Supply & Demand 101.
Understanding demand and supply is key to understanding how the world works. In this essay I wanted to leave myself a clear set of notes for the future whenever I want to review how supply and demand works.
There are two main laws, The Law of Demand, and The Law of Supply. So far, so clear 😉
Let’s start with the Law of Demand, which states:
There is an inverse relationship between price and quantity demanded.
When steel prices go down, the quantity businesses will order will increase.
When the price of petrol goes up, the quantity drivers buy will decrease.
If one decides to plot the quantity demanded at each price point, one ends up with a demand curve, which is a downwards sloping curve.
While it may appear obvious why fewer goods and services are demanded at a higher price, it is worth thinking about the causes:
- Substitution Effect
- Income Effect
- Law of Diminishing Marginal Utility
Let’s tackle the substitution effect first. The substitution effect states that when the price of a good or service goes up, consumers will look for cheaper substitutes.
For example, if steak prices rise, people might buy more chicken instead. If the price of petrol goes up, people might use public transport more. And so on.
Now let’s think about the income effect. The income effect states that when the price of a good or service goes up, people have less money to spend on other things.
So, if the steak price goes up, people might cut back on going out for dinner as they have less money to spend. If the price of petrol goes up, people might drive less as they have less money to spend. And so on.
Finally, there is the law of diminishing marginal utility. This law states that as people consume more and more of a good or service, the satisfaction they get from each additional unit decreases.
So, if someone loves chocolate cake and eats one slice, they’ll be really happy. But if they eat a second slice, they’ll be less happy. And if they eat a third slice, they’ll be even less happy. And so on.
Now that we understand the Law of Demand, let’s move on to the supply side!
The Law of Supply states that:
There is a direct relationship between price and quantity supplied.
So, all factors being equal, suppliers will offer more goods and services when the price increases. When the price goes down, they will decrease the amount of supply, as there is less profit to be made.
The economist Tomas Sowell makes the counter-intuitive point about when prices go up during a natural disaster. The media often castigate the suppliers of crucial items such as hotel rooms, flashlights, food, water, and so on for “price gouging”. But, Sowell argues, that higher prices during an emergency are precisely what we should want.
It is both a good thing —and necessary.
How can this be? How can making necessities more expensive in an emergency help anyone?
If prices are held below the market level, then people will consume more than they would have otherwise. But, crucially, suppliers will not be able to increase their output in the same proportion. So, there will be shortages. And shortages are what we want to avoid during an emergency!
Higher prices act as a signal to suppliers that there is unmet demand. And they will respond by increasing output and, in turn, reducing the shortages.
Let’s think at a practical level.
Is it worth it for a supplier to rush goods across the country, paying overtime and rush fees for shipping, and then to have their team members potentially face harmful conditions (with paid overtime), if the price that they can sell in the emergency is the same as they can sell it down the road from their headquarters?
A supplier has no moral obligation to take a loss to help people hundreds or thousands of miles away. This is not a pleasant line of thought, but it is true. A bottled water company is set up to distribute bottled water in the most efficient possible way to earn the largest profit.
That’s it.
Additionally, higher prices also change the behaviour of the people who are in the disaster zone. A family of four who usually takes two hotel bedrooms, one for the parents and one for the two kids, may reconsider that choice when hotel rooms are three times their usual price. In this emergency, they will fit into just one room and allow another family to use the room they would typically use.
This means that scarce goods and services stretch further during an emergency than normal times.
So, higher prices during a disaster are not only good for the suppliers who face extra costs and risks in providing emergency goods and services but also good for society as a whole.
So next time you are hit with abnormally high prices in any type of unusual situation, don’t complain about the price, be happy that you have access to that particular good or service in the first place.
Of course, this only works if prices are free to adjust to the market level. If the government imposes price controls, we will end up with queues, rationing, and other problems.
There are even some great historical examples of this, with sieges that held for years breaking after the city under siege declared food price controls, thus creating no incentives for smugglers to get around the siege to provide food to the citizens.
So, in conclusion, the Law of Demand is a fundamental economic law that states that all other things being equal, the quantity demanded of a good or service will decrease as the price increases. The Law of Supply is the corresponding law for suppliers and states that all other things being equal, the quantity supplied will increase as the price increases. These laws are essential to understand because they help us to see how markets work and how prices act as signals of behaviour change to consumers and producers.
With regards to government intervention in prices and regulation, I am not against it, but it has to be used in a limited and controlled manner, with a keen eye on whether any adverse effects or unintended consequences are happening due to government regulation.
The place where governments truly shine are ensuring that private companies are including any external costs to society in their profit and loss calculations. The government can achieve this by industry-specific taxation and regulation. An example of this that I am hoping to see in the near future is how governments may tax social media companies concerning the mental health issues that they cause. This is an external cost that is born by users, to enable large profits to a small set of organizations.
But as always, we must be careful with government policies and regulations, precisely because governments are generally not influenced by the laws of supply and demand. The people who create the policies seldom suffer the consequences of being wrong.
After all, the last thing we want is great-sounding policies that harm the people they are trying to help instead of counterintuitive policies that don’t look great on paper, but actually help society.
