Supply and Demand

Supply and demand is a hallmark of economics, you could say it’s a fundamental puzzle piece of your run of the mill Econ 101 course at any university. I’m going to explain this in today’s piece but what I really want to exaggerate is the entrepreneur aspect of this in a free market.

I recently realized that this and a lot more of general finance is not understood by a super majority of the typical American citizen. I believe that this is why we have seen such bastardization of the balance sheet of our country, and the rampant overspending by government, with the majority of that being via pen in Washington, D.C., which was NEVER the intention of our founding fathers but that will be left for another day. Exiting soapbox.

So let’s jump in with the milk farmer. Let’s say that the farmer produces 100,000 gallons of milk to bring to market and that costs him $2 per gallon to produce. He has input cost of $200,000, so in order to make a profit and continue to operate his farm, as well as, pay for his cost of living, he prices each gallon of milk at $3 giving him pretax (we’re going to leave the taxation explanation and my 2 sats for another day) income of $100,000. Now let’s assume that we have perfect pricing equilibrium meaning that we have buyers for exactly 100,000 gallons of milk at $3 each. The milk producer is the “supply” and the buying of said milk is the “demand”. Let’s play with the levers a bit to help you understand the relationship even deeper.

Increased Demand

Let’s say rather than having 100,000 buyers for the milk, we have 200,000 buyers. We have a few different scenarios that can play out but we know, because we are light in supply, that we are going to have upset customers in every outcome, so the farmer can conceptually raise prices until he loses half of the demand. This is a very nuanced process that will play out over a number of weeks until he finds the right price. Let’s say that price is $5 per gallon that bring us into pricing equilibrium matching supply and demand, perfectly. The economics for the farmer are improving dramatically. He now has revenue of $500,000 and, assuming input costs did not rise, $200,000 in costs netting him $300,000 of pretax income. Insert the entrepreneur that sees these fat margins and wants to take the risk to build a milk farming operation to get in on that profit opportunity. This new market participant will bring on additional supply at a price lower than the $5 per gallon to entice buyers to purchase their milk. All else being equal the first farmer will have to lower prices to stay competitive meaning that consumers are better off with competition. If we see too many market participants enter to bring milk into the market, the execution of each farm operation gets ever more important to shave costs and streamline the production process. Competition is good for the consumer and the best producer (or producers) are able to stay in business. We witnessed that under monopolistic price gouging, the entrepreneur comes in to attack that margin. You can see, the capitalist system is a beautiful process that works if left to work without central planning and redundant rules benefiting the incumbents.

Decreased Demand

Let’s say the farmer prices the milk at $4 per gallon and, due to that pricing strategy, the farmer is only able to find buyers for 75,000 gallons. In this instance 25,000 gallons will go bad and the costs associated with the production of those gallons is still due to the suppliers. Let’s dive into the math — 75,000 gallons at $4 per gallon gives the farmer $300,000 in revenue and he has costs of $200,000 (100,000 gallons at $2 per gallon to produce). In order to sell all of the milk in the next run of production, the farmer may lower the price to increase the amount of people that want to part with their time (time = money) for milk. Let’s say that they go with a price of $3.50 per gallon and that brings in buyers for 90% of the 100,000 gallons. The math is $315,000 in revenue and he still has costs of $200,000 resulting in increased total profit despite the fact that they again produced too many gallons *AND* they lowered prices to the consumer. The beauty of capitalism is on display and undeniable.

Increased Supply

Now let’s assume that due to having sold all 100,000 gallons of milk, the producers decide to grow production. Let’s say they produce another 20,000 gallons and we don’t see additional demand to take up that slack. The producers would need to reduce price to move that additional supply. Let’s do the math. Say they decide to move prices down to $2.50 per gallon, and that reduction incentivizes marginal (incremental) demand to increase. 120,000 gallons at $2.50 per gallon results in $300,000 in revenue. 

Decreased Supply

Now let’s assume that due to having to reduce prices from $3 to $2.50, the producers decide to cut supply. In order to maintain the margin of the business, they must raise prices, or risk going out of business thus eliminating all producers (worst case for all) or some (still bad for consumers as they will have to go through an increasing price (inflationary) phase in order to incentivize entrepreneurs to come into the market to attack that increased profit.

This is by no means an all encompassing explanation of supply and demand but I hope it serves as an adequate building block of knowledge as you continue of the journey of financial literacy.