Question about the Law of Supply and Demand

Factual Questions
1

OK, it’s been many years since I took Econ 101, and things are a bit fuzzy.

As I understand it, the law of supply and demand states that as demand for a product goes up and/or supply goes down, the price increases. Alternatively, when demand goes down and/or supply goes up, the price decreases.

My question is why is this the case?

The first part of the “law” seems straightforward enough. If demand falls, a merchant who doesn’t lower prices will soon go out of business since people will stop buying his product. Similarly, if supply increases, customers (assuming they know this fact) will demand lower prices by simply shopping elsewhere if the merchant does not lower prices (assuming there is not a monopoly).

What about the second part, though? If demand increases or supply decreases, what forces the merchant to raise prices? Is it simply the fact that merchants are both smart and greedy, and will always try to charge as much as they can possibly get away with? Or is there some other mechanism at work that I am missing?

Regards,

Barry

2

Three guesses.

  1. At an auction it pretty much works the way that the price goes up when something is scarce.

  2. A merchant who has only limited supply will notice that his clients are bidding up against each other for the remaining stuff; a smart merchant will anticipate such behaviour and increase his prices until he won’t get rid of it any more.

  3. In fact, when business is good, merchants are prone to try to increase the price, to see what the market will bear.

3

The supply curve is upward sloping because the cost to produce the next unit of a good is assumed to cost more than the previous unit. This is a pretty reasonable assumption since cheaper methods are presumably employed first. The producer is assumed to be a price taker, so he sees a particular price and produces up until the nest unit to produce is more expensive then the current price.

Demand is downaward sloping becuae each marginal unit is assumed to be of less benefit then the previous unit. The second cheeseburger provides me less benefit then the first one. Consumers are also assumed to be price takes and will purchase up until the next unit they would consider purchase is less valuable then what it would cost to produce.

The price taker assumption is based on the idea that no one manufacturer or buyer is large enough to influence the price.

4

Scarcity. Let’s say I sell widgets for $10 each. The demand for these is fairly constant, and I make a decent profits. My widget factory can make 1000 widgets a day, and about 1000 people buy a widget everyday. Everything’s groovy.

But then one day, some paparazi photographer gets a shot of Arnold Schwarzenegger using his brand new widget! Suddenly, everyone wants a widget. But my factory can only make 1000 a day. The supply remains the same, but the demand increases. If I continue selling widgets at $10 each, I’ll run out by noon. There will still be more people who want widgets, though, and I won’t be able to sell them any. So I could sell my 1000 widgets for $10 each and make $10,000, or I can raise my price to $20. Once the price goes up, fewer people will want widgets, but the ultra-cool will still be willing to pay. So now I’ve sold my 1000 widgets for $20,000. I have equalized the market. Because demand went up, I raised my price, and because my price went up, the demand has decreased. Obviously I made the right choice since I’m now rolling in the dough, and if I continue making money, I may be able to build more factories and increase the supply, which may drive the price down again.

5

friedo’s example is a good one. Another is the cost of gasoline on September 11, 2001. Suddenly, a large portion of the population wanted to buy gasoline, but the supply hadn’t gone up. If merchants decided to keep the price the same, then the people who wanted to hoard it would get a great deal, while people who really needed it but got there too late would be forced to do without. So the smart and ethical merchants raised their prices to balance this out. They still had gasoline on hand at the end of the day.

6

Well, nothing “forces” them to do it. They do it to maximize their profits or decrease headaches.

Let’s say I have an apple stand. Everyday I start out with 24 apples, and by the end of each day I usually (70% of the time) sell all the apples. This means 24 apples is the right amount of apples to start the day with; it’s not too many, and it’s not too few. Consequently, I have signed a long-term contract with my supplier to deliver me 24 apples everyday at a very good wholesale price.

Let’s also say I sell apples for $1.00 each.

Now around Christmas, for whatever reason, the demand for apples greatly increases. I find myself running out of apples by 10:00 AM just about everyday. And (of course) people are still demanding apples after 10:00 AM. But I can only supply 24 apples everyday. So how can I make everyone happy throughout the day? Answer: I can’t. But I can take advantage of the situation by raising the price of apples to $2.50 each. That way, only the people who really want the apples badly will buy them. And the technique works; instead of running out of apples at 10:00 AM, I run out of apples at 4:00 or 5:00 PM, just like I did before Christmas (when the apples were $1.00 each).

In the above example, the supply was fixed (24 apples per day), but demand increased. Consequently, the price went up.
Now let’s look at what happens when supply increases.

Same apple stand… everyday I start out with 24 apples, and by the end of each day I usually (70% of the time) sell all the apples. This means 24 apples is the right amount of apples to start the day with; it’s not too many, and it’s not too few. Consequently, I have signed a long-term contract with my supplier to deliver me 24 apples everyday at a very good price.

Let’s also say I sell apples the apples at $1.00 each.

Now my supplier just called and says there has been a bumper crop of apples this year. Consequently, the (wholesale) price for apples has gone down considerably. He says, “We don’t want these apples to rot. So I’ll ship you 35 apples everyday instead of 24, yet still charge you the price for 24.” I tell him, “That’s great.”

So everyday I start out with 35 apples instead of 24. “Great,” I think to myself. “I’ll make more money!”

But alas, I don’t make any more money. This is because I still sell only 24 apples everyday (at $1.00 each). And then I have to figure out a way to get rid of 11 old apples at the end of everyday, which is a headache.

So here’s what I did: I cut the price of apples from $1.00 each to $0.70 each. And guess what? Usually, all 35 apples sell by the end of each day.

In the above example, the supply was increased (from 24 apples per day to 35 apples per day), but demand stayed the same. Consequently, the price went down.

7

I will link again to a great article by Hayek which explains why and how the price system works as a transmitter of information and works for the benefit of the individual and of society as a whole. The Use of Knowledge in Society

8

Actually, the law of supply and demand doesn’t say that that if demand increases, the price must always increase. That’s just the quick-and-dirty version of it.

What the laws of supply and demand really say is that if demand increases, the price will not fall. In other words, it’s perfectly possible that the price will stay the same.

The price will stay the same if the supply “curve” for the good is a flat, horizontal line. (Or if the supply curve is flat in the relevant range, i.e. close to where it intersects the demand curvve.)

The supply curve will be flat if additional units of the good in question can be produced at the exact same (marginal) cost.

If, however, it’s more costly to supply additional units of the good, then the supply curve will slope upward, and you’ll get the more familiar “if demand increases, price goes up” behavior.

(In a similar vein, the famous “Law of Diminishing Returns” is better named the "Law of Non-Globally-Increasing Returns.)

9

Greed drives price increases. There is no immutable physical law that requires that prices MUST increase.

Wumpus sums up the real law of supply and demand.