Demand and supply

Demand is the quantity of a product that customers are willing and able to buy at a given price over a period of time. The 'able to buy' part matters — wanting a product is not demand unless customers can also afford it.

One factor is improved technology. New, more efficient machinery raises productivity and lowers the unit cost of production, so firms can profitably make and sell more of the product at each price. This shifts the supply curve to the right — more is supplied at every price — for example, automation allowing a factory to produce more units per hour at lower cost.

The equilibrium price is determined by the interaction of demand and supply. Demand shows the quantity customers will buy at each price (more at lower prices), while supply shows the quantity producers will offer at each price (more at higher prices).

The equilibrium price is the price at which the quantity demanded equals the quantity supplied — where the demand and supply curves cross. At this price the market 'clears': there is no shortage and no surplus.

If the price were set below equilibrium, there would be excess demand (a shortage), and competition for the limited goods would push the price up. If the price were set above equilibrium, there would be excess supply (a surplus), and producers would cut the price to clear unsold stock. These forces drive the price toward the equilibrium, where demand equals supply.

A sharp rise in raw material costs is a supply-side change. Because it makes production more expensive, firms can profitably supply less of the product at each price, so the supply curve shifts to the left (supply falls).

With supply reduced but demand unchanged, at the old price there is now excess demand (a shortage). Customers compete for the smaller quantity available, so the market price rises and the equilibrium quantity falls — less is bought and sold, but at a higher price. For the firm, this means it faces higher costs and may pass some on through a higher price, though it sells fewer units.

The size of these effects depends on how sensitive demand is to price. If customers can easily switch to substitutes, raising the price will lose many sales, so the firm may have to absorb the cost rise and accept lower profit margins instead. If the product has few substitutes (e.g. an essential good), the firm can pass on more of the cost with a smaller fall in sales.

Therefore a rise in raw material costs reduces supply, pushing the equilibrium price up and quantity down; the impact on the firm's profit depends on whether it can pass the higher costs on to customers, which in turn depends on how price-sensitive demand is and how strong its competition is.

Cutting price can increase the quantity demanded, because demand slopes downward — at a lower price customers buy more. But whether this is sensible depends on how demand and supply respond.

The case for cutting price is that it can raise sales volume and market share, especially if customers are price-sensitive and the firm has spare capacity. Lower prices can attract customers from rivals (treating the firm's product as a substitute) and may raise total revenue if the rise in quantity sold more than offsets the lower price per unit. It can also help clear surplus stock if the firm is currently pricing above the level the market will bear.

The case against is that a price cut reduces the profit margin on every unit sold. If demand does not rise much in response, total revenue and profit fall. There is also the risk of a price war: rivals may match the cut, so the firm gains no extra customers but everyone earns less. A lower price can also damage the product's brand image if customers associate low price with low quality. And the firm must be able to supply the extra demand — if it cannot, it creates a shortage and frustrated customers.

Judgement. The decision is sensible only if demand is price-sensitive, the firm has spare capacity to meet the higher demand, and rivals are unlikely to start a damaging price war. Under those conditions, a price cut can raise sales, revenue and share. However, if demand is not very responsive to price, or rivals will retaliate, or the firm risks cheapening its brand, the cut will reduce profit without much benefit. The most defensible conclusion is that cutting price is sensible for a firm with price-sensitive customers and spare capacity in a market where rivals will not retaliate, but not where demand is unresponsive or a price war is likely — so the decision depends on the elasticity of demand and the competitive reaction.

The market price of a product is set by the interaction of demand and supply. Many of the factors driving these are outside a single firm's control, but the firm is not entirely powerless. Whether price is mostly beyond its control depends on the market structure and the firm's own actions.

The case that price is largely outside the firm's control. In a competitive market, price is set by the combined demand and supply of many buyers and sellers, not by one firm. Demand is driven by factors the firm cannot dictate — consumer incomes, tastes and fashion, the prices of substitutes and complements, and the season — while supply is affected by raw material and energy costs, technology available to all firms, the number of producers, weather and government taxes. A small firm in a competitive market is largely a 'price taker': if it charges much above the equilibrium it loses customers to rivals, and if it charges below it sacrifices profit unnecessarily. Major shocks — a recession cutting incomes, a drought raising input costs, a competitor's price cut — move the equilibrium regardless of what the firm wants.

The case that the firm has some control. A firm is not merely passive. Through advertising and branding it can shift demand for its own product to the right and make customers less price-sensitive, giving it room to charge more. Through product differentiation it can reduce the number of close substitutes, increasing its pricing power. By cutting its own costs (better technology, efficiency) it can supply more cheaply and influence price. And in a market where it has significant market power (few rivals, strong brand), the firm can set price within a much wider range. So firms actively try to escape being pure price takers.

Weighing it up (criterion). The extent to which price is outside the firm's control depends on the competitiveness of the market and the firm's market power. In a highly competitive market with little differentiation, price is largely determined by external demand-and-supply forces, and the firm has little control. In a market where the firm has built a strong, differentiated brand or significant market share, it has considerable influence over its own price.

Judgement. Market price is determined by factors outside the firm's control to a large extent in competitive markets, but only partially where the firm has market power. The underlying demand-and-supply forces — incomes, tastes, costs, competition — are mostly external and frequently dominate. However, a firm can meaningfully influence the demand for, and the cost of supplying, its own product through marketing, differentiation and efficiency, shifting the equilibrium in its favour and widening the price range it can charge. The most defensible conclusion is that price is largely outside a small, undifferentiated firm's control, but a firm with a strong brand or market power has substantial influence — so the answer depends on the firm's competitive position rather than being the same for all firms.