When it’s not “Just Supply and Demand”
Contrary to the common saying, supply and demand don’t always move in lock-step. When disruptions set it, a murky world of complexity, inefficiency, and opportunism emerges.
When small changes in price happen in daily life, you often hear people say, “that’s just supply and demand”. This phrase comes from the ‘law of supply and demand’ in economics, which says that prices should rise as goods become more scarce. Yet there’s a problem with this theory as it applies to the real world of supply chains, and that’s that is assumes that supply and demand can move in lockstep.
As demand rises, so do prices, and producers have an incentive to produce and sell more. If demand drops, so do prices, and producers will produce less. This is the basis of the law of supply and demand. However, as I write this article, the world appears to be in short supply of just about everything - beer, furniture, pharmaceuticals, and bread to name just a few. Why hasn’t “supply and demand” come to our saviour?
There are two gaps between theory and reality - prices and supply chains.
First, many firms are unwilling or unable to adjust prices rapidly to account for changes in supply and demand, thus breaking the “law”. Take the example of the pub firm JD Wetherspoon which, at the time of writing, is suffering significant shortages of beer and bread. The beer shortage appears to be driven by logistics and import issues with beers from Heineken including Coors and Carling. The bread shortage is being blamed on labour shortages at a supplier’s factory. The law of supply and demand argues that, when faced with a shortage, Wetherspoons should raise prices until demand reduces to match supply and therefore profits are maximised.
However, most firms are unwilling to dynamically adjust their prices, especially those directly serving consumers. Passenger airlines are a notable exception. The pub group knows that raising the price of the beers in short supply would undermine their image and do long term harm to their sales, instead they are prepared to sacrifice short term profit maximising for long term gains.
It’s also practically impossible for most firms to work out what price they should be charging. The classic law of supply and demand is built on knowing how price sensitive your customers are and on being able to make rapid changes in price. Not only do most businesses not know the exact price to set to balance supply and demand, but the cost of doing so would be enormous. It is not worth Wetherspoon’s while to print new menus every day to reflect supply changes. Instead, beer and bread run short and items are taken off the menu. The firm must hope that customers make substitutions rather than going elsewhere.
Second, massive global supply chains mean that supply cannot ramp up and down as quickly as demand. We accept that demand changes rapidly; today I don’t want a new mattress, tomorrow I might. Yet, as IKEA has found out this month, the mattress supply chain cannot bounce about quite a quickly.
For even a simple supply chain, it can take months for products to move from raw materials to final consumer goods. This leads to long delay between increases in demand and matched increases in supply. If it takes 3 months to produce a mattress, and 3 months ago demand was low, then today’s supply will be low too. If demand spikes suddenly, we can expect shortages and disruption.
There’s an even nastier problem going on here too, known as the “bullwhip effect”. In essence, because every business in the supply chain assumes they should order ~10% more than their customers want to avoid running out of stock, small fluctuations in demand can require enormous changes at the earliest stages of the supply chain.
The current supply disruption, caused by labour shortages, equipment shortages, and a spike in demand will not be fixed by the natural laws of economics. Supply chains are complex, unpredictable systems. Enormous human effort will be required to rebalance the global logistics network. There is no “just” about it.