A fundamental concept in economics is that supply and demand determine the price. The greater the quantity of supply of a product or service available and the less demand there is for it, the lower its price will be.
In contrast, things that are rare and in high demand are more expensive. The market reaches a consensual price based on supply and demand, but participants in these markets also make future decisions about supply and demand based on prices, making the system dynamic and responsive.
A simple example: raw materials
The commodity market is one of the clearest examples of how supply and demand help determine prices. In commodity trading, participants buy and sell the rights to a certain quantity of a commodity on a specified date. Many producers of a given commodity will sell futures contracts in anticipation of having a quantity of the commodity available for delivery at a future date. Businesses that use this product for their own needs will take the other side of the deal, agreeing to purchase this product.
Market fluctuations establish the initial price at which futures contracts trade. As the supply of a product increases, the competition among sellers to find willing buyers becomes fiercer and they reduce the price they are willing to take in order to entice buyers to trade with them. . On the other hand, if the supply drops, there are fewer sellers in the commodity market, and buyers therefore have to compete with each other by raising the price they are willing to pay.
Similar things are happening in response to changes in demand. When buyers need more than one product for their own needs, they pay more to entice sellers to provide additional supplies. When demand for a product decreases, buyers may expect lower prices, forcing sellers to compete in conditions where it is difficult for sellers to find other customers.
How price can affect supply and demand in the long run
In the short term, imbalances in supply and demand can cause prices to fluctuate sharply. Yet the resulting price movements then influence long-term decision-making among market participants.
For example, when oil prices briefly climbed to $ 150 a barrel in 2007, demand was extremely high relative to available supply. In response to these high prices, oil companies have stepped up their exploration efforts, opening up new resources like tar sands and shale oil production. At the same time, consumers of energy products, such as airlines, have taken steps to reduce their consumption by purchasing fuel-efficient planes. The net impact was a major shift in supply and demand that caused oil prices to drop below $ 40 per barrel at the end of 2015.
Supply and demand is a basic economic principle that you will find in the financial markets. Calculating a market price for commodities is what commodity markets do every day, but supply and demand also have long-term implications that investors should also consider when considering making investment decisions.
Ready to put your money at your service? Visit Motley Fool’s Broker Center and get started today.
This article is part of The Motley Fool Knowledge Center, which was created based on the wisdom gathered from a fantastic community of investors. We would love to hear your questions, thoughts and opinions on the Knowledge Center in general or on this page in particular. Your contribution will help us help the world invest, better! Write to us at knowledge [email protected]. Thank you – and crazy!