All markets have a supply and a demand side, leading to an equilibrium price and quantity
The supply and demand of products is a key concept in economics. Briefly, the law of supply and demand states that the availability of a product (supply) and its desire (demand) has a direct effect on the pricing. Accordingly, if the supply is low and demand is high, prices are high and vice versa. This law is true for most products in the market, which can be applied in most market-relevant case interviews.
In a perfect market, demand and supply coincide at a zero-profit price
A perfect market has the following characteristics:
- All goods of a kind are equal (e.g., commodities).
- No transaction costs exist (e.g., taxes, cost to negotiate a contract, and to change a supplier).
- Many competitors exist.
- Everyone has the same information.
For each of the two market participants, a consumer, and a producer, it is assumed that:
- The lower the price for a product, the more consumers can afford it and want to buy it.
- The lower the price for a product, the fewer producers want to sell it, as the profits are lower.
Based on the above assumptions, the following leads to a market equilibrium:
If there is too much supply for a good compared to quantity demand, some producers will not be able to sell, leading to a “surplus”. Thus, those suppliers lower their prices to attract customers, leading to a price war as their competition usually also starts to lower prices. This phenomenon leads to some competitors leaving the market because they realize that they are not profitable anymore with lower prices. Now, because of lower prices, customers demand more of the product, and the demand increases, making the market attractive. Thus, new competitors enter the market. These events continue until the supply and demand match perfectly in an ideal world.
For an individual company, the concept of supply and demand is bad news because companies work at zero profit. The constant threat of a few companies being cheaper than the competitors and therefore attracting all customers forces the rest of the competition to work at the lowest possible margin. In other words, an individual company cannot set its own price different from the market price, as this would cause either having no customers (higher price) or the competition doing the same (lower price).
No market is perfect in the real world and companies are able to make profits by leveraging imperfections
Due to imperfections of the market, the concept’s validity is restricted.
- All products of a kind are not equal.
- Transaction costs do exist (e.g., taxes, cost to negotiate a contract, and to change a supplier).
- Sometimes, an industry has only a few competitors.
- And no one has the same information and knowledge.
The more imperfections exist in a market or industry, the more potential exploitation is possible.
- Product differentiation leads to low comparability. Customers have difficulties assigning a price to a specific level of value and might pay too much.
- Transaction costs make it difficult for customers to change a producer. They have to search for alternatives, which induce costs. They might just pay more instead.
- A few competitors leave chances for cartels. A monopoly is a company’s dream condition, as it can dictate prices.
- Opaque information is another barrier to the comparability of products, as customers don't know if they get what they paid for. Research knowledge leads to inventions that generate a competitive advantage others cannot use.
Deploy the concept of supply & demand in pricing or market entry cases
In a case interview, you can use the concept of supply and demand for pricing or market entry decisions. Clients can either create market imperfections by setting certain industry standards or market their brands for pricing reasons. Clients could also enter imperfect markets. Porter’s five forces can be used as a framework to evaluate the degree of market imperfection in an industry, in which the higher the degree of imperfection, the more attractive an industry is.
- Prices in a market will adapt such that demand and supply match.
- Perfect market competition forces companies to produce at zero profit.
- Market imperfections lead to the exploitation of markets, allowing companies to make profits.