Our next topic in our Financial Literacy Month series is about supply & demand. It’s important to understand how supply & demand affect prices and availability of goods & services. Getting a basic understanding of this topic will bring us closer to full financial literacy.
The starting point for this topic is prices. A financial price is not the same as an item’s value or cost. For example, a book for sale on line might have a price of $7.99. But it costs more than that. You most likely will have to pay shipping, perhaps $3.99. You’ll also have to wait for about a week to get the book, unless you want to pay for express shipping. That same book might have a price of $9.99 at the bookstore. So the real cost of the online book is $11.98 plus a week of waiting. And the real cost of buying the book at the store is $9.99 plus tax, plus what it costs you in time and gas to drive to the store. So while the price of the online book is less, the real cost is lower if you get it at the bookstore.
Value is different still from price and cost. Let’s say that book is a first edition, and it becomes your favorite book. You bring it out every year and re-read it because you love it so much. Is the book still worth $9.99? To you, it probably is; it’s your favorite book. But a buyer looking for a copy would never pay you that price for a used copy when they can get a brand new copy for the same price. So we learn that value is subjective. No two people will necessarily place the same value on a good.
And what if this first edition book is signed by the author? You might not pay the author for her autograph, but having it signed increases the value to you. But will that value be the same for everyone?
Another example: Your 14K gold wedding ring might weigh .15 ounces, so melted down that gold would be worth $175. Is that what the ring is worth to you? If someone offered you $175 today, would you hand them your wedding ring? The important lesson here is that economics isn’t just about money. The monetary price of that gold ring is not its real value.
The market sets prices based on a fundamental rule: any thing is worth whatever someone will pay for it. Last week we talked about how some people erroneously see trade as a zero-sum game. These same people might argue that a thing is worth whatever it costs to produce it. But this doesn’t hold up at all. By that rationale, what is a tree worth in dollars? And if Picasso drew a picture for you in an hour, would that hour’s labor produce the same value as if your child spent an hour drawing you a picture? Even Picasso’s own work varies—different paintings of his have sold at auction for $120,000 to $140,000,000 within a two-year span. So the value of things can vary a great deal, even if produced by the same amount of labor and by the same person. So what it cost to produce a Picasso painting has no relationship to its price. The same is true for everything. The price is whatever someone will pay.
Supply and Demand
All of this talk of prices gets us to supply and demand. I might be in the market for a book, and when I find the book I’m looking for, I’m happy to buy it at $9.99. But what if that book is out of print, and becomes hard to find? I see a bookseller offering a copy for $75. Do I still the buy the book?
Conversely, say I find the book is on sale for $4.99. At that price, I decide I’ll buy two copies and give the second one away as a gift.
This is supply and demand. As the supply of the book decreases, the price goes up. That price affects demand. I decide I don’t want the book after all if I have to pay $75. But if the book is reduced to $4.99, I buy a second copy. If the price goes so high that no one will pay for the book, then supply outstrips demand, and it won’t sell. The price will have to be reduced until someone agrees to the price. And if the price plummets, then more people might buy it because lowering the price increases demand. That’s the idea behind the clearance shelf at the bookstore. The store is probably losing money on those items, but they need to get them sold to make room for more inventory, so they lower the price until demand rises and all of the books are sold.
Other things might affect demand as well. Say I get a huge inheritance, and now have more money than I can spend. Now I might go out and buy that $75 out-of-print book that I passed on before. My demand for the book went up based on my income.
Applying Supply & Demand
Applying these principles create odd situations. For example, this law of supply & demand is why we often increase taxes on cigarettes. Society wants fewer smokers. Knowing that increasing the price will decrease demand, we add a tax onto the cost of cigarettes, hoping that this will reduce smoking overall. Of course, if the taxes are used for a particular purpose, we will inevitably have a problem. As the laws of economics do their work and smoking decreases, we collect fewer cigarette tax dollars, and we can no longer afford to fund whatever program the cigarette tax was meant for.
We also use these principles to encourage behavior. To encourage homeownership, interest paid on mortgages is tax deductible. So we’ve lowered the taxes on mortgages to increase demand for them.
Here’s another example: if you are in a town with only one restaurant, but next year nine new restaurants open, what will happen to prices? They will go down, of course. Supply has just increased greatly. Demand will go up, too—you will probably dine out more because you have many more choices and the prices have gotten more affordable. If prices get too low, some of those restaurants won’t be able to stay in business, and a few might close. Eventually the market will settle with the right number of restaurants for your town.
Now suppose that your town’s mayor owns the only restaurant in town. He doesn’t want nine new restaurants, because he knows increasing supply will drive down prices, and he likes charging high prices at his restaurant. He might push for laws that require costly inspections, building permits, etc. to make it expensive to open a new restaurant. These kinds of distortions are bad for consumers because they drive up prices. This kind of behavior is called rent seeking.
Keep this in mind when you hear about import tariffs. The idea is to make imported goods more expensive to drive down demand for them. This benefits local producers of the same goods. You might reasonably agree with such a policy, but do understand that there are always winners and losers. If a tariff helps protect local jobs, it’s also increasing prices for local consumers.
Effects of Supply & Demand on housing & credit
Supply and demand affect our primary focus here at credit.org. We offer a lot of housing and mortgage counseling services, and housing is often impacted by distortions to basic supply and demand.
One common impact is price controls. Some cities enact rent control laws to keep the cost of housing from getting too high. If the cost of this kind of housing is kept lower than the market would regularly dictate, what happens to the supply of housing?
Now we know that keeping the cost of housing lower than the market rate increases demand. So there will not be enough apartments for rent to hold all of the people who want to live there.
Interest rates rising and falling will also impact borrowing decisions. If interest rates rise, the cost of credit goes up, so its demand will go down. When you hear about the Federal Reserve raising or lowering interest rates, this is part of what they’re adjusting. The Fed has been keeping rates low for many years now in an effort to keep demand high. Depending on your perspective, this may be helping the economy, but encouraging borrowing in this way decreases the demand for saving. People don’t earn very much interest on their savings when rates are low, so they save less. This creates a potential problem for the future, which we’re working to prevent through our partnership with America Saves.
Hopefully understanding these topics will help you see why prices rise & fall, how demand and supply are connected to those price changes, and how the market can be affected by outside forces.
Like all of these financial literacy topics, it can get much more detailed and complicated from here. For our purposes, just understand that:
- A thing is worth whatever people will pay for an item, not what it cost to produce it
- The value of a good is not the same as its price
- As supply goes up, prices tend to go down
- If price goes up, demand will go down
- Prices adjust based on a variety of factors, and those prices emerge from the market, they are not set from the top down.