3.3.2 Supply and Demand
An equilibrium between supply and demand is reached when prices are at a level that is acceptable to both suppliers and customers
In a ‘market economy’, the prices of materials, goods and services and the volumes of business transacted are mainly governed by the economics of supply and demand – as described in Chapter 3 of Samuelson and Nordhaus’s book, Economics (pp. 38-51). Suppliers will only provide materials, goods and services if they can charge high enough prices for them to make a profit – but people will only buy if the price is low enough to make the purchase worthwhile. Equilibrium is reached at the price where the availability of supply matches the strength of demand.
Lower prices are not the only competitive weapon – as described in Michael E. Porter’s book, On Competition. A summary diagram, Porter’s Five Forces of Competitive Position, identifies factors such as geography, numbers of buyers and sellers, ease of starting up in competition, product design, quality and brand image.
The process of setting the market price is conducted by face-to-face negotiation, or haggling, in some parts of the world and for some types of purchase. In shops in Western economies the price is set by the shopkeeper on the basis of trial and error: when a price has been set too high, and the shopkeeper has excess stock, the price has to be reduced to clear the shelves. More recently, Internet auctions are being used to agree a price. Whatever the actual steps taken to set the price, the overarching governance mechanism of an adequately regulated market is the matching of supply and demand: balancing the power of the buyer against the power of the supplier. They each need the other, so neither has an unqualified advantage (provided that each has other acceptable choices available).
Consumers wield the strongest economic power in most countries. It can be argued that this is the purest form of democracy: people demonstrate what they want by being prepared to pay for it. Adam Smith, in An Inquiry into the Nature and Causes of the Wealth of Nations, used the term ‘invisible hand’ to describe the self-interested development of supplier networks to meet the demands of customers – and thereby create economic growth, wealth and employment:
“he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” [IV.2.9]
Leonard Read’s short essay, I, Pencil, is an easy-to-read explanation of how the invisible hand operates; he describes how the wood-cutters, for example, didn’t need to know that some of the wood was going to be used to make pencils – they were simply supplying a demand for a commodity.
Businesses depend upon, and therefore have to submit to the power of, their customers. Consumer power depends upon how many people want similar goods and services, and their disposable income.
But businesses also wield power in the reverse direction: they can stimulate demand by advertising. People respond to a variety of factors: price, quality, service, brands, fashion, or a company’s ethics. Corporate influence is widening to reach customers all over the world, helped by improvements in communications and the Internet.
As companies become larger they reap the benefits of scale: their fixed costs, such as product research, are spread over a greater sales volume, so unit costs per item are reduced – as explained in chapter 7 of the Samuelson and Nordhaus book, Economics (p. 107). Smaller companies find it hard to compete. The emergence of global demand has made some corporations extremely wealthy.
These market forces – the power relations between businesses and their customers – are mostly beyond the control of governments. The buyer and supplier need only to negotiate with each other.
Where there are multiple sources of supply, competition provides one of the purest forms of governance because suppliers cannot be excessively exploitative: any business which charges high prices in a free market risks being undercut by a competitor who is prepared to charge less. Suppliers of unsatisfactory goods and services will fail as buyers choose to purchase elsewhere.
The result of lower prices is to leave money in the customer’s pocket, which can then be spent on other goods and services. Competitive supply and demand thereby fuel economic growth.