Mr. Moderate

It is popularly presumed that most people who live in the modern age naturally understand the Law of Supply and Demand. However, as it actually operates, the law is so complex that I presume few of us actually do understand it. Or, to put it another way, the popular conception of the law is substantially wrong because there are too many presumptions made that are untrue in most real life cases. I’m going to attempt in this brief essay to explain the main points in ways that most people ought to be able to understand.

The basic understanding of the Law of Supply and Demand is that the market price of some particular good or service is established by determining the point at which the demand for that particular good or service exactly matches the available supply. In theory, then, as the supply increases without other changes, the price will be driven down to establish a new balance point where the new demand exactly matches the new supply. And similarly, if the demand increases without other changes, the price will be driven up to establish a new balance point where the new demand exactly matches the new supply. The mathematical relationship is therefore expressed as price being directly proportional to the demand and inversely proportional to the supply.

But of course, things are never quite that simple in real life. There are many factors which distort the natural operation of the Law of Supply and Demand and make the actual results quite a bit more unpredictable. We will now look at a few of them.

The most obvious factor that distorts the natural operation of the Law of Supply and Demand is a measurement called “the elasticity of demand.” Elasticity of demand means that some products will experience dramatic shifts in demand for small changes in the price. Such products are said to have a “highly elastic demand curve.” Other products are unlikely to experience much change in demand due to price changes. Those have an “inelastic demand curve.” One way to view these concepts is to say that products of the first type are viewed as luxury items (the purchase is highly optional) while products of the second type are viewed as necessities (the purchase is necessary regardless of price). But the popular conception of the Law of Supply and Demand is that a change in price will always increase or reduce the demand by an amount necessary to come about equal to the supply. However, due to the differences in elasticity of demand, that might not always be the case, and so market inequalities may result until other factors can come into play (such as a producer making adjustments of the supply amount).

Elasticity of demand is, to at least some extent, a measurement of both the psychology and habits of the buyer community. If I am in the habit of taking a two week driving vacation every summer, the price of gasoline will need to go up a great deal before I will decide to substitute another vacation plan. The vacation plans are worth such a great deal to me, psychologically, that I will not change those plans for anything short of a catastrophic increase in the price of gasoline. Similarly, the gasoline I buy to travel to and from work will tend to be viewed as a necessity. I can’t get to work without it, and it will take a lot to make me change my work driving habits (to car pool or take public transportation). For reasons such as these, gasoline is generally viewed as having an inelastic demand curve.

But, because the psychology of the buying community is subject to influence from mass media, the demand curve itself can be shifted based upon buyer expectations. For instance, those of us who lived through the gasoline mess in the 1970s might more quickly make changes in our personal buying habits in anticipation of future lines at the gas pumps. Economics is a highly inexact science because it tries to predict how a mass of humanity will react to some particular economic change.

Elasticity of demand has its counterpart among suppliers. There are substantial lead times involved in the production of most products, and as for services, there is a limited supply of skilled labor to perform most services. So, if the demand for a particular product or service increases, the supply cannot instantly increase to meet that demand, even if the price is raised substantially. Most farm crops are produced on an annual basis, meaning that the farmer will decide once a year (usually in the late fall or early winter) how much seed to order for the next year, and that decision will set the farmer’s crop size for the next crop year. Any changes in price or demand after the decision to plant has been made cannot influence this year’s supply. Similarly, manufactured products have a production cycle that must be made to balance with the demand, but of course, it lags by some degree or another any changes in the marketplace.

The Law of Supply and Demand works best when there are a large number of sellers and buyers, each of whom is under no unusual pressure to buy or sell at a particular time and place. But the fact of the matter is that sellers are highly motivated by their own profit prospects to create monopolies. So, anybody who goes into the business of selling a product or service will naturally attempt to establish his or her business at a place where they can easily monopolize the market. If you have the only gas station at the only freeway exit for many miles in each direction, you have considerable flexibility in setting prices much higher than you might get away with otherwise. Of course, it does not take too long for buyers of gasoline to come to understand that pricing strategy, and to attempt to plan their purchases at places where competition will keep the prices much closer to the usual market price.

For reasons such as this it is inherent in the planned development of most major shopping malls that the lease contracts for businesses of type X will frequently place restrictions on the number of competing businesses of type X that will be allowed to lease space at that same shopping mall. And frankly, this is a reasonable approach because a mall full of nothing but shoe stores will eventually cause everybody to go broke because only people who need shoes would ever visit that mall, and price competition would be intense.

This leads into a discussion of monopoly power. Most monopolies are small seller monopolies. For instance, a particular owner might have the only dry cleaning business on the west side of town. And, for the sake of this example, his only competition is the owner who has the only dry cleaning business on the east side of town. The two of them compete to a very small extent, but both of them know that few people will deliberately drive to the other side of town to drop off or pick up dry cleaning just to save a few cents per item. This contrasts with gas stations on different corners of the same intersection. Such stations keep a close watch on each other’s prices and match (or close to match) what the other stations do on a daily basis.

So, we can see that one measure of the monopoly power of any given seller is a question as to the distance that a buyer needs to travel in order to reach a competing business that provides an acceptably similar product or service. I’m quite ready to make a U turn to save a penny or two per gallon of gas. But I probably would not even think about driving all the way across town to save a penny or two per item of dry cleaning. Wal Mart has made a fortune being the only big store in many small Midwest towns. This is a monopoly of convenience, and it is based upon the psychology of the buyer wanting a convenient local supplier to meet as many of their perceived needs as possible.

The entire purpose of marketing is to drive demand up. Marketing influences the psychology of the buyer to create a demand for some particular product or service. So, obviously, marketing communications have an influence on the operation of the Law of Supply and Demand. Marketing also influences buyers to shop at one store instead of any alternative. Wal Mart runs a very successful advertising campaign to get people to shop at Wal Mart first because they have the most products and the lowest prices (so say the ads). This drives up the demand for products sold by Wal Mart.

Certain products have specific factors that influence prices in particular situations. For instance, some products have “sell by” dates. The retailer, not wanting to take a total loss if the product does not sell by its “sell by” date, will lower the price on the product even if there is no replacement supply available. Some products, most particularly daily newspapers, have a very limited “shelf life.” In most cases, they will only be sold on the exact day they are made available for sale.

Government policies also influence the operation of the Law of Supply and Demand. If the government allows, or even encourages, the formation of monopolies, prices will tend to increase as competition decreases, and in spite of increases in supply or decreases in demand. The government can also implement price controls, but most people now realize that this is an ineffective remedy that should only be used for short periods in real emergencies. For instance, some states have enacted laws to prevent “price gouging” during the evacuation ahead of a hurricane. The idea is that if a natural disaster causes a particular purchase to become a necessity, the seller should not gain a “windfall profit” off of the plight of the victims of the disaster. Libertarians, of course, argue strongly that the market ought to be allowed to operate freely, and that if a buyer and seller are both willing to agree to a much higher price, then let those who are unwilling to pay that higher price be the ones who are forced to do without. This will be a topic for a separate essay as I sympathize with both sides of this debate.

Government increases overall demand in the economy by increasing the money supply available to make purchases with. In this sentence, I refer to the broadest possible measure of what the “money supply” is, which includes available credit as well as actual cash and cash equivalents. Since there is generally plenty of unused credit available in the economy, it is frequently a question of getting consumers to spend using their credit, which is a question of consumer psychology. There have been occasions where the government has issued tax rebate checks in small amounts to stimulate the economy. People spent that money, and usually more, using credit cards they already had.

Different kinds of governments affect the Law of Supply and Demand in different ways. Communist governments originally tended to use rationing to allocate “basic necessities” to the average consumers. Because the government can’t keep up with the price changes that the Law of Supply and Demand would make, the supply was frequently not up to the demand, or vice versa. Any economy based upon artificial rationing or allocation of goods or services will necessarily be inefficient (wasteful) as compared to one that is not so based. Recognizing this fact, socialist governments tend to control only those industries that are naturally monopolies. Those would include public utilities and similar businesses where a diversity of suppliers is not a good idea, usually because it is too wasteful of investment or other resources (how many sets of telephone poles do you want in your community?).

The Law of Supply and Demand is a simple concept, but it has so many exceptions that we can reasonably say that it is honored more in the breach than in actuality. It always operates, but it is usually influenced by factors far away from momentary questions of the actual supply and demand for some particular good or service.

And nothing can change the fact that sellers are in the business of coercing buyers to pay more for their particular goods or services than the price which could be obtained by that same buyer in a totally free market. Sellers have profit as their motive, and that is still a good thing on balance. Profits are the promise of wealth, and wealth is still desired by most people. While I will not say that “greed is good” (as the Michael Douglas character did in the movie Wall Street), the profit motive will cause people to make decisions that eventually benefit the entire economy. It isn’t so much actual “greed” as it is the natural human desire for success as the best means of survival. (I will argue in another essay that survival is the absolute foundation of morality, and success is the best measure of survival.) If somebody gains a momentary advantage, then somebody else will come along and decide that the opportunity exists to compete for some of the excess profits that said advantage is momentarily providing. At least, that will be the case if the market is truly free, as it should be.

When the market is not free, and when somebody has gained an advantage and so positioned their business that no effective competitor can arise, that business acquires monopoly power, and Lord Acton’s rule begins to operate: “Power tends to corrupt, and absolute power corrupts absolutely.” In the USA during the last third of the 19th century, monopolies were formed and vast fortunes were made by men named Rockefeller, Carnegie, and so forth. They played by the rules of their day, but the government changed the rules when the evils of monopoly power became apparent to the voting public.

So, we are stuck with this one irreconcilable fact: monopolies are both bad and occasionally unavoidable. To avoid the bad aspects of monopoly power on those occasions where the monopoly is unavoidable, it is up to the government to step in with either regulation or ownership to act on behalf of the people as a whole to ameliorate as much as possible the bad effects of an unavoidable monopoly.

At the end of it all, when you hear somebody (on the news or otherwise) talk about how prices have gone up due to reduced supply for one reason or another, you will know that this story is but a small snapshot of the whole truth. Price increases can take effect at the retail level at a moment’s notice. The actual increased costs are days, weeks, or months away due to the natural lead times required for products to be produced. We all now understand that this instant price increase represents a “windfall profit” for whatever product inventory is in the production pipeline. And of course, we all recognize that the businesses that are raising their prices are taking advantage of buyer psychology and the inelasticity of demand. The buyers want to buy because they believe supply will be restricted and the inelasticity of their demand means they won’t worry too much about small price increases. And when does the price come back down again? Certainly not until all of the “high priced” product has been sold! That is just the producer protecting the profit margins it expects to make.

Thus, again, the Law of Supply and Demand does not work when the sellers all cooperate, either consciously or unconsciously, to take advantage of market situations that benefit all sellers as a group. Consequently, the usual case is that the exceptions rule the Law of Supply and Demand.