Supply and Demand are the forces that make market economies work. They determine the quantity of each good produced and the price at which it is sold. In the book Principles of Economics – Gregory Mankiw gives few examples
- A cold snap hits Florida, the price of orange juice rises in supermarkets throughout the country.
- The weather turns warm in New England every summer, the price of hotel rooms in Caribbean plummets.
- A war breaks out in the Middle East, the price of gasoline in the United States rises.
Demand
The law of demand states that, other things being equal, the quantity demanded of a good falls when the price of the good rises. Imagine that you love to eat ice creams. You will eat ice creams regularly if the price of the scoop is $1.00. If all of a sudden the price per scoop increases to $3.00 then you will consume less of it. The quantity demanded goes down when the price goes up. Given below is the price of an ice cream cone and the quantity of ice cream cones demanded.
| Price | Quantity Demand |
| 0 | 12 |
| 0.5 | 10 |
| 1 | 8 |
| 1.5 | 6 |
| 2 | 4 |
| 2.5 | 2 |
| 3 | 0 |
If we plot the above data with the number of ice cream cones demanded on the X axis and the price per cone on the Y axis we get
The downward sloping line relating price and quantity demanded is called the demand curve.
Remember that the demand varies as the price of the good varies, while all other factors are held as constant. If some things other than price changes the quantity demanded then the demand curve shifts. Any changes to the following items will shift the demand curve.
1. Income
What happens if you lose your job? Your income falls and with that the quantity demanded also falls.
If a demand for a good falls when income falls, the good is called a normal good.
There are few goods for which the demand goes up even though your income falls.
If the demand for a good rises when income falls, the good is called an inferior good.
During 2008 recession many people lost their jobs. Lots of them avoided going to bars and restaurants and instead signed up for Netflix subscription. Here is an interesting article about this.
I could only arrive at one reason for this phenomenon and that is the millions of the unemployed are using part of their severance and unemployment checks for a bit of entertainment in the form of DVD rentals. I have several unemployed friends doing just that now. Most are foregoing visits to bars and restaurants and instead are sitting in front of their 50inch plasma TVs passing time watching movies. Several of them have subscribed to Netflix.
2. Prices of related goods
Suppose the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt and buy less of ice cream. Why? Because ice cream and frozen yogurt are both cold, sweet, they satisfy similar desires.
When a fall in the price of one good reduces the demand for another good, the two good are called substitutes.
Suppose the price of DVD player falls. This increases the demand for DVD players and also the DVDs.
When a fall in the price of one good raises the demand for another good, the two goods are called complements.
3. Tastes
If you really like something you buy more of it. If you love eating ice creams you will purchase more of them.
4. Expectations
Your expectations about the future will affect your demand for a good or service today. Suppose you know that you will get a big raise in three months time then you might purchase a luxury item.
5. Number of Buyers
If the number of buyers increases then the quantity demanded as a whole will go up. For example if a government health organization comes out with a report that drinking coffee boasts your brain power. The number of coffee drinkers will go up.
Given below is the price of an ice cream cone and different amounts of quantities demanded for the same price.
| Price | Demand Shift Down | Normal Demand | Demand Shift Up |
| 0 | 14 | 16 | 18 |
| 0.5 | 12 | 14 | 16 |
| 1 | 10 | 12 | 14 |
| 1.5 | 8 | 10 | 12 |
| 2 | 6 | 8 | 10 |
| 2.5 | 4 | 6 | 8 |
| 3 | 2 | 4 | 6 |
Supply
The law of supply states that, other things being equal, the quantity supplied of a good rises when the price of the good rises. Imagine you are an ice cream shop owner. If the price of an ice cream is $0.25 then you will stop the supply. Why? You will be running the shop at a loss. On the other hand if people are willing to pay $3.00 for an ice cream you will supply a lot of ice creams. Why? If your cost for one ice cream is $0.50 then by selling it at $3.00 you will make a lot of profit. Given below is the price of an ice cream cone and the quantity of ice cream cones supplied.
| Price | Quantity Supplied |
| 0 | 0 |
| 0.5 | 0 |
| 1 | 1 |
| 1.5 | 2 |
| 2 | 3 |
| 2.5 | 4 |
| 3 | 5 |
If we plot the above data with the number of ice cream cones supplied on the X axis and the price per cone on the Y axis we get
The upward sloping line relating price and quantity supplied is called the supply curve.
Remember that the supply varies as the price of the good varies, while all other factors are held as constant. If some things other than price changes the quantity supplied then the supply curve shifts. Any changes to the following items will shift the supply curve.
1. Input Prices
Milk is one of the inputs for making an ice cream. If the cost of the milk goes up then the profit per ice cream sale will go down. Hence the ice cream supply will go down. On the other hand if the price of milk goes down then profit per ice cream sale will go up. Hence the ice cream supply will go up.
2. Technology
The invention of mechanized ice cream machine will reduce the amount of labor necessary to make the ice cream. This will result in lower cost and thus increase the supply of ice creams.
3. Expectations
If the firm expects the price of ice cream to rise in the future, it will put some of its current production into storage and supply less to the market today.
4. Number of Sellers
If the number of sellers go up then the supply of ice creams will also go up.
Given below is the price of an ice cream cone and different amounts of quantities supplied for the same price.
| Price | Supply Shifts down | Normal Supply | Supply Shifts up |
| 0 | 0 | 0 | 0 |
| 0.5 | 0 | 0 | 0 |
| 1 | 1 | 2 | 3 |
| 1.5 | 2 | 3 | 4 |
| 2 | 3 | 4 | 5 |
| 2.5 | 4 | 5 | 6 |
| 3 | 5 | 6 | 7 |
Demand meets Supply
The point at which the supply and the demand curves meet is called as the equilibrium. The price at this intersection is called as equilibrium price.
At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell.
Given below are the data for supply and demand. Supply and Demand meets at price $1.5 for the quantity 6
| Price | Demand | Supply |
| 0 | 12 | 0 |
| 0.5 | 10 | 2 |
| 1 | 8 | 4 |
| 1.5 | 6 | 6 |
| 2 | 4 | 8 |
| 2.5 | 2 | 10 |
| 3 | 0 | 12 |
If the market price for the good drops to $1.0 then the quantity supplied will be 4 and the quantity demanded will be 8. Look at the table and the graph above. This situation is called as shortage of good or excess demand.
On the other hand if the market price of the good raises to $2.0 then the quantity supplied will be 8 and the quantity demanded will be 4. Look at the table and the graph above. This situation is called as surplus of good or excess supply.
Regardless of whether the price starts off too high or too low, the activities of the many buyers and sellers automatically push the market price toward the equilibrium price. Once the market reaches its equilibrium price, all buyers and sellers are satisfied.
Remember the real estate crash of 2008 in the US? During the period 2001 to 2006, due to greed from buyers the price of the homes sky rocketed (excess demand). This in turn made builders to create an over supply situation (excess supply). From the year 2007 onwards the home prices started to fall. The price fall continued until the excess home inventory situation got cleared. Warren Buffett in the 2011 letter to shareholders writes
Housing will come back – you can be sure of that. Over time, the number of housing units necessarily matches the number of households (after allowing for a normal level of vacancies). For a period of years prior to 2008, however, America added more housing units than households. Inevitably, we ended up with far too many units and the bubble popped with a violence that shook the entire economy. That created still another problem for housing: Early in a recession, household formations slow, and in 2009 the decrease was dramatic.
That devastating supply/demand equation is now reversed: Every day we are creating more households than housing units. People may postpone hitching up during uncertain times, but eventually hormones take over. And while “doubling-up” may be the initial reaction of some during a recession, living with in-laws can quickly lose its allure.
At our current annual pace of 600,000 housing starts – considerably less than the number of new households being formed – buyers and renters are sopping up what’s left of the old oversupply. (This process will run its course at different rates around the country; the supply-demand situation varies widely by locale.) While this healing takes place, however, our housing-related companies sputter, employing only 43,315 people compared to 58,769 in 2006. This hugely important sector of the economy, which includes not only construction but everything that feeds off of it, remains in a depression of its own. I believe this is the major reason a recovery in employment has so severely lagged the steady and substantial comeback we have seen in almost all other sectors of our economy.
Learning from other disciplines
Charlie Munger in his speech on Academic Economics asked the following question.
You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?
Surprisingly even in the top business schools 1 in 50 person will give an answer to this question. Why? There is too little synthesis across disciplines. Higher price is associated with better quality and hence the demand for the product goes up. This idea is borrowed from psychology. Munger writes
This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.
What if you raise the price and bribe the middle man to increase the sales? Yes this will also increase the demand. Remember incentive caused bias a model from psychology. Munger writes
One of the most extreme examples is in the investment management field. Suppose you’re the manager of a mutual fund, and you want to sell more. People commonly come to the following answer: You raise the commissions, which of course reduces the number of units of real investments delivered to the ultimate buyer, so you’re increasing the price per unit of real investment that you’re selling the ultimate customer. And you’re using that extra commission to bribe the customer’s purchasing agent. You’re bribing the broker to betray his client and put the client’s money into the high-commission product. This has worked to produce at least a trillion dollars of mutual fund sales.
Read the following article on pharma companies bribing doctors
The national secretary of Federation of Medical and Sales Representatives Association of India (FMRAI) Alok Kumar Banerjee has alleged that some multi-national pharmaceutical companies were resorting to the unethical practice of bribing doctors with foreign jaunts and by also giving them costly gifts such as four-wheelers to increase their sales.
Remember that technological improvements increases supply. Is this good for you as a business owner? It depends on the type of business that you are doing. If you are in the commodity business and there is already an excess supply situation then technology is not going to help you as a business owner. Why? In Elementary worldly wisdom – Munger writes
The great lesson in microeconomics is to discriminate between when technology is going to help you and when it’s going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does. For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles—which are a real commodity product. And one day, the people came to Warren and said, “They’ve invented a new loom that we think will do twice as much work as our old ones.”
And Warren said, “Gee, I hope this doesn’t work because if it does, I’m going to close the mill.” And he meant it. What was he thinking? He was thinking, “It’s a lousy business. We’re earning substandard returns and keeping it open just to be nice to the elderly workers. But we’re not going to put huge amounts of new capital into a lousy business.”
And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.
That’s such an obvious concept—that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.
Buffett used multiple models to come to the conclusion. Other people who invested money in their commodity business based on improved technology did not think beyond supply and demand from microeconomics. Remember what Munger tells
It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.” And of course, that’s the way the chiropractor goes about practicing medicine. But that’s a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you’ve got to have multiple models. And the models have to come from multiple disciplines—because all the wisdom of the world is not to be found in one little academic department. That’s why poetry professors, by and large, are so unwise in a worldly sense. They don’t have enough models in their heads. So you’ve got to have models across a fair array of disciplines.
Seeking Wisdom 