Understanding the Basics: Supply, Demand, and Elasticity in Macroeconomics

Economists are always throwing around economic terms as if everyone in the world speaks their language. You probably understand the basics of supply and demand, but you might not be familiar with the concept of elasticity, unless you studied macroeconomics at some point.

Supply and demand are the most fundamental concepts in economics and are the central force in a market economy. The relationship of supply and demand largely determines the allocation of resources within the economy.

Understanding economic terms will boost your understanding of the economy in general. It can also help you with investing.

Supply

The supply of anything, in economic terms, refers to the amount of goods and services that are available at a given price point within an economy. Suppliers are willing to provide more supply as the price increases.

You, like most others, would probably be willing to bake more pies for a bake sale if you found out the selling price would be higher than you originally expected. If you happened to bake more pies than people were willing to purchase, you’d lower your price in an effort to get rid of the rest of your pies.

Demand

Demand is simply the desire of the members of an economy to consume a given product or service. It’s largely a function of price. Assuming all other factors are constant, more people want an item as the price drops and fewer people want an item as the price increases.

At this moment, you probably wouldn’t consider purchasing a Mercedes. However, if the price for a brand new Mercedes dropped to $100, you’d likely purchase one immediately.

Equilibrium of Supply and Demand

When supply and demand are exactly equal, the economy is considered to be in equilibrium. This is considered to be the most efficient condition for the economy because the goods being supplied are equal to the goods being purchased. In general, everyone is satisfied when the economy is in equilibrium.

The manufacturers are selling everything produced and the consumers are able to purchase all the goods they demand. Unfortunately, equilibrium only exists in theory.

But, when there’s a difference between supply and demand, there’s an opportunity for investors to make money.

That’s why it can be important as an investor to attempt to predict future supply and demand for the products and services produced by companies you’re considering investing in.

Elasticity

Elasticity is simply how flexible demand is as a function of price. For instance, many consumers are loyal to either Coke or Pepsi, as long as the prices are comparable. But most individuals will quickly switch brands of soda as the price spread increases.

Luxury items tend to be rather elastic. You probably wouldn’t take a cruise if the price went up dramatically because no one needs to take a cruise. Taking a cruise is a luxury.

Some products are not very sensitive to price increases. Utilities would be considered relatively inelastic because you probably purchase about the same amount of electricity, gasoline, and water, regardless of the price.

When the economy is struggling, companies with non-essential, luxury type items tend to struggle. People are more focused on necessities and are hesitant to spend money on things they don’t need.

Conclusion

Supply, demand, and elasticity are the fundamental concepts that make up our economy. Each of these plays a pivotal role in how the economy grows and shrinks. They also affect the ability of companies to be successful.

Consider these ideas when examining your investments and the amount of risk you’re willing to undertake.