Wednesday, December 29, 2010

I Hope We Never Run Out of Beer: Supply and Demand for Non-Economists

I am not an economist.  In fact, in my four years of higher education, I never even took an economics class.  But I am an investor, and I am also a consumer.  In being so, I think it is important to understand the basic forces that explain and influence our economy. 

Over the next couple of months I will attempt to understand and explain these laws of economics in plain English.  If you enjoy reading this post, please subscribe to my RSS feed for regular updates.

Today, I’m starting with the most fundamental building block of an economy, Supply and Demand.

The Basics

Stripped down, supply and demand is the meeting of buyers and sellers to exchange goods. As markets and populations grew, individual meetings gave way to malls, outlets, and the internet.  In order for the system to work efficiently, certain conditions had to be met.  These are (1)

  1. The market must be open and competitive
  2. There must be many buyers and sellers, enough so that not one has the ability to influence price
  3. Buyers and sellers must be well informed
  4. Buyers and sellers must form distinct and separate groups
  5. Strong and well-defined private property laws must be enforced

Assuming these statements are true, supply and demand is defined as “an economic model of price determination in a market.” (2) It concludes that in an open, competitive market, the price of a good will be determined by the quantity supplied and it’s relation to the quantity demanded.  As the forces of supply and demand push and pull, they will eventually settle at equilibrium, where the quantity demanded by consumers will equal the quantity produced by suppliers. 
The Law of Demand
The Law of Demand shows an inverse relationship, so that when the price of an item decreases, the demand for that item increases, all things remaining equal.  As prices go down, the opportunity cost of owning an item decreases, meaning that the consumer has to give up less in order to own that good. 

For example, if you have $10 to spend, you can either purchase a sandwich, or a beer.  The opportunity cost of the sandwich is the beer, and opportunity cost of the beer is the sandwich.  However, if the cost of the sandwich and/or beer decreases to the point where you can purchase both for $10, the opportunity cost has decreased, and demand for beer and sandwiches will increase.

As stated above, this model only works if all other factors remain equal.  For the sake of simplicity, we will assume that the income of the consumer and their preference for the item remains unchanged, along with any other extraneous factors. 

The Law of Supply

Unlike the law of demand, which shows an inverse relationship, the law of supply has a direct relationship.  As the price of a good goes up, so does the supply.  The reasoning behind this relationship is simple.  For a seller, the goal is to sell as many items as possible at the highest price possible, maximizing my revenue.

An important consideration in the law of supply is time.  Suppliers must be able to quickly adapt to changes in demand or price, and also decide whether these changes are permanent or temporary.  Take for example an outdoor festival in the summer.  Local retailers know that demand for water will increase during the festival, but return to normal afterwards.  So they increase their inventory, and hike up the price of water by a few dollars.  Since the demand for water increased temporarily, so did the price and quantity.  When the festival is over and demand subsides, price will return to normal, as will inventory. If instead of a passing festival, the population of the town grows by 5000 people, the demand for water will increase permanently, and supply and price must be adjusted accordingly. 


Some goods that we purchase are more necessary than others, and we will continue to buy these items even if the prices rise.  We are less sensitive to price fluctuations in goods such as food or medicine than we are to Ipads.  How demand and supply react to changes in price is known as elasticity.

Let’s say you enjoy drinking Budweiser.  If the price of Bud increases, you could simply replace your Bud bottles with cheaper Miller cans.  Because of this, Bud bottles are an elastic good; a change in price has a large effect on demand. 

If however, the price of hops increased, there would likely be a small, if any, change in the consumption of beer.  This is because beer is inelastic, and not easily replaceable (I venture to say irreplaceable…).  You could switch to vodka or wine, but you’ll probably keep drinking beer, and reminisce about a time when beer was cheap.

There are three main factors that influence an item’s elasticity (3)

  1. Availability of substitutes – products within an industry tend to be elastic, while industries themselves tend to be inelastic
  2. Amount of income available to spend – this relates back to opportunity cost
  3. Time available to purchase and use a product – changes in price may not at first be noticeable, but may weaken demand over time (think rising oil prices)
 How Does this Affect Your Investments? 

This is undoubtedly a simplified explanation of supply, demand, and how they affect our economy, but I think it is important to take this model into account when we purchase a security.  When you make an investment in a company, you are betting that the company supplies a good that consumers demand, and will continue to demand, into the future. 

Before you buy, ask yourself, will the companies business exist in 10 or 20 years?  If it does, will that company be a top competitor, or even better, still maintain an economic moat?  Are the goods they produce the first to be cut from a budget during hard-times? Does the company have pricing power from strong brand names, or will consumers ditch the products when cheaper alternatives roll out?  Answer these questions not just once, but over the life of an investment.  A good buy today could be a business dinosaur tomorrow.

Take for example OpenTable Inc, (NASDAQ: OPEN) an online reservations system that connects diners and restaurants.  For the past few years, the company has grown to become the major player in its industry.  But as cheap, readily available “apps” have become more commonplace, and smart phones more prevelant, OpenTable, Inc. faces stiff competition from newer, more advanced, and less expensive options like Urban Spoon’s Rezbook.  There is still a demand for this service, but is OpenTable Inc. positioned to be the main supplier, and can they do so at a profit?

Hopefully, we can all find companies that will supply consumers’ demands for years to come, and pay us ever larger dividends along the way.  To be a successful investor, we must we must examine a company from every angle, including economic, social, moral, and financial.  Only by taking all factors into account can we expect to reach our investing goals. 

Full Disclosure:  I do not own any securities mentioned in this article.  My full list of portfolio holdings can be found here


1 comment:

  1. Nice explanation of demand and supply - the foundation of our theory of value. Even though you haven't had a course in economics you can still be an economist. Adam Smith and David Ricardo never had a course in economics. Adam Smith wrote the Wealth of Nations and David Ricardo is considered by many to be the greatest economic theorist of all time.
    I look forward to future posts.