A smile never increases in price or decreases in value.

Supply & Demand II

In light of the popularity of my blog called Simple Economics (click to read)I decided to take economics a bit farther and introduce you to the supply and demand curves. We discussed the basic principles of the two curves Monday. If you didn’t read it, please scroll down and read that one before proceeding with this.

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Today, we’re going to discuss what happens when prices rise above or decline below this point of stability. Although this is just the raw basics, hopefully this will make some sense out of the world of economics for you.

As we discussed Monday, the point where the two curves cross, which we have labeled “Equilibrium,” is the point at which the number of units of product or service are exactly equal to the number the public is willing and able to buy. In a perfect world, there would be no reason for prices to go up or down from that point, because supply and demand are in balance. In our imperfect world, however, the prices tend not to be that stable.

If the price goes up, suppliers are willing to produce more units—either from the expansion of existing producers or from additional companies getting into that market as it becomes more lucrative. However, fewer people are both willing and able to purchase at that higher price.

Think about yourself for a moment. With most items, you are both willing and able to buy at a certain price, but if the price starts rising you begin to lose interest in purchasing. Let’s think of a couple of products with totally different reactions to this.

You enjoy taking your family out to dinner after church on Sundays. As long as the price remains reasonable, you continue to do so, but as the price goes up, this is an item you can pretty easily do without, so you just start going home to eat after church. In a case like that, the demand curve would be somewhat flatter than that in our example, because the price doesn’t have to go up too much before you change your habit.

In general, restaurant employee don’t have to be highly skilled, and expanding the supply is not all that difficult, nor does it involve years of building new factories or whatever. As the price goes up, supply can expand pretty rapidly, so the supply curve is also relatively flatter than that in the diagram.

Now think about gasoline. The summer of 2008 the price of a gallon of unleaded gasoline shot up from under $3.00 a gallon to over $4.00 a gallon. Did you sell your car and buy a horse? No. You need your car, so you just paid the higher prices. You may have exercised more restraint in how much you drove, but you didn’t quit driving. As the price increased, demand waned somewhat, but it still remained strong.

Likewise, increasing the price doesn’t immediately cause a tremendous increase in the supply of gasoline. There may be a marginal capacity available to increase the supply, but for real increases, we need years to find new fields, drill new wells, and build new refineries. Both the supply and demand curves for gasoline would be much more nearly vertical than the examples in our diagram.

Make sense so far? I hope so.

Okay, if the price increases, demand will decrease—even for gasoline—and supply will increase. What effect does that have?

It means suppliers can’t sell all they are producing. They begin having to store the excess, which is a costly process, and they come to realize they could sell more by lowering the prices.

By the same token, if prices drop too low, some producers will cut or curtail their production, while buyers want to purchase more. Then a bidding war will drive the price back up toward equilibrium.

So we see that, without any action on the part of Ralph Nadir or Karl Marx or the federal government, the law of supply and demand inevitably forces prices back toward equilibrium. This is the beauty of the free enterprise system. Left to its own devices, it is automatically self-correcting.

This discussion has been oversimplified to make the principles understandable. It is more or less the way things would work if there were no international trade and no interference from the government, labor unions, environmental activists or other outside forces.

In reality, international trade has a major impact on all of this, because costs of production are so much lower in other countries that their equilibrium points are much lower than ours. Some of the demand that would normally support prices here is filled by foreign producers, removing that demand from our domestic companies and forcing lower prices here. This is largely why General Motors, Ford and Chrysler struggle so much and account for so much smaller parts of our auto sales than they used to.

Taxes and environmental regulations add to the costs of domestic companies. To understand the effect of these things, imagine the curves in the diagram above, and imagine what would happen if you arbitrarily moved the blue supply curve higher. I don’t mean move to a higher point on the curve—I mean move the curve itself higher. The equilibrium point would move upward and to the left to find where the two arcs cross, cutting back on the demand without adding a penny to the net coffers of the producers.

Labor unions, industrial safety regulations and other outside factors also add to the prices, moving the supply curve higher without adding to the companies’ revenues. This is not an argument for unsafe industrial practices or other such things. I just point out the effect that these external influences have on our supply and demand and prices.

If you believe in high taxes or strong labor unions or crushing environmental regulations, that is your right. But please understand the cost to you and to our country every time we add to any of these pressures. We increase our own cost of living and reduce the amount of goods and services available with each addition. And as companies react to these pressures, more of them move production overseas. They’re not being evil; they’re just reacting to outside pressures brought to bear on them.

David N. Walker is a Christian father and grandfather, a grounded pilot and a near-scratch golfer who had to give up the game because of shoulder problems. A graduate of Duke University, he spent 42 years as a health insurance agent. Most of that career was spent in Texas, but for a few years he traveled many other states. He started writing about 20 years ago, and has six unpublished novels to use as primers on how NOT to write fiction. Since his retirement from insurance a few years ago, he has devoted his time to helping Kristen Lamb start Warrior Writers’ Boot Camp and trying to learn to write a successful novel himself.