Understanding the Law of Supply and Demand

Both Republicans and Democrats make a mistake of thinking their approach is always what is needed.

“What do you know about supply and demand?”

Sam, my oldest son was in middle school and replied, “Isn’t that where if it is a hot summer day and everybody wants watermelons the price will be high and when it is cool and nobody wants watermelons the price will be low?”

I thought he did pretty well. There is depth to the discussion that we might get into later. For today’s post, I’ll just cover the basics and the implications for politics.

The Law of Supply is that the higher the price of something the more people will want to sell it. Imagine that we have a gadget that sells for $100. You know you can make it for $10. You would make $90. Maybe 100 people would be interested in making $90. If each person made one. Total supply would be 100.

If the price dropped to $50 the profit would only be $40. Maybe only 60 people would be interested in making $40. The total supply would be 60.

If the price drops to $8, people making gadgets would lose $2 per gadget. Nobody will make them at that price.

We see that as price goes up the quantity supplied goes up and as price goes down the quantity supplied goes down.

The Law of Demand is that with higher price fewer people will buy. Imagine our gadget cost $100 and only 10 people could afford to buy it. However, supply was 100. What happens to the remaining 90? Price will decline until they are sold.

Now imagine the price dropped to $50. If 60 people would buy at $50 and the supply was 60, the supply equaled demand. That is the equilibrium price point.

Imagine supply was 100. Imagine 10 people bought at $100, leaving a supply of 90. The price dropped to $50 and 60 people bought, leaving a supply of 30.

Imagine the price dropped to $40 and 100 people wanted to buy but only 30 were in supply. There is an unfulfilled demand for 70 gadgets. Producers might be willing to make 30 gadgets to sell for $40 but the profit is not nearly as attractive.

If the price dropped to less than $10. People would stop making them because they were losing money.

What has supply and demand got to do with politics?

When Republicans get into power, they want to decrease taxes to stimulate supply. The idea is that tax is a cost of doing business. If tax is reduced, business becomes more profitable. More people offer more gadgets at a lower price because they can do so and still make a profit.

When Democrats get into power, they want to increase taxes and give money to people, thus stimulating demand. When people can afford to spend more money on gadgets the price goes up. Think about it. Why would a producer sell at a lower price if people are willing to pay more?

In 2008, the world went into a recession. There was an oversupply of houses. People couldn’t afford to buy them. What is the solution?

If nothing is done, suppliers would have to reduce prices and potentially take a loss to sell the inventory. Reducing taxes on suppliers would not help if they were taking a loss anyway. What needed to be done was give people money so they could buy houses. Interest rates were dropped. Money supply was increased. However, some houses were destroyed just to reduce supply.

During the Covid pandemic, many people were told not to go to work. Supplies were reduced. The Federal government gave out money so people could survive. The result was demand but no supply. Prices increased. When people were told it was safe to go back to work, they still had money but there was limited supply. Prices increased.

The Biden Administration used fiscal stimulus (paying for roads and bridges) and gave money to some companies to help them build bigger plants. That further increased demand for all goods and services because more people had more money. It helped increase supply of the goods that got Federal dollars. However, that increase is in the future. It takes time to build a factory.

Due to increased inflation, the Fed increased interest rates. That resulted in increased payments on cars and homes and reduced demand. However, the supply did not catch up with demand. As the Administration continues to spend more money, demand continues to increase. The Fed and the Administration are doing opposite things. The Fed is reducing demand by increasing interest rates and the Administration is increasing demand by government spending.

In the meantime, regulation is slowing the growth of supply of houses. In my area, some people are waiting 2 years for permits to build a home.

The point of this post is that neither supply side nor demand side stimulus from government is always the correct approach. Everything should be considered to take appropriate steps.