Both nature and economic life are fundamentally a competition for limited resources. Biologically we compete for usable energy, economically we compete for customer wealth, time and attention.
The forces that make market economics work are supply and demand.
What is The Law of Demand
The law of demand states that there is an inverse relationship between the price of a good and the quantity of the good demanded.
In other words: if the price goes up, demand goes down, and vice versa.
Factors that influence individual demand:
- The price of the good
- Income level of the buyer
- The price of related goods
- Example: the increase in mobile phone prices, decreases not only demand for mobile phones but also the demand for phone chargers and accessories
- The availability of substitutes (that satisfy the same need)
- Consumers’ tastes and preferences
- Customer expectations, which is a combination of:
- Their perceived value of the product
- Their trust in the product satisfying their need
Exceptions to the law of demand
Giffen goods
A Giffen good is an inferior product for which the demand increases as the price increases.
An example is inferior staple foods whose demand is driven by poverty, such as bread or potatoes. As the price of these products increases, people can no longer afford luxury substitutes, such as meat and vegetables, and must purchase more of the inferior staple food to survive.
To be considered a Giffen good, a product must:
- Be an inferior good
- Have no or few close substitutes
- Take up a large percentage of the buyer’s income
Veblen goods
Unlike Giffen goods, Veblen goods are generally high quality products. Examples are luxurious items such as diamond, gold, antiques, paintings and luxury cars, watches and bags.
These products offer exclusivity appeal and status. A higher price puts the product out of reach for an average consumer, attracting more status-conscious people.
Veblen goods are technically not an exception to the law of demand: while societal/group demand increases as a result of the price increase, on an individual level demand still decreases as, among other reasons, fewer consumers can afford the product.
This doesn’t take away the fact that the demand for Veblen goods reacts differently to price increases and decreases than it does for other goods.
Basic or necessary goods
These are goods that people need no matter how high the price is. Medicine covered by insurance, for example. Regardless of the price increase or decrease, demand stays the same.
Expectations of change in the price of a commodity
If people expect the price of a commodity to increase, they may buy more at the present price. On the other hand, if they expect the price to decrease, they may postpone their purchase.
A good example was the 2020 global pandemic when people purchased more toilet paper and masks because of expected supply crunches (and subsequent price increases) as a result of announced lockdowns and expected supply chain issues.
Charlie Munger’s exceptions
In Poor Charlie’s Almanack, Charlie Munger mentions 4 instances in which “if you want the physical volume to go up, the correct answer is to increase the price?”
- The above-mentioned Veblen goods
- Non-luxury goods for which a higher price indicates higher value. A good example is industrial goods where high reliability is an important factor.
- Raise the price and use the extra revenue in legal ways to make the product work better or to make the sales system work better.
- Raise the price and use the extra revenue in illegal ways to drive sales by the functional equivalent of bribing purchasing agents or in other ways detrimental to the end consumer, such as mutual fund commission practices.
Like the Veblen goods discussion above, none of these is technically an exception to the law of demand: the individual demand in each instance still decreases when the price increases. The entire demand curve, however, moves as a result of an increase in value or the removal of substitutes.
These examples are largely driven by psychological factors, such as social proof, envy and jealousy, incentives, feedback loops and commitment and consistency bias.
What is The Law of Supply
The law of supply states that there is a positive relationship between the price of a good and the quantity of the good supplied.
In other words: if the price goes up, supply goes up too, and vice versa.
Increasing prices signal opportunities to make a profit, incentivizing a producer to make more.
As an example, if computer engineers’ average salary increases (more than other jobs), more people will choose to study computer science. Similarly, a company is incentivized to produce more of a profitable product than an unprofitable one.
Supply goes where the money is.
Factors that influence individual supply:
- The price of the good
- Production costs
- Technological costs
- Capacity and productivity
- Weather and natural disasters (in the case of agricultural products, for example)
- Government policies, such as quotas, tariffs, subsidies and taxation
Exceptions to the law of supply
Mass-produced goods
As production increases, the cost per unit decreases and producers transfer these benefits to consumers who enjoy lower prices. This is known as economies of scale.
Rare goods
Precious and artistic goods that have a limited supply. There’s only one Mona Lisa, after all.
This also applies to such products as hotel rooms and flight tickets which have a limited supply: as fewer become available – demand exceeds supply – prices for the available rooms or seats increase. But, unlike precious or artistic goods, these prices come down close to the consumption date to avoid unsold rooms or seats.
Perishable and out-of-fashion goods
Perishable goods, such as milk, will sell at lower prices as they get closer to their expiry date because if they remain unsold they will only yield a loss. Similarly, out-of-fashion goods “expire” in the eyes of society and will be sold at lower prices to stimulate demand.
Monopoly
When there is only one seller of a commodity, he controls and determines the price.
Economic equilibrium – when supply equals demand
The point at which supply and demand for a given good are equal is called an equilibrium, as can be seen at P0 in the image below.
The A area shaded green indicates excess demand, where demand exceeds supply. Conversely, the B area shaded red indicates excess supply, where supply exceeds demand.
The above model works when markets are perfectly competitive:
- When the goods being offered for sale are all the same
- When there are so many buyers and sellers that no single buyer or seller can influence the market price (as in a monopoly)
As the exceptions to the laws of demand and supply above showed, the market is rarely perfectly competitive. This causes equilibrium points, in practical life, to be dynamic and changing, never static.
What’s important to remember is that supply and demand are the forces that make market economics work and markets constantly move toward their (often dynamic) equilibrium points.
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