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Introduction to Fundamental Analysis


The Law of Demand

The law of demand and its application to fundamental analysis of commodities rests upon an understanding of consumer behavior. The factors which characterize consumer choice, and how individual consumer responses are reflected in the marketplace, are key components of this economic theory. Understanding what factors have affected demand in the past will help to develop expectations about demand in the future and the impact on market price.

Demand for a particular product or service represents how much people are willing to purchase at various prices. Thus, demand is a relationship between price and quantity, with all other factors remaining constant. Demand is represented graphically as a downward sloping curve with price on the vertical axis and quantity on the horizontal axis (see figure 1).

Figure 1

Generally the relationship between price and quantity is "negative." This means that the higher the price, the lower the quantity demanded. Conversely, the lower the price, the greater the quantity demanded. Market demand is the sum of the demands of all individuals within the marketplace. Market demand will be affected by other variables in addition to price, such as various value-added services including handling, packaging, location, quality control, and financing. The point is that the demand for an agricultural commodity is typically derived from the demand for a finished product. In other words, the demand for coffee beans might be strongly influenced by the demand for coffee-based beverages sold by retailers such as Starbucks.

It's important for you to understand that a free market economy is driven not by producers, but by consumers. Ultimately, the market value for any good or service is determined by its value to the consumer. Increased demand leads to higher prices. Higher prices mean higher profits, and higher profits provide businesses with the incentive and the means to expand production of those goods and services that consumers value the most. So, profit driven expansion is the market's response to stronger buyer demand. On the other hand, when consumers are unwilling to buy what is offered at the current price, the seller will have to lower the price ultimately resulting in lower profits, or even losses to the producer. Losses reduce incentives to produce things for which demand is weak, which ultimately force production cuts as producers lose money.

This is the discipline of the marketplace. Those who produce things that consumers are willing and able to buy are rewarded. Those who produce things that consumers don't want or can't buy are penalized. Suppliers must produce for the markets. They cannot expect to find or create a profitable market for whatever they choose to produce.

Next chapter: Basic Description of The Law of Supply

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