Many of us got tough lessons in supply and demand over the past few years.
The COVID-19 pandemic found many Americans hoarding toilet paper, jumping into new hobbies or splashing out on counterfeit N95 masks. In the spring of 2020, you might have done all three at once. Those bad old days are a useful case study for the economic fundamentals we’re covering this week.
You’re more than halfway done with Econ 101! We’re reading Chapter 7 of the Core Econ textbook “Economy, Society, and Public Policy.” Find links to all the lessons in this Crash Course here. If you aren’t enrolled yet, sign up here to get all these lessons emailed to you!
Key takeaways
Supply and demand are fundamental forces governing any market you can think of — pharmaceuticals, personal training, sourdough starter — forces we can model in a chart like the one below.
Here’s an example about bread from the textbook:
With the inventory in the x-axis and price in the y-axis, the demand curve slopes down and to the right. The top shows the maximum amount anyone would be willing to pay for a product or service, and the cheaper it gets, the more customers will be willing to buy.
The supply curve moves the opposite way. It starts with the lowest price any seller would accept and slopes upward as higher prices incentivize more sellers to take the deal. The point where supply and demand meet is the equilibrium price, point A in the chart above.
At 2 euros, we clear the market for bread. Both the bakers and the hungry masses get the maximum surplus from the exchange. At a higher price, you’ll have excess supply of loaves for the day-old bin. At a lower price, the bakery will sell out before everyone who’s willing to pay 2 euros gets their loaf.
But market conditions can change, sometimes quickly. The COVID-19 outbreak upended cost and profit calculations in all kinds of industries. Manufacturing shutdowns in China restricted the supply of medical masks and semiconductors, while the prospect of quarantining drove new demand for household essentials and home exercise equipment.
These shocks threw prices into disequilibrium, and the market had to adjust. As the world opened back up, market conditions kept changing. Take Peloton: The high-end stationary bike was so popular circa 2020, the company started building a new factory to churn them out. Two years later, the company was in financial trouble and $1,500-plus bikes could be found secondhand for a steal.
But how do firms like Peloton, or your local bakery, set prices? They start with the cost of making their product or providing their service. Raw materials, equipment, labor, even opportunity cost go into that calculation.
Large firms often have an advantage because of economies of scale. The more units they make, the more the cost per unit shrinks. In this case, we say their marginal costs are decreasing, which you can see in the supply curve above.
To maximize profit, we can look to a cousin of the indifference curves from a few weeks back. Isoprofit curves show all the combinations of price and production that would generate a certain profit. Zero profit would follow marginal costs exactly. The highest possible isoprofit curve will meet the demand curve at a sweet spot of pricing and output. The example above, about Spanish lessons, is from the book.
We’ve seen the way market conditions can change that calculation, but firms can influence the market too. Advertising and innovation can drive demand or bring costs down; just look at breakfast cereals and AirPods.
It’s important to note that even when a market is in equilibrium, and that’s rare, it doesn’t mean the market is Pareto efficient. Maximizing profits inherently comes with deadweight loss — customers that firms lose out on because they will pay more than the unit cost, but not the price that’s offered. Firms may try to minimize that loss through price discrimination or control market conditions in other sneaky ways. More on that in David’s note below.
Finally, it’s important to remember that nothing we talked about today — maximum profits, controlled costs, pricing equilibrium — is necessarily fair. Though if you were in the market for a home during the pandemic and lost out to an all-cash buyer, you probably don’t need the reminder.
Important definitions
- Equilibrium: The price where supply and demand meet, maximizing the exchange’s surplus and clearing the market.
- Marginal cost: The cost of producing one additional unit of a good or service. Large firms may use economies of scale to lower their marginal costs.
- Elasticity of demand: The amount that demand for a product or service changes as the price increases by 1%. Low elasticity means a flatter demand curve, high elasticity means a steeper one.
- Shocks: An external change that would fundamentally alter the models we’re looking at.
David Brancaccio’s thoughts on Chapter 7
Treating people differently based on categories such as race or gender is discrimination — a word I associate with a social ill, one not to be tolerated.
Tell that to the economists who framed the idea of price discrimination, “a selling strategy in which different prices for the same product are set for different buyers or groups of buyers.” It happens online a lot, as I’m sure you’ve experienced.
Done wrong, price discrimination can be illegal. But what about selling discounted movie tickets to seniors or charging students less for admission to a museum? I’m not opposed to it.
At the start of the pandemic, some retailers were accused of jacking up prices for hand sanitizer. We call that price gouging. The practice violates what economists call a social preference, namely, that we don’t tolerate people trying to take advantage of one another during dangerous times.
It’s not the only sneaky way to influence the market. The textbook referenced a cartel (a group of firms that collude to increase their profits) of lightbulb manufacturers that conspired in the 1920s. Philips, Osram and General Electric agreed on a strategy of “planned obsolescence” to shorten the lifetime of their bulbs so consumers would have to replace them more frequently. The cartel named itself after the Greek god of light, Phoebus. (More on that here.)
I’m among those who learned a lot about how the world works from Mad magazine. Mad had an occasional feature about precisely this, planned obsolescence. There were diagrams of goofy prototypes such as — to return to one of the most popular topics of the day — toilet paper with fake perforations so that clumsy long ribbons of the stuff would come spindling off … forcing you to go through the roll more quickly.
More from the show
“The term ‘willingness to pay’ makes it in some sense sound like we’re all starting with the same amount of money,” Homa Zarghamee, an economics professor at Barnard College who advises Core Econ, told David in 2020. “That gets very distorted when you have inequality because, really, what willingness to pay is, is your willingness and ability to pay. And so somebody with much higher income will always be willing to pay more because they’re able to pay more.”