Supply And Demand: Managerial Decision Making

Tea is the most popular beverage in the world in terms of consumption. Its consumption equals all other manufactured drinks in the world including coffee, chocolate, soft drinks and alcohol put together (Macfarlane, 2004). Most consumed tea outside East Asia is produced in India and Sri Lanka, which is intended to be sold to large enterprises. Unilever, the largest tea company in the world and as the international buyer of 12% of black tea in the world and selling finished products packaged tea in 130 countries, Unilever is in a central place to have a significant impact and difference. These teas are scarce and expensive, and may be compared with some of the most expensive wines in this regard. India is the world’s largest tea drinking nation, though the per capita consumption of tea consumption remains a modest 750 grams per person per year (Ceylon tea portal, 2009). Turkey, with 2.5 kg of tea consumed per person per year, is higher per capita consumer in the world (Market search world, 2009).

Supply and Demand is one of the most important factors that determine the production of tea. The quality of tea is affected by a number of factors and can be classified into 4 main factors, namely, cultivar, environment, cultural practices and processing techniques of tea. Small changes in the handling of each step can affect the final quality, including appearance, color tea liquor, aroma and flavor. It is not surprising to find that the qualities of the teas from a batch of fresh leaves can vary greatly from every individual processor (Chui, 1990).

Economics is the study of what, where and for whom to produce and is central to all managerial decision making whether at the level of the firm, household or government (Philp, Wheatley, Galt, 2009). The company looked into is Unilever and an in-depth analysis of the Global tea market is done. Due the high fluctuations in the supply and demand of tea, it becomes a challenging task for managers to make decisions. The report talks about how managers make decisions even in these fluctuations. The principles of demand and supply and the role of the invisible hand, the economies of scale are explained, finally ending with a summary and conclusion.

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Theoretical Section

The principles of supply and demand are fundamental to the study of markets (Philp, Wheatley, Galt, 2009). It is a model to determine a price in the market. In a competitive market, price will level the quantity demanded by customers and the quantity supplied by producers, creating a balance in price and quantity.

Supply and demand is perhaps one of the most fundamental concepts of economics and is the backbone of the market economy. Demand refers to what Quantity of a product or service is desired by buyers. The amount requested is the amount of a product people are willing to buy at a specific price. The relationship between price and quantity demanded is known as demand relationship. Supply represents how much the market can offer. The quantity provided refers to the amount of a particular good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is available on the market is known as the supply relationship. Price is therefore a reflection of supply and demand.

The Law of Demand

In mainstream economics effective demand is driven by a number of factors which include the price of the good, income levels of consumer, prices of substitute goods, social and climatic factors. Therefore for the production of tea, the quantity demanded (QDi) is a function of its price (pt), the income levels of each of the (n) consumers (Y1….Yn), the price of substitute goods such as coffee and chocolate drinks (c1….ci-1) and various social and climatic factors (S). Hence the market demand can be written as

QtD = f (pt, Y1… Yn, c1…ct-1, S)

In the analysis of supply and demand, they will often hold the factors constant and analyze markets solely in terms of price. The bar above the factor signifies a constant and hence market demand can be re written as

QtD = f (pt, Y1… Yn, c1…ct-1, S)

The law of demand says if all other things were equal, the higher the price of goods, the less the demand will be. The quantity of tea purchased by customers at a higher price is generally lower because the price of tea increases and so does the opportunity cost of buying tea. As a result, people will naturally avoid buying tea which forces them to give up drinking something else (ex – coffee, chocolate, soft drinks and alcohol) which they value more. The below chart shows that the curve is a downward slope.

Fig 1

In Fig 1, A and B are the points of the demand curve. Each point of the curve reflects a direct relationship between the quantities required (Q) and price (P). Thus, at point A, the quantity demanded is Q1 and the price is P1. Demand curve shows the negative relationship between price and quantity demanded. The higher the product price, the lower quantity is demanded (A) and lower the price, the greater the quantity demanded (B).

The Law of supply

Suppliers are also motivated by price. Factors affecting supply are the price of the good, cost of production, technology used and other factors such as climate and tax. As the price rises in a competitive market existing firms will be motivated to try to produce and sell more, and new firms will be motivated to try to produce and sell more, and new firms will be encouraged to enter the market. This is what has happened with the production of tea until the recent past where supply has exceeded demand. Hence, quality supplied is usually deemed to be positively related to price. The price of the good (pt), the cost of the goods used in the production process (F1, F2 …Fm) and the wage rate (w) determine the quantity of a good which will be supplied. The function T reflects the state of Technology at a given point of time. Hence the market supply can be written as

QtS = T (pt, F1, F2 …Fm, w)

As with the theory of demand, mainstream economics tends to analyze supply mainly in terms of price. Thus, they assume in the first instance that factors other than price are constant. Hence the market supply can be written as

QtS = T (pt, F1, F2 …Fm, w)

Just like the law of demand, the law of supply demonstrates the quantities that will be sold at a fixed price. But unlike the law of demand, supply relationship shows an upward slope. This means that the higher the price, higher the quantity supplied. The producers supply more tea at a higher price as it increases the revenue.

Fig 2

In Fig 2, A and B are points on the supply curve. Each point on the curve reflects a direct correlation between quantities supplied (Q) and price (P). At point A, the quantity supplied will be Q1 and the price will be P1, and so on.

Unlike the demand relationship, the supply relationship is a factor of time. Time is important to supply because suppliers must react quickly to a change in demand or price. So it’s important to try and determine whether a change in price caused by demand will be temporary or permanent. For example, rapid economic growth in many developing countries like China, India and Russia, has led to an increase of middle class consumers with high disposable income. These consumers have shown the premium market behavior, increasing their purchases of packaged tea, branded and specialty varieties. The growing health and concern trend has been a major driving force for increasing the value of tea in world market. These people are willing to pay more for the advertised health benefits of tea varieties such as specific herbal and fruit teas (Aginsky, 2009). The change in demand and price will be expected to be long term and suppliers will need equipment and production facilities in order to meet the long-term levels of demand.

When supply and demand are equal, the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of tea being supplied is exactly the same as the amount of tea being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the tea dust that they have produced and consumers are getting all the tea that they are demanding.

Fig 3

As shown in Fig 3, equilibrium occurs at the intersection of demand and supply curve, which indicates no allocate inefficiency. At this point, the price of goods will be P1 and the quantity will be Q1. These elements are referred to as equilibrium price and quantity. In the real market, equilibrium can only be achieved in theory, so that prices of goods and services are constantly changing in relation to fluctuations in demand and supply.

Imbalance occurs when the price or quantity is not equal to P1 or Q1. If the price is too high there is a possibility of excess supply being created within the economy and there will be allocative inefficiency.

Fig 4

At price P1 the quantity of tea that producers wish to supply is indicated by Q2. At P1, the amount consumers want to consume in Q1, much smaller quantity Q2. Because Q2 is greater than Q1, too much is produced and too little is consumed. Suppliers produce more, which they hope to sell to increase profits, but those consuming the goods will find it less attractive and buy less because the price is too high.

World tea production grew by more than 3% to an estimated 3.6 million tons in 2006. The record production levels of tea in China, India and Vietnam in 2006 offset declines in major tea producing countries. The size of the global tea market in 2007 in terms of retail value was 23.323 billion U.S. dollars and in terms of sales volume was 1,765 million kilograms (GMI cited in Aginsky, 2009). The annual rate of growth of world tea market for the period 2006-07, in terms of sales value was 4.5% and in terms of sales volume was 3.5%. The world per capita consumption of tea in 2007 was 0.3 kg. Driven by double digit growth in sales of black bags of specialty tea, green tea and other types, the global tea market is expected to grow by almost 10% in value and over 13% in volume between 2005 and 2010 (Aginsky, 2009).

From 2004 through 2007, global supply of tea has exceeded demand. Graph 4 below, shows the global supply and demand statistics for tea during that period.

(Fig 5 Aginsky, 2008 cited in TBI, 2008)

As we see in the above graph, world supply has exceeded the world demand of tea, which has caused an imbalance of the market, making the wholesale prices of tea to drop down. There is the existence of the invisible hand in this matter, as we see that demand has had fluctuations due to either mid class consumers now opting for better quality tea or because of tea plantations being expanded and cultivated extensively in the tea producing countries.

As the global supply of tea has consistently outstripped world demand, the major tea producers have been applying different marketing strategies and focus only on those markets with high growth rates. Given the dynamics of supply and demand of tea, understanding of market needs and development of niche products or specialty tea becomes crucial for market players.

Excess demand is also created when the price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not supplying enough of it.

Fig 6

In this situation, at price P1, the quantity of goods demanded by consumers is Q2. In contrast, the quantity of goods that producers are willing to produce at this price is Q1.Therefore, there are very few goods produced to meet consumer demand. However, as consumers have to compete with one another to buy the goods at this price, demand will push the price, making suppliers want to supply more and bringing the price closer to equilibrium.

Empirical Context

Though the supply of tea exceeded the demand until 2008, it has never been stable. The prices of tea have increased as the demand for tea has exceeded supply now. Figures just released by the Office for National Statistics show the cost of Tea has already risen by 2.5% in February this year (FAO, 2010).

Now the question remains as to why demand of tea has risen all of a sudden? Demand has remained strong, despite economic downturn. Even if incomes fall, consumers see tea as an essential item. We can say demand for tea is income inelastic. Tea may even be considered as an inferior good (ie, as incomes fall due to recession, people may buy tea, rather than more expensive drinks). There has been a growing demand from China, which is developing a taste for drinking more tea. There have been draughts in the major areas of production such as India, Sri Lanka and Kenya leading to lower supply of tea (Business Intelligence, 2010). The nature of growing tea is that producers can’t easily increase supply in the short term. Demand is price inelastic. A small rise in the price of tea doesn’t deter consumers from buying it. There are few alternatives to tea, and it is only a small % of income. Therefore, the higher prices aren’t reducing demand.

Fig 7

In Fig 7, we see that though the price has increased from P1 to P2, due to the supply available (S2) for tea, the demand still had an increase from D1 to D2.

Having studied the Supply and Demand of tea, let us take a look at Unilever, which owns the biggest brands in the tea industry such as Brooke Bond and PG tips. Unilever is a multinational company, formed by British and Dutch ownership, which has many of the brands in the world of consumers in food, beverages, cleaning products and personal care products.

Unilever’s economies of scale –

Specialization –

Agriculture provides more than two thirds of the raw materials for Unilever brands. On the basis of its reputation of best practices, Unilever is now an industry leader with Sustainable Agriculture Initiative. The way forward, is to develop Environmental sustainable supply chains that offer benefits to create value for the stakeholders and meet the needs of consumers, now and in the future. Sustainable agriculture is productive, competitive and efficient, while protecting and improving

the natural environment and conditions of local communities.

Technical economies –

Production of crops with high yield and nutritional quality is being done to meet current and future needs, while keeping resource inputs as low as possible. It ensures that adverse effects on soil fertility, water and air quality and biodiversity of the agricultural activities are minimized and the positive contributions are made whenever possible. It optimizes the use of renewable resources and minimizing use of nonrenewable resources. It also enables local communities to protect and enhance their welfare and environments (Cultivating sustainable agriculture, 2001).

Financial economies –

Unilever owns more than 400 brands, as a result of acquisitions. However, the company focuses on what are called the “billion dollar brands – 13 brands that each reach annual sales exceeding 1 billion €. Top 25 Unilever brands represent over 75% of sales (Unilever, 2010). The brands fall almost entirely into two categories: food and beverages, household and personal care. In this way, the losses are recouped by profits from its successful brands.

Marketing Economies –

Unilever has different brand names for several of its items. In this way each product stands on its own, when it comes to customer sales. It is also mentioned that the Brand is a part of Unilever, so that the customers are assured of quality standards. In 2008, Unilever was honored at the 59th annual Technology and Engineering Emmy Award for outstanding achievement in Advanced Media Technology for the creation and distribution of interactive commercial advertising delivered through digital set-top boxes (emmyonline, 2009).

The diseconomies of scale –

Being a global organization, the recession caused a drop in Unilever’s profits, forcing it to resize its work force. Unions representing employees of Unilever worldwide have registered a number of complaints about the company, including tens of thousands of jobs lost in recent years. Many former Unilever employees are outsourced, unions leading to write about “the vanishing Unilever worker”. In December 2007, a global day of industrial action against Unilever was called (IUF, 2009).

Summary and Conclusion

Based on the supply and demand of tea and the economies of scale available, managers try to maximize profits by trying to have the marginal costs equal to the marginal revenues at all times. Due to the rising demand of tea in the recent past, managers at Unilever have come up with the concept of sustainable tea. Unilever anticipates certified tea can be priced 10-15% higher than currently searching for tea auctions, allowing producers around the world to collect 2 million pounds more for their tea in 2010 and another 3 million pounds in 2015 (Mabbett, 2009). This decision will transform the tea industry, which has been suffering for years from oversupply and underperformance. The company believes the program has the potential to reassure consumers about the origin of tea to enjoy drinking, while allowing brands to differentiate the company from competitors. Farmers are only one side of the equation of tea. Sustainable tea will work if consumers maintain their consumption of tea and those in the middle, and packers and distributors are able to buy and sell at a profit. That is why the unilateral price manipulation is in favor of producers at the expense of consumers. The supply and demand fluctuations make it very complicated for the managers to make decisions. The supply in the last two years has fallen because Tea producing countries as distant and different as China, India, Sri Lanka, Indonesia, Turkey and Kenya had been badly hit by world oversupply and falls in real price paid for tea. They are now opting for alternate crops.

Unilever formally announced its aims in mid 2007. Consumer focus is on the UK, a market downing 60 billion cups a year. Tea producing nations around the world are affected by the current price malaise. Unilever are hitting the right notes and striking the right balance as far as consumers are concerned, and especially in the UK market. Unilever wants to be at the very front of this brave new world of tea. Certification will help to roll out the standards to the rest of the supply chain and credibly tell the story to consumers.