Supply and Demand or Pricing?

If you believe in supply and demand, then pricing doesn’t matter.  The market sets the price. 

Ouch!  I believe in supply and demand and I darned well believe that pricing adds value.  What’s the scoop?

Do you remember the Jay Leno commercials for Dorito’s?  They ended with the line, “Go ahead and crunch.  We’ll make more.”  This implies an infinite potential supply.

The answer to this dilemma, of course, is that markets are much more complex than simple supply and demand.  Supply and demand may explain prices monopolistic markets, like your electric utility.  Supply and demand may also explain prices in commodity markets, like oil and corn.   But supply and demand are pretty irrelevant to competitive markets with differentiation, like Dorito’s (or snack foods in general).

The company sets a price for Dorito’s, implicitly colluding with competitors.  All competitors know if they lower prices they can probably gain share in the short term.  Then the competitors who were losing share would also lower their prices, so the share gain by the first firm was temporary.  Now they are stuck with the same share and lower prices.  This is why implicit collusion exists, so firms don’t lower industry profits.  This dynamic isn’t driven by supply and demand, it’s driven by competitive (or non-competitive) behavior.   And this describes most markets.

What about the dynamic pricing of the Giants?  They raise and lower prices based on supply and demand.  But they also act more like a mini-monopoly.  Not many people say “What would you like to do this weekend, go to a Giant’s game or the opera?”  Usually people only make the “Will I?” decision when talking Giants baseball.  When a customer is only making the “Will I?” decision and not the “Which one?” decision, then the market acts more like a monopoly.  Supply and demand become more important to understanding the market.

When else does supply and demand matter?  When there are market shortages, prices often move up.  When the VW Beetle was relaunched in 1998 and demand for the car far outpaced supply.  The manufacturer chose to not raise prices, but for a short period of time used Beetles sold at higher prices than new ones.  Remember the high demand for Cabbage Patch Dolls?  How about Beanie Babies?  Supply and demand also influence prices when there is excess inventory and when good are perishable, like fruit or airline seats.

However, the majority of companies are in industries where the manufacturing capability could be easily raised by one or more competitor.  However, these companies don’t build more because they can’t sell them at the price they want to charge.  Apple can make more computers.  Ford can make more cars.  Dorito’s can make more chips.  This means the price points drive the manufacturing.  Of course these decisions are interrelated.

The ultimate example of supply and demand being irrelevant?  Software.  Since the incremental cost of serving the next customer is close to zero for software companies, there could be an infinite supply.  But there isn’t.

How does supply and demand effect your business?  What happens when there is a shortage or a glut of competitive products?  What happens when demand shrinks or grows.  How will these market dynamics effect your industry and more importantly what decisions you will make?

Mark Stiving, Ph.D.

Photo by Kevin Spencer