We are going to attempt to cover an important model in trade relating to commodities, pricing of related materials, and the effect on companies throughout the supply chain, with the effect on the economy in detail. We will review the metals supply chain, but this same model can be used for other commodities, such as plastics, chemicals, wood, and even foodstuffs, such as pork bellies or wheat.
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Before we get into the subject of inventories and trade, let’s step back a moment to define supply and demand and how prices are determined in a free market. Economics 101 teaches that when supply exceeds demand, prices will drop until supply comes into balance with demand. When supply is much lower than demand, prices will rise until supply meets demand. In a perfectly elastic market, these mechanisms work exceedingly well.
When there is excess supply, some producers will get out of the business if they have to reduce prices to sell their goods as the business is less profitable. This should result in a drop in supply. In addition, buyers may have a fixed budget to buy those goods and can now purchase more of each good raising the number of goods desired. At some point, price aligns supply and demand. The opposite case holds for excessive demand coming down when prices rise. Think about how you may drive your car less when fuel prices rise too much.