Why is chicken $.98 per pound, while rib eye steak is $7.99 per pound? My water from the sink tap is about $1.50 per 1000 gallons, but the 16-ounce bottle of water I bought at Disney World was $3.00. A $200,000 house in my town of Hot Springs, Arkansas, would cost about $2 million in Beverly Hills, California. What?!
It’s all about economics. The most fundamental principle of economics is demand and supply. Sure, you’ve heard and read that, but what does it mean exactly? How does it work? Well, first we have to understand how the consumers’ demand for a product or service and producers’ supply of that product or service together determine the price paid and quantity purchased. The more buyers want something, the more they will pay for it. Similarly, the more suppliers receive for something, the more of it they will produce. You’re thinking, “duh,” but take a moment to really consider that principle and let it sink in. Understanding the more intricate aspects of economics requires you to have this basic concept down very clearly. Here is the first and most elementary graph an economics student has to be familiar with:
First, a few points about graphs: A graph is simply a depiction of the relationship between one set of data (horizontal, or X, axis–in this case, Quantity) and another set of data (vertical, or Y, axis–in this case, Price). Those relationships are marked by dots connected by lines we call curves (although they are not always curved). In this example the curves are linear and, therefore, straight for simplicity. Note that the graph shows that 400 slices of pizza would be sold (quantity demanded) if the price were $2.00 (see the dot at the intersection of 400 and $2.00). However, if the price were reduced to $1.00, customers would buy 800 slices. The supplier (pizza store owner), on the other hand, is only willing to make and sell 400 pizza slices at $1.00, but would make and sell 800 slices at $2.00 per slice. So, at the $1.00 and $2.00 prices, the supplier loses a lot of sales, and not many consumers get to eat pizza. For instance, at the price of $1.00, the supplier will only make 400 slices for 400 consumers, and the other 400 consumers who would have bought slices at $1.00 have no pizza. The demand curve shows an “inverse” relationship, since the lower the price, the more the quantity. The supply curve shows a “positive” relationship, since the higher the price, the more the quantity. The demand curve always slopes downward, while the supply curve always slopes upward. Make sure you can see and understand this before going further. Understand, the curves are not driving anything; they just provide a picture of all relationships between price and quantity demanded or purchased.
It is obvious from this graph that the only way the supplier and consumers will come together to maximize their desires is to agree on one price and one quantity that they can both live with. Can you see where they came to an agreement at 600 slices produced at a price of $1.50? It is where the two curves intersect. That became the price that the supplier put in his menu, and he is satisfied to sell 600 slices per day at that price.
But, how do we determine the quantity and price relationship? How do we know that 1200 slices wouldn’t be purchased at $1.00 instead of 800 slices? Good question. When a new product or service is introduced into the economy, lots of marketing research or trial marketing is conducted. Usually, before anything hits the market, the supplier has tested the market to determine what most potential buyers will purchase at what price. This testing results in a schedule of buying behaviors that form the demand curve. In the example above, the research and testing had shown that the supplier would sell 1,000 slices of pizza if he only charged $.50 per slice, but a few buyers would pay as much as $2.50 for a slice–200 buyers in this case. The supplier knows he would be willing to make 1,000 slices if he could get that $2.50 per slice, but that would be producing 800 more than he could sell.
The point where the supplier and the consumer agree on a reasonable price for a reasonable number of sales (in this case $1.50 per slice at 600 slices) is called the “equilibrium price.” Everything you spend money on, from pickles to pedicures, from hoses to houses, from dogs to doctors, you pay an equilibrium price that has been negotiated between the suppliers of those things and the consumers of which you are one. The price is the point where willingness to sell meets willingness to buy. This is how the free market economy arrives at prices in most cases.
Next week, we will dig more deeply into demand and supply and address some questions still hanging from the first paragraph in this post. Click “Follow” on this page to ensure that you don’t miss the next post. Become a classmate with those who follow each post.