Economics for Dummies: The Forces of Supply and Demand

I told you last week that my friend Erin asked me 3 questions about economics.  Her second question really contained about 3 different sub-questions.  Today I'm going to answer the last part of her question.  It focuses on Supply and Demand which are the core forces involved in economics.  

Question: Why can't everyone just agree that $1 bill=a can of beans? How does it actually work?

The reason a can of beans can't just always equal $1.00 is because there are so many things that affect the price of the beans.  Sometimes the price needs to be higher to prevent shortages.  And sometimes it needs to be lower to prevent surpluses.      

I'm a visual learner so I'm going to take you though a lot of illustrations to try to show you why prices change.  I'll use cans of beans as the example, but really this could apply to anything - food, labor, cars, homes, pretty much whatever.  And don't feel bad if your eyes glaze over and this doesn't quite make sense.  It took me almost 5 months before I clued into everything that my high school econ teacher had been teaching us about Supply and Demand.  (If it wasn't for Mr Miller I never would have been an econ major)

To start out lets look at the way economists graph things.  First of all we try to make things as simple as possible.  So this example may seem a little simplistic.  Yes, in real life things are much more complicated, but we are talking about the basics here.    

We use a graph with Price on the Y axis and Quantity on the X axis.  Since neither price or quantity can really be negative we only worry about the 1st quadrant of the graph.  So pretty any economics graph is going to look like this:

Supply and Demand Curves

Then we add some lines to the graph.  The first one is the Demand Curve.  This curve illustrates how many cans of beans will be bought at certain prices.  So if the price is high like $5 a can then people are only going to buy 10 cans.  Where as if beans are $0.05 then people will go out and buy 10,000 cans.  (FYI I'm pulling these numbers out of thin air - economists are always "assuming" things.) The demand curve slopes down from the left to the right.  (Helpful hint: Down and Demand both start with the letter D.)

In a future post I might talk about what effects the steepness of the slope (in econ terms it's called elasticity), but for this example we'll just assume it looks like this.

The other line is the Supply Curve.  It illustrates how many cans of beans will be provided at certain prices.  So if a can of beans costs $0.05 then the suppliers aren't going to bother growing a lot of beans and they will only supply 10 cans.  On the other hand if the price of beans is $5.00 than the suppliers are going to want to grow 10,000 cans worth of beans.  The Supply Curve slopes up from the left to the right and looks like this.  

When you put the two curves together on a graph you can determine what the Price will be and what the Quantity Demanded at that price will be.

The way you do that is to find the point where the supply and demand curves cross.  That point is called Equilibrium.  Whatever number on the Y axis corresponds to the equilibrium point is the Price.  And whatever number on the X axis corresponds to the equilibrium point is the Quantity Demanded.

We could say that the price is $1.00 and the quantity sold at that price is 1000 cans. 

I'm sure you're thinking, "okay, so a can of beans equals $1.00.  Why can't it always equal that?" The reason the price can't stay constantly at $1.00 is because there are always changes to the Supply and Demand Curves.  Lets talk about those.

Changes to Supply and Demand Curves

So far we've just talked about one demand curve.  On this chart it's labeled D1.

But the position of the demand curve can change.  Let's say some scientific study came out and said that beans were a superfood and everyone started wanting to eat more beans.  Instead of being willing to buy 10 cans when the price is $5.00 a can they would be willing to buy 100 cans at $5.00 a can.  And at a price of $0.05 they would be willing to buy 20,000 cans (people can recognize a bargain). That change in willingness to buy would cause an increase in the demand for beans and the whole curve would shift the the right.  That's the line labled D2.

Or lets say that there were reports that canned beans might make you cause grey hair.  People wouldn't be so willing to buy canned beans anymore.  At $5.00 a can they would only be willing to buy 2 cans and at $0.05 they would only want 5,000 cans.  The decrease in demand would cause the demand curve to shift to the left.  On my chart its labeled D3

The Supply curve can also shift around.  We've been looking at the supply curve labeled S1.  But lets say that there was a late frost that killed off a lot of the bean plants.  There would be a lot less beans available to can.  The decrease in supply would cause the curve to shift to the left.  This is S2.

Or lets say it was a record year for bean production.  Many many beans grew and were canned.  That increase in number of cans available would cause the whole supply curve to shift to the right. This is S3.

There are lots of things that can cause the Supply and Demand Curves to shift around.  Demand can be influenced by consumer income, tastes and preferences, the price of substitute goods (ie fresh beans), and the price of complementary goods (ie canned corn.)  Supply can be influenced by changes in technology, changes in labor, and some other stuff that wikipedia isn't reminding me of right now.  The most important thing to remember is that Price is not a shift factor.  Price can vary along an individual supply or demand curve, but a price change wont cause the demand or supply curves to shift.

So let's see what happens to our price of $1.00 when the Supply and Demand curves shift.

This graph illustrates an increase in the supply of canned beans due to a bumper crop.  All those extra cans of beans shift the supply curve to the right.  But demand hasn't changed, people aren't eating more or less beans than normal.  The place where the new supply curve crosses the demand curve is our new equilibrium.  The price has changed to $0.60 a can.  At that price people will buy 1500 cans.  If the price had to stay at $1.00 then only 1000 cans would be sold.  There would be a surplus of 500 cans just sitting around.    

Or what if the supply of beans decreased due to that early frost we talked about. The Supply Curve shifts to the left. Once again people aren't avoiding or clamoring for beans anymore than usual so the demand curve doesn't change.   The new supply curve crosses the demand curve at a higher place than before.  That means that the price of beans has increased to $1.50.  Only 800 cans of beans are sold at that price, which is good because there are fewer beans to be had.  If the price had to stay at $1.00 than there would have been a shortage of 200 cans of beans.  

Let's switch gears just a little bit and imagine that the demand curve is changing while the supply curve stays the same.

If the demand for beans decreased because of rumors grey hair causing chemicals then the curve would shift to the left.  There haven't been any changes to the supply of beans so the supply curve stays the same.  The new equilibrium point has the price at $0.75.  That lower price is enough to convince people to buy 800 cans - grey hair or no grey hair it's a good deal.  If price had to stay at $1.00 there would have been a surplus of 200 cans.

And finally lets look at an increase in demand.  Beans are the new super food and everyone wants to eat them.  The Demand Curve shifts to the right while the supply curve stays the same.  The new equilibrium price is $1.33.  At that price 1300 cans are sold.  If price had to stay at $1.00 there would have been a shortage of 300 cans.  

Supply and demand can both shift.  But they don't always shift the same way.  There are infinite combinations of what could happen.  Supply could decrease while demand increased, supply could increase while demand decreased, supply could increase while demand increased.  I wont show you all the possibilities, but here is an example of what Supply increasing (I mislabeled it price) while Demand decreasing looks like.

This is what would happen if there was a bumper crop of beans (increase in supply) the same year that everyone got spooked about grey hair from canned beans (decrease in demand).  The new equilibrium price would drop dramatically to $0.45.  The quantity of cans demanded at that price would also drop to 950 cans.  If price had to stay at $1.00 there would have been a surplus of at least 50 cans.  

Price Floors and Ceilings 

So hopefully you can see why we can't just have set prices for everything.  There are so many factors involved that it's best to just let the forces of Supply and Demand take care of setting a price that wont result in shortages or surpluses.  

Just in case you still don't quite get it, lets look at it one more time.  Let's say the government sets the price of a can of beans at $1.00.  

If this happens to be where supply and demand meet then everything is fine.  But the government is rarely that good at determining the best price.  And as we've seen the market changes anyway.

So lets say the cost of a can of beans really should be $2.00.  For whatever reason the government wants the price of a can of beans to stay at $1.00. It could be that they are trying to make sure that poor people can still afford beans.  When a price can't go above a certain amount it is called a Price Ceiling.  This gets confusing because it may be below the equilibrium price so you'd think it would be a price floor.

Semantics aside, the price of $1.00 is too low.  People are going to want to buy more cans than the suppliers can supply at that price.  This will result in a shortage.  (And those poor people are still probably not going to get their beans.)

On the other hand the government may decide to help out the farmers who grow the beans.  The government may decree that the Price of canned beans can't go any lower than $1.00.  This is called a Price Floor because that's as low as price can go.  Everything is fine if equilibrium point puts the price above $1.00.  But if the price should really be something like $0.75 then there are problems.  People aren't going to buy as many cans as are supplied and there will be a surplus.  (And the farmers wont make as much money anyway.

Just for fun, here's a graph that shows both a price floor and a price ceiling so you can see how they relate to each other.

Anyway, I hope I didn't confuse you more.  The bottom line is that the factors governing price are very complicated - even for something as simple as beans.  It's best to just let the natural forces of Supply and Demand take control.

Disclaimer:  I had to reach WAY back in my memory to draw all these graphs and to describe what is happening with Supply and Demand.  I apologize if there are any errors.  They are either from trying to remember something I first learned in 2003, or from one of the many interruptions that happened while writing this post.  (You try writing about economics while keeping track of 3 toddlers.)