Part I: The Law of Supply and Demand
The Law of Supply and Demand is exactly that, a Law. Much like gravity or centrifugal force, heat, and light energy; Supply and Demand are actual laws which govern how humans exchange goods and services. There are a great many politicians who like to play with language in attempt to make people think that they do not exist; but rest assured, after all is explained, your light bulb will go off and so much about the world around you will make sense. I’m going to break this down into easy to understand terms, and trust me… Just like riding a bike, you will never forget it.
I remember hearing people back in college talking about how Psychology courses were the way to figure out how the human mind works, I learned that this was wrong. If you want to know what’s going on in someone’s head, watch how they spend their money.
I said that Supply and Demand is a LAW. Pay attention kids, this gets good…
Supply and Demand can be explained very simply as; people are only likely to pay only as much as they have to for any given product. THAT’S IT. There, that wasn’t so hard, was it?
People (you) will only pay as much as you have to in order to obtain a good (gas, paint, gum, hamburger, etc.) or service (oil change, cable, internet, etc.).
When someone says “Supply side economics, e.g. ‘Free Market Capitalism’ failed”, to be frank; they’re either full of shit or naïve to the point of placing their genes into our collective gene pool should be punishable by death. Allow me to explain…
Let us start with the “Supply” side. You have 1 of something, you have 100 of something – it doesn’t matter, you have a supply of something. Let’s use a reference of something common… How about Beer?
Let’s say there are 5 beers…
They have to have value, right? Why else would they be bought or sold? Ok, so 5 beers…
How do we determine how much they’re worth? Well, remember that the Law of Supply and Demand states that someone is only going to pay as much as they have to in order to obtain that good (in this case, the beer) or service. Someone has to want the good or service in order for it to have value.
So now let’s say there are 5 guys standing around in a garage. Each of them wants a beer; each of them can have a beer, but remember that there are ONLY 5 beers. The value of that beer is a 1:1 ratio, as the beer is only worth what it is to each guy.
This is called “Demand”. So now let’s put a green line in to show the Demand side.
So… That’s a pretty graph and all, but what does it mean?
Well, I’m glad you asked – that’s a good question, I’m going to tell you!
Basically it’s showing you that at 5 guys (5 on the green line) and no beers (0 on the red line), there is no value. At 5 beers (5 on the green line) and no guys (0 on the red line), there is equally NO value.
If there were 4 guys and 4 beers, the value would not change. They could assign any value to the beer they wished; dollar, a button, a punch in the mouth… it’s completely irrelevant because it’s a 1 to 1 ratio. Now look at where the two lines intersect. This is where the law becomes truth…
That point is called the “Equilibrium”.
This shows that with 3 guys there are 3 beers. Each of the guys have a more or less equal value of their beers.
So now let’s suppose that one of the guys accidentally knocks someone else’s beer over. Remember, there are only 5 beers… Based on past experiences, that would earn one an adverse reaction should this happen (I’ve seen fists come out). The question is; why? Well simply because the beer has value. So now let’s assign a value. It can be anything; a dollar, a quarter, a loony, a yen; just assign a unit. Now let’s look at it again.
At 3 beers, the value or price is $3.00, or 1 beer for $1.00, depending on how you wish to think of it. So it is therefore a 1 to 1 ratio. This is because at $1.00, the guys drinking the beer are satisfied paying that price them. Now let’s take it one step further and see why this is so.
Remember equilibrium? Well that point is very important, because it not only sets the market price, but determines what will happen if something happens to the supply or demand of, in this case beers.
Any point above the equilibrium would result in a surplus. This means that selling the beer for more than $1.00, the person who is selling the beers is going to have an abundance of beers and no one guy is going to buy as many beers at that price, hence the seller has to lower the price if he wants to sell them off (Yes I know that in reality, the guys are going to buy beer at pretty much any price, but the beers in this case are only used as an example of a “good”).
This is what happens when there is a surplus of any particular good or service; the individual providing the goods or services is stuck with excess and is therefore not generating any revenue. If they want to make money, they have to keep their price at the equilibrium point.
So what happens if the price is under the equilibrium point? OH! Good question, I thought you’d never ask.
Any point under equilibrium is called shortage. A shortage sucks because that means that there is not enough of a good or service to go around. If the person selling the particular good or service lowers their price beneath the equilibrium point, more of their goods or services will be bought up and there won’t be enough to go around.
In the case of the 5 guys drinking beers, anything under the $1.00 mark would mean they could buy more at the lowered price than before at the higher price, their $1.00 now has more purchasing power, or their $1.00 goes farther. The consequence of that is that the beer will run out faster.
Surpluses and shortages have a funny way of driving the price of everything. In the winter, the price of sidewalk salt goes up because everyone is buying it, and in the summer, gasoline tends to go up because everyone is out driving and going on various trips. The market forces work perfectly when left alone, as they have proven for thousands of years, and all failed empires throughout history have the same thing in common, they screwed with or broke Law of Supply and Demand.
The forces of supply and demand are at work all around you and will be explained further in later tutorials. I hope this better helps you to understand what is happening in the world around you, and take what you learned here to educate others.