Sunday, February 7, 2010

Why An Increase In Supply Will Lead To A Drop In Price?

This is a question being asked by my student recently. Simple. Let's use a little bit of economics and business sense here. Imagine that if there is only one seller in an area or there are just very few available around. This means, it is rather difficult to get hold of that particular item or service. As such it gives the producer some room to adjust the price upward since they are in control of the situation
On the other hand, if a good or service is so widely available that consumers can get hold of it just anywhere, then the producers will not be in advantageous position to manipulate the price upward. This is because, an increase in price will cause the consumers to substitute away from that firm and move towards its competitors. A reduction in price makes more sense in order to get rid of those stocks which may be sitting on the shelves too long. Furthermore there will be new stocks coming in from time to time. If those old stocks are unsold, then there is no place to keep these new ones

Economic Reasons For Price Increase

In what circumstance will a producer increase prices?
(1) Demand inelastic. A business person will be more likely to increase the price of their good or service in case if they realise that the price elasticity of demand (PED) is less than 1. This means a large increase in price will lead to a less than proportionate fall in quantity demanded as can be seen from the steep demand curve. In layman, it means a big increase in price that will not affect the quantity demanded by much. This normally happens to the sellers of necessities or addictive goods. It could also be due to presence of strong brand loyalty that keeps these consumers coming back all the time that they wouldn’t even be bothered by a price increase

(2) Lack of competition. The location of the outlet can also give it a competitive edge. If it is a pioneer in an area, very likely that it will continue its dominance in that area despite the presence of rivals. This is because it has made itself established there. It can also be a situation where there is no competition at all since rival firms may not be able to secure a strategic place to position itself due to overcrowding of outlets

(3) Rising demand. The most fundamental reason of all. When there is an increase in demand which cannot be met by supply, producers will be in power to increase prices. It can also be due to both demand and supply increasing but demand is escalating at a higher rate

(4) Desire to increase revenue. This is closely related to the elasticity of demand for a good. If the demand is inelastic, it will be wise for businesses to increase prices since it will contribute to an increase in total revenue and therefore profits

(5) Increase in production costs. The most common practice in business. When there is an increase in the production costs such as rental, raw materials in use, wages and number of workers, utilities, logistics etc, sellers will most likely pass it on to consumers in the form of higher price. Having said so, it also depends on the level of competitiveness. If the competition is already stiff, it is wiser for the business to cut costs elsewhere or absorb it, or else a price increase is suicidal

(6) To reduce the demand. Sometimes a business is just too small for such a large number of clients or customers. The person itself may no longer be in such a capacity to attend to so many people. As such one of the ways is to increase the price of the good or service to reduce the number of customers. Businesses with such nature are like small hair saloon, clinic and private tuition