Supply and Demand

I.          Introduction

We’ve had our first introduction to economics and are ready explore the topic in greater detail.  Remember that this course is about the purchase and sale of goods and services in free enterprise.  By “free enterprise” I mean business transactions with little or no government interference.

The first obvious question about the purchase and sale of goods is this: what determines the price and quantity of goods sold?

We could spend the remainder of this course on that simple question.  Thousands of people and factors affect the pricing of a good or service, so this question is not as simple as it looks.  Assumptions have to be made in order to draw conclusions.  In some cases, price behavior baffles even the greatest experts in the field.

For example, the pricing of stocks freely traded on the stock exchanges is often a mystery.  The value of a company’s stock reflects how much people are will to pay for it.  A company that has one billion shares of stock in the market, valued at $15 per share, has a market value of $15 billion.  Logic dictates that when a stock increases its value, then the company is increasing its overall value.

During the internet “dot-com” boom of the late 1990s, stock prices of companies that were losing money seemed to disprove every basic principle of economics.  Sometimes it seemed like the more a dot-com company lost money, the higher its stock would go!

But that was an exception that could be understood by questioning typical assumptions.  It was also highly unusual.  More often, stock value in a company that consistently loses money declines to approach zero.  The stock value in a company that increases its profits each year increases to reflect those higher profits.

Stock prices on the New York Stock Exchange and NASDAQ (the stock exchange for new and often high-tech companies) are determined entirely by “bid” and “ask” prices of the buyers and sellers.  Someone will “bid” a certain amount to buy a stock, and a seller will “ask” for a certain price.  When the bid and ask amounts equal, then a sales transaction occurs.  Prices can move very quickly and unpredictably when millions of people are involved.

The price that a stock trades on the exchange is where the “supply” by sellers equals the “demand” by buyers.  When a seller of stock asks too high a price, then there are no buyers and the stock does not trade.  When a buyer of stock offers too little a price, then there are no sellers and the stock does not trade.  The transaction only occurs when SUPPLY EQUALS DEMAND.

Today we will discuss this important principle of economics and many of the surrounding issues.

II.        Supply and Demand

For any given good or service, there is a supply and demand.  The supply consists of quantity and price.  The price has enormous influence over the quantity.  No company can afford to build cars to sell at a price of only $1.  But at a sales price of $30,000, a vast number of cars can be built.  The cause is price, and the effect is quantity.

The demand for a good can be described in terms of price and quantity also.  At a given price, there is an amount of demand by the public for the good.  A billion people might buy a car if the price were only $1.  At a much higher price of $30,000, the demand drops to a quantity in the millions range.  At a still higher price of $100,000, the demand falls much further to the thousands range.

Because supply and demand can both be expressed in terms of price and quantity, they can be plotted on the same graph.  The y-axis is typically price, and the x-axis is usually quantity.  The supply curve is usually upward sloping: the higher the sales price, the higher the quantity that companies can produce for sale.  That is because higher sales prices bring in greater revenue to fund the production costs.

Demand curves are usually downward sloping.  The lower the price, the greater the demand.

This brings us to three basic laws in economics:

I. When demand exceeds supply at a given price, the price tends to rise. Likewise, when supply exceeds demand, the price tends to decrease.

II. A rise in price tends to increase supply and decrease demand. Conversely a fall in price tends to decrease supply and  increase demand.

III. Price tends to move to the amount at which the quantity in demand is equal to the quantity in supply: SUPPLY EQUALS DEMAND.

III.       Equilibrium & Information

Note the use of the verb “tend” in the laws of economics cited above.  Companies that consistently lose money “tend” to go bankrupt and out of business.  But it does not happen immediately, especially if the company is large.  It takes time for the market to come to equilibrium.  Ultimately supply does equal demand, but only after enough time and activity passes for the conditions to attain equilibrium.

“Equilibrium” is “where things are going” or where they have already arrived.  The equilibrium for the universe is complete disorder and chaos, with every creature extinct.  A constant increase in entropy is what drives situations to their equilibrium.  (Devolution is the process, not the alleged evolution pushed by liberals in biology.)  Economic equilibrium is when all the imbalances in selling and buying prices have disappeared and there are no more trends to different price levels.  Randomness and profit-making pressures drive pricing to equilibrium.

The ultimate equilibrium when there is perfect competition occurs when the marginal revenue to the seller equals its marginal cost of the product.  In other words, the supplier keeps producing more and more goods until its marginal profit on each extra good falls to very close to zero.  That profit decline may be because the goods are not selling as quickly or due to unsold goods.  For example, the first SUV produced by Ford is sure to sell at a fat profit, but its last SUV in a given year will have to be discounted so heavily that the profit disappears.  Ford doesn’t want to make any more SUVs in a given year that it might have to take a loss on.  It produces just enough so that marginal revenue falls to marginal cost, as best as can be predicted.

Imbalances in information are a reason for the delay in pricing to reach equilibrium.  Buyers do not immediately realize when they can obtain the same good more cheaply another way.  For many years people continued to pay high costs for renting telephones after it became legal to buy inexpensive ones.  The effects of competition are not often felt overnight.  A lower-priced competitor has to educate the public of the availability of its goods, and that takes time.

There is also a more permanent imbalance in information between the buyer and seller of a good.  The seller always knows more about his good than the buyer does.  The seller does not want to disclose the disadvantages, weaknesses, defects, and outright dangers of his good.  The buyer has to beware in paying money to the seller for a good: caveat emptor (Latin for “let the buyer beware”).

Tobacco companies did not want to disclose that cigarettes cause cancer.  Abortion providers do not want to disclose that abortions cause cancer.  Used car dealers do not want to disclose that a car is a lemon (i.e., constantly needs fixing).  Food manufacturers do not want to disclose all the fat and artificial ingredients in their products.

Governmental regulations require some of these disclosures.  This may be the best and only effective type of governmental regulation.  Food packaging now must state what the ingredients are and how much fat is contained.  The buyer doesn’t have to guess about this information.  The buyer must still beware, but can do so with more information than before.

IV.       Price Discrimination

The term “price discrimination” sounds ugly, but it means selling the same good or service at different prices to different people.  It is an attempt by a seller to capture additional money from buyers who are willing to pay more.

Airline tickets are an example.  Businesses are willing to pay more for airline tickets for their employees to travel to business meetings than tourists are.  Why?  Because the businessmen are traveling to make more money for their company, and the airline ticket can be paid out of their profits.  If they are flying to do a deal worth $100,000, then they’re willing to pay many thousands of dollars for the airline ticket.  Not so for tourists who fly.

The airline wants to sell the same seat at a price low enough for the tourist to pay, and then at a different, much higher price for the businessmen.  This is price discrimination, because it distinguishes or discriminates based on who the buyer is.  “Perfect price discrimination” sells each unit of a good at the maximum amount each individual buyer is willing to pay.

There are laws against price discrimination, but most sellers find clever ways to do it anyway.  Airlines distinguished between business customers and tourists by its “Saturday night stay-over” rule.  If the traveler reserves the return flight to include staying over at least one Saturday night, then he is likely a tourist.  If he flies out and back in the same week without staying through the weekend, then he is likely a businessman.  So the airline tickets were then priced much more cheaply for those who stay over at least one Saturday night.

In general, price discrimination depends on the existence of obstacles to prevent buyers from reselling their goods to other buyers.  If the same good is sold at $X to person A and $Y to person B, and X<Y, then person A could buy an extra good and sell it to person B at less than $Y.  The price discrimination would collapse due to the resale market.

But some goods cannot be resold.  Goods that are personal to the buyer, like a tailored suit or dress, cannot be resold.  Price discrimination works fine for personalized goods or exclusive markets, because there is not a resale market to destroy the discrimination.

V.        Minimum Wage and Price Controls

So far we have been talking about economic exchanges in the absence of government controls.  But the government does interfere in many ways in our economy.  America enjoys more free enterprise than any other large country, but we are still heavily regulated.

During World War II, the government imposed controls to prevent companies from raising prices during the war.  The needs of our military for goods increased demand that would ordinarily shift the demand curve and increase prices.  But the government prohibited this from happening by limiting price increases.

Controls on prices (and also wages) were also imposed to control inflation in the early 1970s.  A war in the Middle East, and assistance in that war by the United States of Israel, caused the Arab nations to reduce their supply of oil to us.  That created gasoline shortages and increased energy costs, which then drove up inflation.  Price controls were designed to limit the increases.

Today, the government prohibits employers from paying wages below a certain amount per hour, called the “minimum wage.”  It is now $5.15 per hour.  If you work 40 hours a week for 50 weeks, or a total of 2000 hours, then that translates to a yearly salary of $10,300.  It is nearly impossible to support a family that amount in most areas of the country, and many politicians are constantly demanding an increase in the minimum wage.

Unfortunately, it is even more difficult to survive without a job at all, which is what happens to many people (particularly teenagers) when the minimum wage is increased.  Employers who would hire someone to work at $4 per hour might not be able to hire them at $5.15 per hour.  Isn’t a job at $4 an hour better than none at all?

Moreover, illegal aliens find a wage of even $2 an hour better than what they could make in their homeland.  Companies move operations offshore to take advantage of places that do not have minimum wages as high as ours.  Alternatively, workers enter this country illegally to work at low wages and displace American workers, according to several lawsuits.

VI.       Socialized Medicine

The single biggest industry in the United States is health care, and it is sharply increasing in expenditures each year.  It has three major components: government-controlled (Medicare and Medicaid), insurance-controlled, and private pay or uninsured.  Each year, the demands for the government to take over the field grow louder, as insurance costs skyrocket.

Most other countries have some form of socialized medicine.  In the countries of Canada, North Korea and Cuba, it is actually illegal to pay money to a doctor simply to see you.  The government control there is so great that you can only see a doctor paid by the government in those countries.  In England, there is a two-tiered system: good care is provided to those who can afford to pay for it, and free but inferior care is provided by the government to those who cannot.

The Canadian government destroyed free enterprise in medicine there, and took over the health care system.  The government now sets limits on wages and prices.  Lowering the wages and prices prevents supply from rising to satisfy demand.  Because demand is much greater than supply, patients have to wait a long time to see a doctor.  There is a lower survival rate from cancer in Canada than the United States because of the delays in diagnosis and treatment there.

If an elderly Canadian is vacationing in Florida and falls and breaks his hip, which is very painful, the Canadian system of health care will not even reimburse the patient for surgery at the nearest hospital.  Instead, the patient must fly back to Canada in excruciating pain to be operated on by a government-controlled doctor there.

In the United States, where health care still includes free enterprise, a patient can enter a doctor’s office or hospital at any time and receive services based on a promise to pay for them by check or cash.  Prices vary, and it is worth shopping around.  But immediate access is available.

VII.     Assignment.

Read and, if necessary, reread the above lecture.  Then read the Wikipedia entry for “supply and demand”: http://en.wikipedia.org/wiki/Supply_and_demand

Homework questions:

  1. In a free market, the price and quantity at which goods are sold are where _____ equals _______.
  2. Suppose the price demand curve is P = $20 – Q, where P is price and Q is quantity.  Also suppose the price supply curve is P = $4 + Q.  At what price and quantity will the good be sold?
  3. What is the supply and demand for a non-scarce (i.e., free) good?  What is the supply and demand for a good that cost $1 trillion dollars?  (Note: no individual or company or even the U.S. government can afford to pay $1 trillion to buy a good).
  4. Suppose 1000 persons in a town each have the following weekly demands for gas, and the gas stations have the following weekly supplies:

    Gallons Demand
    Price/gallon
    Supply
    Price/gallon
    10 $2.50 $.50
    20 $2.00 $.75
    30 $1.00 $1
    40 $.75 $1.50
    1. What is the price and overall quantity of gas sold each week?
    2. Suppose Congress declares war and imposes a price control of $.75 per gallon.  At what price and overall quantity will gas sell each week?
  5. Suppose you went to see the opening of your favorite new movie, but it is sold out.  However, there are four independent scalpers selling tickets outside.  (A scalper is someone willing to resell his ticket, usually for a higher price.)  You and three strangers are each willing to pay at most $15, $10, $9 and $8 for a ticket.  The scalpers are initially willing to sell each of their tickets for at least $7, $8, $9, and $12.  The eight of you get together and bargain, and then tickets are sold at a common price.  What is the price and how many tickets sell at that price?
  6. Explain price discrimination.  Is it a friend or foe of free enterprise?
  7. The demand curve for cash-only medical services depends on the alternatives, which consist of third-parties like insurance companies or the government paying for medical care.  Third-party payers have been increasing costs for patients in the form of “co-pays”.  Many patients now have to pay $20 as a “co-pay” when they see a doctor, even though they have insurance.  What effect does an increase in “co-pay” have on the demand curve for cash-based medical services that disfavor or reject insurance as payment?  Explain.
  8. It has been said that the only good governmental regulations are those that require disclosure of information by sellers to buyers.  Do you agree?  Explain.
  9. Consider the supply and demand for workers (labor).  What effect would the minimum wage have on the demand for employment of illegal aliens, assuming that they can be paid in ways that circumvent the minimum wage laws?

Extra credit (4 points each for questions 10 and 11; 6 points for question 12):

  1. Define “invisible hand” as best you can in your own words.  What causes the “invisible hand”?  Where would we be without it?
  2. How can misinformation or lack of information distort demand?  Give an example.  Do sellers have an incentive to mislead buyers?
  3. Suppose you were planning a dinner to raise money for charity.  You would invite a speaker and reserve a number of seats for dinner, before you know how many people will purchase tickets.  Assume the meal will cost $30 apiece.  What price would you set for (i) one person, (ii) a couple, (iii) children and (iv) a table of 10?  Explain, mentioning price discrimination.