From how some people are reacting to Tesla, I am not entirely sure the concept of supply
and demand is that clear.
So I wanted to go through an entire scenario to illustrate best how it works.
DEMAND But the fact is demand is not an issue for
Tesla, instead price is.
It seems that many people are struggling to really understand how supply and demand works.
If you have a business, and sell a product that is very popular, it means a lot of people
want it, this is your demand.
In this scenario most people try and then find ways of producing more of these products
to make sure they can sell to all of the people trying to buy their products.
This means increasing supply.
However, to increase supply it may not always be as easy for some industries as much as
others.
For example software is very simple, especially if it is just downloaded from the cloud.
But if it's a physical good, that must be manufactured then you may need to expand your
production lines, this may involve building new factories, or expanding existing.
Then you can produce more of this product, however your product may need other components
and materials from your suppliers.
So you increase your orders with them for more parts, but they are facing the same issue
that you now face, and they may also have to expand their factories.
They also may not wan to do that just for you, as they don't know how long your additional
demand may last.
They don't want to expand just for one customer, only to potentially lose that customer and
be left with all this additional expense.
PRICE Yet your business has all this demand still
and you aren't able to supply enough products to your customers, and you now have a backlog
building up, and customers unhappy that they have to wait months in order to get your product
shipped to them.
Well instead of just increasing supply, you can increase price.
You've created too good a product, offering too much value to your customers, and thus
you must adjust the price accordingly to find the market clearing price where supply matches
demand, and you end up with minimal wait times, or the minimal stock in inventory.
MARGINS But now due to these price rises you have
also increased your profit margins, and your total profit has increased too.
You are still trying to expand, but it is happening slowly.
Instead you have also cut back on other expenses that were further adding to the demand issue
like advertising.
You no longer need to advertise as you don't need the extra business, and instead that
is now also added further to profits again.
So your business now has a nice buffer of excess margin and the potential of later advertising
if you need to get demand back again.
Meanwhile expanding supply has become even more profitable due to this additional margin
and profits you have created.
MORE DEMAND But it doesn't stop there, your product is
so good that all your customers are telling their friends about it too, and they also
want one, and demand is still increasing further despite you already raising prices so much.
So now you start to get desperate in trying to increase supply faster.
Some of these new expansions you have been working on are coming to completion, but you
need more supplies.
However now you are significantly more profitable, and are able to offer your suppliers some
big contracts in order to justify their expansion too.
You offer them long term contracts, and they are now more willing to expand and supply
to you, as the reward is now worth the additional risk and cost for them to undertake.
And for some other suppliers you have decided to fund their entire operation and build them
a factory to operate in.
And some of the other suppliers are still not willing to play ball, but you are getting
very profitable now, and you can actually afford to just buy these suppliers out.
Or alternatively you simply start up your own facility of what they are doing.
You are vertically integrating and expanding.
But what has this done, now your have these longer term contracts your suppliers are giving
you an even better rate than before, and some of this other vertical integration is also
cutting your costs further, despite having to invest some large capital initially to
get it started, but it all has a very positive return and ends up saving you more money.
Your margins and profits have ended up increasing yet again.
And you have managed to secure deals with all the major suppliers for the components
you want.
NEW FACTORIES
Meanwhile your new factories that you decided to build for expansion have come online.
Unlike your previous old one, these factories are custom designed exactly around building
your product.
Located in the right area beneficial to supplies, in a city that has great talent, or talent
wants to live in, and near your major customer base.
You have also spent time, and research in improving your production techniques, of which
these new factories are also incorporating.
Your suppliers are also expanding and see that you are not some over the night business,
and look like you are here to stay, so they are more eager to do business with you, and
see that you are very beneficial to their growth.
They are happy to expand, and offer you better deals.
Especially if they are worried you may just end up doing the job yourself with more vertical
integration.
Now they are bending over backwards to keep you as a customer.
These new factories, and new deals have further reduced your costs.
Not only that, despite all these efforts you are making, you still can't keep up with demand,
so you have no choice but only to continue to keep raising prices.
On top of that you have been improving your product this entire time too, so demand has
been naturally increasing due to more features your product offers.
COMPETITION But now you are a noticeable success, your
products are being seen everywhere and your financials are public.
People can see just how profitable your products are, especially with these high prices and
low costs, and what are now absolutely insane margins, and profits.
The competition think that they can do that too.
It's not that difficult, they just need to follow the same footsteps as what you did,
and then they too could be making similar profits.
This is what free markets are all about.
Competitors to enter a market place and compete due to such high profits it becomes incredibly
attractive, it is easy to get investors who also like the look of the prospective industry
and potential profits.
It looks like a great return on investment.
Of course if you have patents then they could keep out some of the competition.
But lets say this is a totally laissez-faire market and patents don't apply here.
So the competition enter the market, except you have been at this for a really long time,
and have a lot of experience along with intellectual property.
It has taken you a really long time to get to where you are today.
You are also incredibly smart and know this industry better than anyone in the world.
You pretty much built up the entire industry, its your industry, how can these new comers
have any idea of what it really is.
But they can't resist themselves, they see your profits, and they want a piece of it.
And they want it now, they don't want to have to grow slowly like you did, and they are
backed by big money investors so can jump right into the deep end.
Eventually they start manufacturing their equivalent of your product.
However, the technology is vastly inferior, it's simply too hard to catch up.
Therefore they have to offer their product at a much lower price than yours.
As no one in their right mind would want to buy theirs over yours, due to the massive
amount of extra value your product is able to offer.
COMPETITION COSTS Unfortunately for your competition though,
they don't have all these economies of scale, vertical integration, refined manufacturing
techniques, and massive amounts of experience you have accumulated being in this industry
alone for such a long period without any serious competition.
Therefore not only do they have to offer their product at a lower price due to it being so
poor in comparison, their costs of making this product are significantly higher too.
They end up offering a lower quality product, at a lower price, with a higher cost to make.
So much so that they actually end up losing money on it.
COMPETITOR EXPANSION But it doesn't defeat them, despite the huge
losses.
They have a lot of money behind them, and have the knowledge that if they can catch
up, then they have seen the rewards that you achieved with your products, it's just a matter
of reducing costs and improving the product.
They go to their suppliers and tell them they also need to expand, and need more components
and materials.
But a lot of these suppliers say they can't, they are already locked into supply everything
they have to you, with long term contracts.
They keep searching, and find some smaller suppliers, but they cost a lot more.
But there's nothing else out there, so they have no choice.
As you have taken all the low hanging fruit, the larger lower cost suppliers, and locked
them in for long term contracts.
Leaving the crumbs for any other potential competitor.
They build factories too to try and save money, by doing as much as they can themselves and
in-house, except they don't have much manufacturing experience with this product, and must use
old traditional ways of manufacturing, that are a lot slower, less efficient, and cost
a lot more.
Eventually all these efforts they make, only create a small saving overall.
Still nothing close to the cost you can produce your product for.
COMPETITORS SHAREHOLDERS But these companies have had a fortune invested
in them, they need to show something to their shareholders, so instead of trying to beat
you on cost, or units produced, instead they start offering more models, and more varieties.
They offer more customization, and try and compete in other ways instead.
All adding to cost, but now they have a reason to also increase the price to their customer.
Offering a more differentiated product from you.
Meanwhile your demand is still increasing, you are finding even more revolutionary new
ways of producing your product even faster, and at lower cost, and improving it further
and further, that demand keeps coming.
And you haven't needed to add any other different models as this first model is still just so
popular you still can't make enough of it.
However each time you do make more of it, then the cost keeps coming down more, and
more economies of scale kick in, and eventually you finally build enough factories, that you
are starting to meet demand.
LOWER PRICES So your demand is finally starting to saturate,
and because your prices are so high, the competition have also been able to price their vehicles
a little higher too, so much so that they are now approaching close to break even.
But the thing is that because you are making so many of your product now, well the economies
of scale are so ridiculous that the margins are just stupidly high.
You can start cutting back on them somewhat and offer some lower price point variants,
to attract a larger market.
Yes, all this so-called competition is at a lower price point where there are simply
that much larger a pool of consumers for these products.
But now you are finally at a point where you have enough supply, you can start to lower
prices, and tap into this larger pool of customers.
The competition have based all their numbers, expansion, returns on these current price
points, and possibly even hoping to raise their prices further, along with continued
expansion in demand and supply.
But now you are offering lower cost versions of your product, they are losing their demand,
as consumers who would have previously bought their product can now buy yours.
The competition can't afford to lower their prices or they will end up losing too much
money.
Meanwhile their only hope to actually make a profit was to further increase their sales,
which are now being eaten up by your lower priced models.
What happens from here on in?
Well you have to stay tuned.