Problem Management — principles
Economics

One economic model that very few people seem to really understand is that of supply and demand. Yet it is fundamental to just about every aspect of economic theory. The principle is simple, the mathematics obvious, but in practice people have trouble relating it to reality.

When asked why gasoline, gold, diamonds, and bottled water are so expensive, many people will reply Because they want to gouge us., Because it's so valuable., Because they're so scarce., and Spell Evian backward..

There might be some truth to these explanations, but the real reason why these, and all other products, cost what they do is much simpler than that: they cost what they do because that's how much people are willing to pay for them. That is the fundamental principle of supply and demand.

If the price of a product goes up, those people that really need or like it will pay the extra cost, while those that don't will reduce or eliminate it from their purchases, and so fewer units will be sold. If the price of a product goes down, some people that previously couldn't afford it will try it and some that already use it will buy more, and so more units will be sold. Using this principle, industries set their prices so as to maximize their total profit.

Consider the example when, in the Winter of 2007, a fire damaged an Imperial Oil refinery in Ontario, and for a month or so, the total available supply of gasoline was significantly reduced. What should the gasoline retailers have done?

If they did nothing different, customers would continue to buy fuel at the same rate as normal, and stations would run out. Customers that really need the product would be hurt the most. Can buses, ambulances, police cars, and fire-engines afford to shut down for one or two days a week?

The government could have stepped in and implemented a rationing system, allowing only so many litres of gasoline per citizen per day. Such a system worked during WW-II, but the cost and logistics of implementing it on short notice for such a short period of time would make it effectively impossible to do in this situation.

Instead, the oil companies simply raised the price of gasoline. Some people decided that they couldn't afford it and canceled or postponed trips, walked or took the bus instead of their car, car pooled, or drove their small cars instead of their SUVs. This meant that less gasoline was sold, the limited supply was able to meet the remaining demand, and those people that really needed the product were able to continue purchasing it.

That was a simple and effective solution to the problem, one based strictly on the principle of supply and demand. But most people just didn't understand it.

Interviews on television and radio tended to point to two targets of blame: the oil companies for gouging the public, and the government for not temporarily lowering taxes to keep the price down. Yes, the oil companies did make a lot of profit, and that is their primary goal, but in this case they really didn't raise prices for that purpose; they raised prices to protect those customers for whom their product was essential. And yes, government taxes do make up a significant part of the price of gasoline, but lowering those taxes would have only made the situation worse and the oil companies would have had to raise their prices even more to make up for it. If anything, the government should have raised their taxes, not lowered them, but that wouldn't have gone over very well come the next election.

But no one, certainly not the television interviewers, seemed to understand the very simple process that was controlling the whole situation.

Similar situations occur when bad weather damages crops in Florida or California. The price of fruits and vegetables go up, not because the intrinsic value of the product has changed, not because distributors and retailers are deliberately gouging the public, but because it is essential to reduce the demand for the product in order to avoid running out. If the price of an orange doubles you'll grumble, but if you really really want an orange and none are available at any price you'll get much more upset. The price is high because they want you to decide not to buy it. And the price will keep rising until enough people decide not to buy it that the supply won't run out.

It's that simple.

We originally said that the basic principle of supply and demand is that things cost what they do because that's how much people are willing to pay for them. We could equivalently have said it's because that's how much people are willing to sell them for. Either view is valid, but, because generally there are far more buyers than sellers and generally the sellers have greater control over the prices, the first view is usually more useful.

But in a case such as a large multi-national company buying products from third-world workers, the second view prevails. That is, the companies pay as little as they do for the goods or services because that's how much people are willing to sell them for.

In the case of the stock market, both buyers and sellers are plentiful, and so the prices reflect the views of buyers and sellers equally. But again note the most significant aspect of this: these prices reflect what people are willing to buy and sell the shares for, they do not necessarily reflect the inherent value of the shares themselves.