There is a saying, teach a parrot to say ‘supply and demand’ and you have an economist. Economics is about supply and demand. In order to understand how the invisible hand of a market economy operates, you should be familiar with the law of supply and demand. Not surprisingly, this is one of the most important laws in economics. This law states that the price is where supply and demand are equal. An example about the market for coffee can clarify the magic of the invisible hand.
If coffee would be free people might like to drink lots of coffee but producers can’t make coffee for free. Producers go bankrupt if the price is zero because they have costs, for instance employees and equipment. If the price of coffee is low, for instance € 3 per kilogram, that may not cover all the costs. Some producers can produce cheaper than others because they have more efficient production facilities, so when the price is € 5 a few producers might start producing coffee because they can make a profit.
That may not be enough to satisfy all the demand that is out there. The low-cost producers have a limited production capacity so they may be able to come up with 650 kilograms of coffee. Consumers might want to indulge themselves in 1,700 kilograms if the price is only € 5 per kilogram. In that case there would be a shortage of coffee of 1,050 kilograms. Consumers who fear that they are going to be left out of the action might then offer more money so that the price of coffee rises.
When coffee becomes more expensive some consumers might not be able to afford coffee. Others may buy less because they have other expenses like beer and milk. On the other hand, some producers might start making coffee because they can make a profit at these prices. So when the price goes up, supply goes up and demand goes down.
At € 10 per kilogram every producer may be able to make a profit, even those who have high costs, and producers may come up with 2,000 kilograms. However, consumers may only buy 600 kilograms if coffee costs € 10 per kilogram so there may be a surplus of 1,400 kilograms. Producers may then try to sell off their surplus at lower prices before it gets spoiled in order to recover some of their costs. When prices are lower, consumers are willing to buy more, but high-cost producers can’t make a profit and may stop making coffee. So when the price goes down, demand goes up and supply goes down.
The price may settle where supply equals demand. When the price is € 7 producers may make 1,200 kilograms and consumers may gobble up 1,200 kilograms. So € 7 per kilogram could be the price of coffee according to the law supply and demand. Of course, things in reality are a lot more complicated than that, but the law suffices for a basic understanding of markets. A graph can illuminate what has been discussed so far.
The graph above shows the quantities of coffee demanded and supplied at different prices. When the price goes up, demand goes down and supply goes up. The downward sloping black dashed line represents demand. The upward sloping black line represents supply. If the price is low the supplied quantity is low and the demanded quantity is high, leading to a shortage. At a price of € 5 there will be a shortage of 1,050 kilograms as demand is 1,700 kilograms while supply is only 650 kilograms.
If the price is high, demand is low and supply is high, leading to a surplus. If the price is € 10, there will be a surplus of 1,400 kilograms as supply is 2,000 kilograms and demand is only 600 kilograms. The lines of demand and supply cross at 1,200 kilograms and a price of € 7. Supply and demand are both 1,200 kilograms at a price of € 7, which must be the price according to the law of supply and demand.
In reality things often differ a lot from the simple model. There may be different qualities of coffee and each may have its own price. In some markets there is a lot of competition and corporations hardly make a profit. In other markets there is little or no competition and corporations make huge profits. And there hardly ever is an equilibrium as there are many factors that influence supply, demand and price, and they constantly change. Nevertheless, simple examples like this one are useful because they help to explain how a market economy works.
Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.