The Law of Supply

Definition

As price increases, the quantity supplied increases. As price decreases, the quantity supplied decreases.

Example

We see the this (the law of supply) in the mobile phone industry today. When Apple first entered the market with, what was then, an expensive phone and had success with large margins for profit, other suppliers began entering the market. Until we got to the point where we are now, with a glut of phone suppliers and a lot of phones selling with thin margins and little profits trying to compete on price.

Prediction

I think we’re going to see a lot of phone suppliers leave the market as the price and profit margin of phones get driven lower. This isn’t a radical prediction as we’re already seeing the beginnings of this and it logically follows from the law of supply that as price decreases the supply will decrease.

Market saturation, in the U.S as least, has been reached, but Market equilibrium hasn’t. There are more phones being supplied (at a given price) than being demanded. Market equilibrium has not been reached in developing countries either, but for the opposite reasons.

Outlier

Apple remains one of the only phone suppliers that has retained it’s pricing and is actually increasing sales as demand is driven higher as most other phones are seen as inferior goods.

Normal goods/Inferior goods

Definition

A normal good is any good in which demand increases and decreases with income. As income increases, demand for normal goods increases. As income decreases demand for normal goods decreases. An inferior good is any good in which demand decreases as income increases and increases as income decreases.

Example

Piggybacking on our last example, in the phone market, Apple and Samsung are the two normal goods suppliers (maybe even Apple being considered ‘more normal’), with most other phone supplies seen as inferior goods. As income increases $700, usually spread over $30 a month, doesn’t seem too intimidating, and a lot of people will trade up from their $99 phone. But as income decreases, more people will settle for their $99 phones and a cheaper monthly bill, rather than spend $100 a month (monthly payment + data plan + talk/text plan) to have the iPhone 6s Plus.

Prediction

No change, Apple will remain to be seen as a ‘normal’ good, while everyone else races to cater to those who can only afford ‘inferior’ goods.

Elasticity

Definition

Elasticity is how much demand is influenced by price. A product (or service) is said to be elastic if a given percentage change in price leads to a large percentage change in demand. Another way to put this is that demand is highly influenced by price. A product is said to be inelastic if a given percentage change in price leads to a small percentage change in demand. Another way to put this is that demand is not influenced by price very much.

Formula

% change in quantity demanded / % change in price

Remarks

It’s important to note that elasticity is the percent changed. So if you price your product at $2.00 and have a demand of 30 units and then increase the price to $4.00 and have a demand of 20 units, you will have a higher elasticity because you increased price by 50% but demand only dropped by 33%.

You might also notice that total revenue can be increased by increasing the price to $4.00 ($4.00 * 20 > $2.00 * 30). Which means that it would make financial sense to set the price at $4.00.

Relevance?

How is this relevant to what is happening in our industry? Well instead of companies setting prices at $4.00 to increase total revenue, prices are being kept low (at say the hypothetical $2.00) sacrificing total revenue, so that the user base and market share can grow faster.

Consequences

The most insane part is that investors actually like this model. Especially with startups where most profit that investors see will not come from the revenue of the company, but from the acquistion of the company by a larger company or after the startup’s IPO.

This hope for future returns is flawed in its fundamental premise, that users are loyal to one brand and the cost of switching brands is higher than the cost of staying.

Users will also become accustomed to the lower prices and as soon as prices increase, demand will increase for substitute goods by competitors and most of their market share will be wiped as quickly as it was created.

Here’s an idea. Look for companies that don’t take or need a lot of outside money and grow their revenue alongside their quantity demanded until market equilibrium has been reached.
Instead of the current unsustainable model where market surplus is reached, the company is sold or goes public, everyone cashes in, and the company implodes as the market contracts, rapidly shrinking the companies overgrowth.