The law of supply and demand, and how prices are formed

How does the law of supply and demand work, and what’s its relevance in the formation of commodity market prices?

May 17, 2023

hEDGEpoint Global Markets

For us to understand how prices are formed in commodity markets in general and individual commodities, one of the aspects that we need to observe and understand well is the law of supply and demand: that is, what the volume of a given product being offered is, and what the demand for it is.

Written like this, it seems easy to grasp. But in reality, understanding the corresponding mechanisms isn’t that simple… which doesn’t mean that it can’t also be an excellent intellectual exercise, with interesting repercussions. These can be applied both in an individual’s personal life and in the most diverse professional activities. Would you like to take a look?

But what does this mean?

Relative scarcity concerns the fact that—at least from a theoretical point of view—resources are always scarce and thus insufficient. In other words, there’s a limit, either in the ability to produce something (which implies buying and/or maintaining equipment, purchasing inputs, remunerating people’s work, and then working on distribution and marketing, etc.) or in the availability of resources needed to acquire certain goods or products.

On the one hand, this means that while the producer makes decisions about processes and volumes produced, seeking to sell his production at the best prices, the buyer or consumer also decides what, when, how much, and from whom to buy, from a given amount of resources, which are also limited.

In short, there’s a strong connection between who makes the decisions regarding the quantity and flow of a certain product offered in the market (the producer) and who has the intention or need to acquire it (the buyer). This connection and interdependence are called supply and demand. And it’s based on its constant dynamic mobility, known as the “law of supply and demand,” that prices are defined.

The greater the supply, the lower the price

The law of supply and demand says, in a simplified way, that the greater the offer of a product in the market—that is, the more units of a given good that are available—the lower the prices paid for them are. This is especially true if, at the same time, there isn’t much demand for that product—either because it’s not a priority, or because it can be replaced by a similar one. Let’s take a glance at a practical case to make this clearer.

Suppose there’s an exceptionally bountiful corn crop in a particular agricultural region. This can be the result of favorable weather conditions, technological advances in agriculture, or even the expansion of cultivated areas. At the same time, corn demand remains relatively stable, with no major changes.

In this situation, the corn supply significantly exceeds the available demand. With a greater amount of corn available on the market, producers face fierce competition to sell their products. As a result, corn prices tend to decline.

Producers faced with this situation can reduce their prices to attract buyers and avoid the accumulation of unwanted stocks. Furthermore, if prices remain low for an extended period, some producers may choose to store their grains to sell later, hoping that prices will recover.

More demand and lower supply: the price rises

But the law of supply and demand also says the opposite, which is: the lower the quantity of a product placed on the market, combined with a greater desire (or need) to acquire it, the price paid will be higher. For example: imagine there was a terrible natural disaster at the time of the cocoa harvest, and the crop harvested was much lower than expected.

Cocoa buyers who make chocolate from the commodity will thus have a smaller amount of final product to place on the market because the volume of the raw material they managed to acquire was smaller. And they still had to pay a little more than usual to guarantee their quota in the tough competition they face with other chocolate brands, due to the cocoa scarcity.

We also need to remember that fixed commitments (electricity and water bills, salaries, taxes, etc.) continue to occur monthly. Hence, everything indicates that chocolate prices on the market will be higher—not least because sellers know that (regardless of the cocoa harvest being lower), the consumer still wants to buy chocolate anyway, and at least in theory, is willing to pay a higher amount than they’d pay in a “normal” situation. Thus, the supply shortage causes prices to rise.

Other variables

To simplify more, we could say that the market price will be the one consumer is willing to pay, on the one hand, and that companies are willing to receive to offer such a product on the other. Therefore, the equilibrium price is what reconciles these two antagonistic objectives. Do you agree?

You can already see that the subject is a bit more complex than it first appears. But there are still countless other factors involved, such as competition between those who produce and offer the same things (goods, products, and services), and compete for the attention (and resources) of those who want to acquire them. These agents coexist in a given context which we simply call the market.

The law of supply and demand, and hedging companies

From everything we’ve discussed so far, it’s easier to understand how and why the law of supply and demand plays a significant role in the work of hedging companies. These companies use strategies to manage the price risks associated with certain assets or commodities. They work to hedge against unfavorable price fluctuations and ensure more stable profit margins.

Hedging companies generally operate in markets where there’s price volatility, such as commodity markets. By applying the law of supply and demand, they seek to anticipate changes in asset prices, by analyzing geopolitical events, weather conditions, and other economic indicators, to map price trends and make more strategic decisions.

For example, if a hedging firm expects an increase in demand for a particular commodity due to factors such as global economic growth, it may decide to buy futures contracts for that commodity to protect its clients against a possible price rise. This way, you can secure a fixed price, and avoid losses if prices do rise.

Likewise, if a hedging firm anticipates a fall in asset prices due to an increase in supply, it can take steps to protect against that fall, by selling futures contracts or using other trading strategies.

The ability of companies like hEDGEpoint to analyze and understand supply and demand dynamics in each market is vital to their activities. Taking advantage of forecasting models, market analysis, and up-to-date information to make informed decisions about the best strategies, we focus on minimizing risk and maximizing profits for our clients.

Would you like to know more about this subject? We’re always available.

Talk to a hEDGEpoint expert today.

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