Supply=Demand at the Right Price

April 13, 2010

Supply=Demand if the Price is right

The term “supply & demand” is in common use, but apparently not commonly understood. Or perhaps people think it is unfair, like when they find the cost of filling their gas tanks rising dramatically. When the price goes up, the consumers complain. When the price goes down, the producerprice,s complain.

But changing prices are necessary to influence supply and demand to “clear the market” that is, to match supply with demand. That’s why price controls cause problems.

Let’s consider the price of widgets. (Definition: a watchmacallit).

Supply: There are several suppliers with similar widgets for sale. Each supplier has some minimum price at which he is willing to sell all of his stock of widgets. At a lower price he will withhold some or all of his stock in hopes of a higher price later. Some suppliers, in need of quick cash, might be willing to sell some or all of their stock at any price.  The supply, then, is the combined effect of the preferences of all suppliers; the number of widgets available for sale depends on the price offered by prospective buyers.

Demand: There are many people wanting to buy a widget, or maybe a few widgets, depending on the price. Each buyer has a maximum price he is willing to pay for a widget, and perhaps a lower price at which he will buy 2 widgets, and so on. He may also prefer a particular brand of widget, or features that only some widgets have. The demand, then, is the combined effect of the preferences of all buyers, the number of widgets all buyers are willing to buy, depending on the price they have to pay.

So an increasing price increases the supply, and reduces demand. At some particular price, supply equals demand, and the “market will clear”. There may be many different widget models, with assorted special features, made by different widget-makers, and thus selling at different prices, but they all compete to sell to the same buyers.

If the market fails to clear from day to day, the prices will keep changing so that, on average, supply always meets demand and the market for widgets clears, and keeps on clearing day after day.

Changes in the market price of gasoline are more familiar but the reasons are less obvious. There is a long process between finding oil to extract from the earth, and filling your gas tank with the refined product. The loss of an oil well or a refinery or a sudden increase in demand for any reason will, for a while, cause a price increase. The free market raises the price to balance supply and demand. In a sense, this is a voluntary rationing system.

The price increase not only reduces demand to match supply, but also impels those in the supply chain to extra effort to speed the flow from oil well to gas station.

People with socialist leanings and even some with charitable instincts may consider it unfair that poorer people will necessarily be the ones to limit gas consumption. They will insist on government stepping in to establish price controls and rationing to cause a more “fair” distribution of the available gas. History shows that this doesn’t work. Poverty means having to do without. There is no way to eliminate poverty. But that’s another subject.

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One Response to “Supply=Demand at the Right Price”

  1. Bill Harding Says:

    I agree! Too often ( modern Greece ) govt tries to provide goods and services ( Postal Service ) without enough focus on ‘the market.’ BUUUT Didn’t the old testament’s Joseph ( coat of many colors ) set up some storage plan to counter the famine cycles that occur? What’s a good way to reconcile Joseph with ‘no way to eliminate poverty?’
    Bill Harding
    When we’ve our eyes open and we’re wide awake we see that we’ve new, cool stuff all around us . . . and new, cool stuff within us. 630 859 0100 we also have http://foxbillharding.blogspot.com/
    http://www.FoxBillHarding.com
    http://www.facebook.com/FoxBillHarding


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