Post 2: What Everybody Ought to Know about Economics

Most people misunderstand the law of supply and demand - are you one of those people?

I posted a thought on economics on social media. A friend said that we all understand supply and demand. The problem, as I saw it, was that she didn’t apply that understanding. In fact, I find most people really don’t understand.

In this series, I will be teaching from Economics, 3rd Edition by Professor Timothy Taylor. I am providing the link so that you can take the course yourself. I found it quite enjoyable.

Think of three different markets. Usually, we just think of the market for goods and services. There are really two other markets. The capital market provides money to households, businesses and governments. The labor market provides labor to businesses and governments. Supply and demand affect each market.

Here is a typical diagram of the Law of Supply and Demand. The supply curve shows that as price goes up quantity supplied at that price goes up. Notice that businesses will not supply if the price is too low. Obviously, if the price is below the cost of production, the business would go bankrupt.

The demand line shows that as price goes down the quantity that will be demanded at that price goes up. Notice there is probably a price that would be so high nobody would want it. Where the supply and demand lines cross is known as the equilibrium price. If price is below the equilibrium price, demand will increase, and supply will decrease putting pressure on price toward equilibrium.

Notice demand is not based on cost of production. Buyers set price based on their need or desire for the products or services. Businesses set prices based on demand not based on cost of production. If costs of production go down, profit goes up. If costs of production go up, profit go down.

Now let’s apply what we know to each market.

In the market for goods and services businesses will supply at the price that gives them the most profit. If businesses can reduce costs, profit goes up. As profit goes up, more businesses will be willing to supply at that price. The increased quantity puts downward pressure on price. If all buyers who are willing to buy at a certain price have purchased, there is nobody left to buy at that price. In order to sell the remaining supply, businesses must reduce price to increase demand.

Imagine costs of manufacture go up. That does not change the demand curve. Business cannot increase price. Businesses begin to fail. Supply goes down. Businesses may increase prices. The supply curve would move up, business would price higher at the same quantity. So, price would go up, but demand would go down. The equilibrium price would shift to the left.

In the capital market, price is interest rate. As interest rate goes up, more banks and households are willing to invest their money. Supply increases. As rates go up, fewer businesses and individuals will want to borrow money. Again, the equilibrium price is where the two lines cross. Increasing interest rates will lower demand. It will also lower the supply of goods and services. The lower supply will increase prices. Lowering interest rates will have the opposite effect.

In the labor market, price is salaries and wages. If salaries and wages go up, more people are willing to work. Supply of labor goes up. As salaries and wages go up, demand by employers goes down. The equilibrium price is where the two curves cross.

How do we get salaries and wages to go up? A great economy is one way. Demand for labor goes up and salaries and wages go up. I read about an oil boom in the Dakotas. People were buying trailers to live in and moving to take advantage of the high wages. I believe I read that McDonald’s employees were making $25/hour decades ago.

What about increasing minimum wage? Increasing the minimum wage would increase supply of labor. At the same time, it reduces demand. Employers will look for ways to eliminate labor such as automation.

Now we’ve gone through a much more thorough discussion of supply and demand than the average person has considered.

What are your thoughts?