The Laws of Supply and Demand
The principles of supply and demand stem from individual economic theories based on peoples’ reactions to incentives. These theories are so predictable that they are called laws. The two economic laws are: the law of supply and the law of demand.
The law of demand says that consumers should be willing to buy (demand) more of a good as the price falls. For example, if you see something on sale, you are likely to buy more of that good than if the price had not been reduced. With the lower price, you have the incentive to buy more units than you normally would purchase.
This assumes that all other factors affecting a consumer's decision stay the same. If we didn't assume that all else stayed the same, it would impossible to make generalizations about behavior. For instance, if price falls because the product has been declared unsafe, we may still see the number of items purchased fall and not increase, as the law of demand would otherwise predict. When economists speak about the laws of supply and demand and their effect on peoples' behavior, they assume that only the price changes – all else remains constant.
The reverse of this law is also true. If price rises, consumers will demand less of that good. This is exactly why we assumed, at the beginning of the course, that increased speeding fines would reduce the number of speeders. As the price of speeding tickets rises, drivers demand less speeding.
The law of supply is similar to the law of demand, but moves the opposite direction. It focuses on the producers, or suppliers, of goods. It says that more of a good will be supplied as the price rises, assuming all other factors stay the same. If the price of computer chips suddenly spikes up, you can be sure that Intel and other manufacturers will respond by making more chips. Computer chip manufacturers realize they will make more money with the higher prices, so they have the incentive to produce more.
Conversely, if prices fall, suppliers will not bring as much product to market. The laws of supply and demand hold true because of the proper self-serving incentives given to the consumers and producers, which we will discuss shortly.
As stated earlier, it is the supply of and the demand for any product or service that determines its value. For any given demand of a product, as the supply rises, its value will fall. Likewise, for any given supply, as the demand rises, so will its price. Notice that supply and demand tend to counterbalance each other. For example, if consumers suddenly want more of the good and drive the price up, suppliers then have the incentive to produce more, which tends to bring the price down. Conversely, if consumers suddenly want less of the good and prices fall, suppliers will produce less, which tends to drive the price up. Eventually a point is reached where the amount that consumers demand is exactly equal to the amount that is supplied and price equilibrium is reached. At equilibrium, the price is no longer jumping up or down because there is no net buying or selling pressure. When the market is in equilibrium, that price is said to clear the market. In other words, every buyer willing to buy at that price is exactly matched with a seller at that same price and there are no surpluses or shortages of buyers or sellers.
While these economic concepts of incentives, supply, and demand may sound fairly simple, it is best to demonstrate with an example to show just how powerful their predictive values can be.
How Much Should You Charge?
Good news! Your wealthy uncle has just left you a large plot of land. The bad news is that it's in a desert. The good news is that it is home to the only oasis around and you discover there is an average of ten tourists per day passing by who want water. Understanding that water is essential for life, you feel you could make a killing by selling it to the tourists.
We'll assume the oasis can provide an endless supply of water, so there are no restrictions on supply. Now let's present some economic questions and see how the laws of supply and demand apply. How much water will you sell daily? How much should you charge?
Many who do not understand economics will tell you to charge an "outrageous" amount since you are the only supplier around, which is called a monopoly. Okay then, should you charge $50, $100, or just go in for the kill and charge a million dollars? Hopefully you are starting to understand why supply alone does not determine price. Even monopolies must consider the valuations – or demand – that people put on their products or services.
In order to answer the questions of how much water will be sold and what price you should charge, we need to know to what extent people desire the water at your location. In other words, we need to estimate their demand. To make things easy, you hire a marketing research firm, which finds that each tourist typically wants one liter of water and that the usual amount each person is willing to pay is shown in Table 1 below:
Table 1
Once we know the maximum amount each person is willing to spend, it's easy to predict how many liters will be sold and at what price. Because we know the seller (you) and buyers are acting in their own self-interest, economists would make the following predictions: Six liters will be sold daily for a price of $6. Despite the outrageous amount of money you could charge, you should charge six dollars and expect to make $36 per day.
Why would economists arrive at those answers? Our basic economic principles discussed earlier can supply the answer. Suppliers are only interested in doing what's best for them – they are interested in maximizing their profits. Let's assume the research firm didn't understand economics and told you to charge $100, since it is an "outrageous" price and the proper pricing scheme used by monopolies. If you followed their advice, what will be your total revenue per day? At $100 per liter, you will have no sales because none of the tourists valued your water at $100 or higher. Your profit will be zero.
Maybe you should charge $11 per liter since, according the data, there is someone (tourist #1) who is willing to pay that much for it. If you charge $11, you will sell only one liter and the total revenue generated will only be $11. However, if you reduce the price, the law of demand tells us you should, at some point, see new buyers appear. If you charge $10, for example, then tourist #1 and tourist #2 will both buy. Tourist #1 values one liter of water at $11 so will certainly pay the reduced price of $10. Because two liters are sold for $10, your total revenue is now $20, exactly double the amount you’d receive if you charged $11. We can continue this line of thinking and get the following results in Table 2:
If you look at the total revenue column in Table 2, it is easy to see why economists would predict that six liters of water would be brought to market and sold for $6 each (highlighted in yellow). That’s the point where profit is maximized for the seller. If the price is $6, tourists number one through six will all purchase one liter for a total revenue of 6 tourists * $6 per liter = $36 revenue. Any other price results in lower profit. By acting in your own self-interest and seeking to maximize your profits, you will charge $6 per liter and exactly supply the number of people willing to pay that price. To do that, you must find a balancing point between supply and demand; you must find the equilibrium price.
It should now be obvious that sellers do not just pick high prices out of the air – even if they are a monopoly. Sellers are constrained by the demand, the perceived value in the minds of consumers, and price products accordingly. In this example, you could choose to charge $11 in order to take advantage of the highest bidder or try to "price gouge" by charging $100, but you choose not. This decision was not for benevolent reasons but rather for self-serving reasons. You wanted to maximize profits.
The buyers are acting in their self-interests too. As long as one liter of water is priced at or below their perceived value, they will buy. In other words, as long as costs do not outweigh the benefits, they will respond accordingly and buy. At a price of $6 per liter, the first tourist will certainly buy because he feels it is worth as much as $11 but only has to pay $6. In this case, the benefits ($11 worth of water) outweigh the cost of $6 so he will purchase. Tourists seven through ten think it is worth no more than $5 per liter so will certainly not pay $6. All tourists therefore are doing what's best for them. While we don't have the room to show it, just understand that it is an interesting fact of economics that buyers and sellers acting in their own self-interests actually create the most competitive prices.
Notice a special characteristic about the $6 equilibrium price. It acts to “clear” the market, which just means that all buyers willing to pay $6 can do so. There are no surpluses or shortages of buyers or water. The supply of water exactly matches the demand.
We just found out that an equilibrium price acts to clear the market by exactly matching the number of buyers with the goods offered for sale. However, if you decided to sell water for a price below $6, you’d end up with a line of buyers whose orders could not be filled. On the other hand, if you charged a higher price, you’d end up with a stack of inventory. At this point, it’s important to understand that any price other than equilibrium creates a long line. You’ll get a long line of buyers if prices are too low and a long line, or buildup, of inventory if prices are too high. It’s only when prices are just right – equilibrium – that no lines are formed.
This will be especially helpful to understand when we talk about inflation and how the Federal Reserve attempts to combat it. If the price is too high, lines of inventory are created. When price is too high, there are many consumers who do not buy and the business is stuck with excess inventory. Conversely, if price is too low, lines of people will form at the doors since the business cannot handle (supply) all of the demand at that price.
For example, if you chose to price the water at $5, then there would be seven people willing to pay that amount but only six liters available, which is a shortage of water and you, would know to raise prices. By raising prices, the law of demand tells us that buyers start to fall out of line. Sellers can therefore use price to change behavior and control the number of buyers that show up.
Likewise, if you priced the water at $7, then only five people would be in line yet you’d only have six liters to sell, which is a surplus of water (buildup of inventory). You would know to lower the price. By lowering prices, the law of demand tells us that additional buyers will show up. Once a price of $6 is reached, all six liters are sold and nobody is left standing in line and you are not left holding any inventory – the market is cleared. Remember that if the seller is left with a line of inventory, prices are too high and will eventually fall. If buyers are standing in line, prices are too low and will eventually rise.
A realistic example of this fact is often seen at concerts where ticket prices are often controlled by the government. The government restricts the upper prices of tickets (called a price ceiling) since tax dollars are used to build arenas and the government wants to make it "fair" for everybody to participate in the events held at the arenas. Because of the price restriction, the price is often far below equilibrium (there is excess demand) and it is not uncommon to see very long lines of people camping out in front of the gates the night before tickets go on sale. You will also hear many people saying they wanted to go but couldn't get tickets. These are all clear signs of price being too low. In normal operating markets, the people in line would start to compete for tickets by increasing their bids for the tickets. Once this happens, some of the buyers start to drop out of line because of the new higher price. The price continues to rise until it is in equilibrium and the market is cleared meaning that every person who wanted a ticket (at that price) got one.
Government restrictions cause market inefficiencies and this is why economists are so against price controls. In this example, the price restriction didn't make the concert "fair," it simply changed who got to go and gave the arena less money in the process. For example, say tickets are priced at $20 and well below the fans' perceived value and there are long lines forming because of the excess demand. Now let's suppose there is a prominent businessperson in the area who is willing to pay $200 per ticket. But the long wait in line has effectively increased the cost of the ticket (opportunity cost) well above their perceived value. The businessperson may lose thousands of dollars in business -- lost opportunity – by waiting in line for the ticket, which is not worth a ticket valued at $200 in their mind. The businessperson chooses not to go and the arena only gains $20 on a ticket the businessperson would have paid $200 for.
Now you may think the businessperson could pay someone to stand in line for them and still get to go. Let's say they pay someone a maximum of $180 to stand in line to get the ticket. That way, the businessperson spends a total of $200 for the ticket, which is the value of it in their mind. However, the arena gains only $20 on the ticket while somebody else gains $180 for his time in line, and the businessperson gets to attend the concert. Wouldn't the arena be better off taking the additional $180 instead? And what about the people camping out all day and night waiting for the box office to open? Is that the most efficient use of their time? Or are there serious opportunity costs by having many people sleeping on the sidewalk waiting for the ticket booth to open?
No matter how you analyze it, the arena fills its stands for far less money than if they let market forces determine the price. Ironically, the businessperson probably paid more taxes toward the arena, yet cannot attend. Keeping the businessperson out of the concert is no fairer than keeping someone out who cannot afford a $200 ticket. If the arena is built to generate revenue, it should do so efficiently and maximize profits. Government price restrictions do not make things fair; they just change who gets it in a very inefficient way.
When competitive forces set price, products and services are rationed so that everybody willing to pay that price can have one – the market it cleared. If the government caps prices, you can be sure there will be shortages of goods and long lines of people. For example, in Florida we often have hurricane warnings during the summer months. Whenever hurricane warnings are issued, people become worried that water supply lines may be broken, possibly for extended periods of time, and rush out to stock up on bottled water. Of course, the supermarkets would like to respond appropriately, as any business seeking to maximize profits would, and raise the price of bottled water. This is only sensible since the store cannot immediately supply more water on the shelves, yet the value of it, which is set in the minds of buyers, has been raised significantly.
But then the community goes into an uproar and screams "price gouging" until the government comes to the rescue and caps the price of the bottled water (and nearly all other essential goods). If you've ever been in a supermarket under these conditions, you know the outcome of the government's actions. The checkout lines wrap through several aisles in a never-ending fashion and end at the meat department in the back. But the most damaging effect of the price ceiling is that there is not one bottle of water, of any size, on the shelves.
The government's attempt to make things fair only keeps many people from getting water under the now higher demand conditions. You will see one person in line with 12 gallons of water, priced at $1 each, and many people staring at empty shelves willing to pay far more per gallon. Under the higher demand conditions (the prices that exist in consumers’ heads), the person in line with 12 gallons feels it is a very good deal at $1, so does what's best for him, which leaves everybody else with nothing. If the store was allowed to raise prices, people would buy less, which leaves more on the shelves, shortens the checkout lines, and maximizes store profits.
You may be thinking, certainly there must be some benefit from the lower prices. What's missing in the analysis? There's nothing missing. The value that some people gained from the lower prices was transferred from those who got none. For example, say there were two people left in the community who wanted water, Fast Eddie, the one in line with 12 bottles, and you. Fast Eddie beats you to the supermarket and grabs the last 12 bottles priced at $1. The supermarket makes $12 revenue.
Now let's back up and assume the government lifted the price restriction and the store prices the last 12 bottles of water at $4 per gallon just before Eddie arrives (the store manager is just a little faster than Eddie). Assume Eddie only wants six gallons at a price of $4, which leaves six gallons for you. If you buy all six, the store now makes $48 revenue instead of $12 because the store sells 12 gallons for $4 each instead of $1. On the surface, it appears that the store made $36 in excess gains (the difference between $48 and $12) at Eddie's and your expense. This is the "price gouging" effect the community is initially screaming about. They see it as a store taking advantage of conditions and charging "outrageous" prices and gaining an extra $36 for something only "worth" $12.
But your new understanding of economics reveals that's not the case. Where did the $36 extra come from? By raising the price, Eddie reduces his purchase to only six gallons so the store receives $24 from him but loses the sale of the additional six gallons for $1, a difference of $24 - $6 = $18. Because of the higher price, Eddie leaves six gallons on the shelf, which you pick up for $4, and a net gain of $3 to the store. Remember, the store can either sell the six bottles to Eddie for $1 or to you for $4, but not both. It must make a choice and decide whether it is better for the store to take the $6 from Eddie or take the chance on getting an additional $3 from you. Economics is about tradeoffs.
The store is better off by $3 by selling you the six bottles for another gain of $18. The $18 gains to the store from both Eddie and you total $36. So the additional $36 the store gains is not due to price gouging. It reflects the higher price you were willing to pay and that Eddie was not. The higher price does its job and forces Eddie to share with you. The government restrictions simply removed your equal opportunity to bid for water and left you with none. When the price was restricted, the $18 premium you were willing to pay was transferred to Eddie. Again, government price restrictions don't make things fair; they only change who gets what.
Inefficiencies with price restrictions don't stop there. What would keep you from approaching Eddie in the parking lot and offering him $4 (or more) per gallon? If he agrees to sell you some, the store misses out on the revenue (not to mention the government will likely miss out on the tax), you get the water and everybody else involved, including the government, is worse off.
I may think another grocery store item, say milk for example, is outrageously priced at $3 per gallon. If it were priced at 50 cents per gallon, I would buy several gallons. However, under the "price gouging" scheme of the farmers and supermarkets, I reluctantly buy only one gallon – but that gallon is always there every time I go to buy it. Consequently, I also know it's always on the shelf every time you go to buy it too, and now you know why. Price acts to ration a given supply of goods. However, the government's actions to save people from hurricane "price gouging" prices only guarantees that many will be left without water. A store cannot "price gouge" any more than you could by trying to sell water in the desert for $100. All products and services are bounded by the perceived values in the consumers' mind.
We've said that price serves a rationing function and now you've seen it work. It acts like a faucet handle, which can either increase or decrease the flow and regulate the number of buyers and sellers. If you need more buyers, lower price. If you want fewer buyers, raise price. Need more supply? Raise your bid. If you want less supply, lower your bid. These laws of supply and demand insure that there are no excess buyers and no excess goods for sale. How? Because that's where sellers maximize profits and the market is cleared with buyers obtaining the lowest price. Consumers acting in their own self-interest ensure that it happens.