand. The supply and demand curves are not even necessarily a straight line. With supply and demand being primary drivers for price and inventory (quantity), I like to draw the curves in reverse. The supply line drawn with a downward slope and the demand line drawn with an upward slope.

fintekneeks_ourview_supplydemand

As people demand more products, you are traveling up on the curve along the path of the demand line. Thus, the price increases with more demand. Again, with the different supply line, as more products are made, increased inventory puts pressure on the price, and thus price needs to be lowered to induce more sales.

Where demand and supply intersect, this will represent the optimal price where equal number of buyers and sellers meet. Commodity prices tend to behave along the supply and demand curve. Prices in exchanges tend to move as regular reports indicate an increase or decrease in demand, as well as increase or decrease in supply. The dynamics of the price action is complex as other factors need to be considered along with supply and demand. Foreign currency exchange rates, global political implications, natural disasters, weather, and many other factors will affect the price of commodities.

Price Elasticity

Another factor to consider is elasticity. When price does not move even though the demand may increase, this is considered inelastic. Consider Apple products. The company tends to set pricing of their products and do not reduce in price as the products age. Other tech companies tend to adjust their price as their products mature. Sometimes, if the demand is not there, they would provide incentives in terms of rebates or discounts during holidays. However, Apple tends to keep their prices stable. Rarely do they discount due to lack of demand. This pricing strategy keeps their margins high, but it also means lost opportunity for them during periods of slow demand, especially the time before their new product introduction.

The buyer can take advantage of situations where price seems inelastic, especially when the supply is too high. For example, at a car dealership, sales have to meet monthly and quarterly quotas. Dealerships are incentivized to meet these sales targets, and will receive huge bonuses from manufacturers when they meet them. If you go during any other day of the month, sales are less likely to bargain with you, thus the sticker price seems inelastic. Therefore, the best day to make a deal is at the end of the month, the last month at the end of the quarter.  Ideally, it would also mean you are likely to get the best deals at the end of the manufacturer’s fiscal year.  This can easily be found through the SEC filings for the manufacturer of the car you want to buy. If this coincides with the introduction of next year’s models, the negotiation power is magnified for the informed buyer. Also, the time of the day is important. If you go too early, sales will feel they have all day to sell you the car. If you go in the last hour, sales will more likely to accept your low offer, which can be significantly under sticker price. They want to make the sale and go home at a decent hour. It’s not a guarantee, but the excess supply works in your favor. Majority of the time, sales are under the gun to make more sales at the end of the month.

In my previous company, I dealt with price negotiations with customers through sales. Although we tried to keep some sort of price integrity and price structure for volume, significant amount of deals were made at the end of every quarter. So for the first two months of the quarter, we are less likely to offer big discounts to customers who come in to negotiate at this time. However, this created an artificial demand to our products, and the perceived value of the brand was diminished. The value of the product features were ignored and in my opinion, the products became a commodity, strictly purchased on price. In many ways, these practices created “hockey sticks” sales. Product sales would be slow for most of the quarter and buyers will come in and make deals at the end of the quarter. Product shipments will rocket at the last two weeks of the quarter. This repeated again the following quarter. This type of practice made it difficult to plan manufacturing and maintain the right product inventory mix, especially if lead times to inventory were significant. Predictably, the corporate buyers would often accept meetings during the last four weeks of the quarter with our sales to make deals. You could imagine the buyers got some fantastic deals every quarter.

Conclusion

This is a brief discussion of supply and demand related to price. We will continue to produce additional articles giving examples of how prices are affected by supply or demand. Instead of accepting the quoted “price,” one can take advantage of inefficiencies in price to reach your monetary goals.

[1] http://www.investopedia.com/university/economics/economics3.asp

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