Thursday, December 26, 2013

Economics is a science filled with special words and acronyms.  To a trained economist they each have specific meanings, although they often feel licensed to misuse them.  In some cases, the words are used to describe a situation, while in others the same words are used to obscure or confuse a situation.  Using big words is not limited to economists, and misusing them certainly does not belong solely to that profession.

However, the guts of economics is actually pretty simple.  While you can argue the effects of monetary policy, or the value of austerity, the facts remain pretty simple.  With that in mind I'm going to discuss two of the most basic...perhaps even THE most basic...terms in economics.  And...I'm going to explain why they no longer mean what they have traditionally meant.

The two words are Supply and Demand.

In the simplest examples these two words, and the balance point between them, should represent how an economy functions.  Today, however, especially in the United States, that is no longer true.

Supply made simple

In simple terms, Supply simply means how much of something is available.  "I have a six week's supply of napkins."

In the marketplace, it typically relates to the amount you can sell during a period of time.  "We have a 5 day supply of milk."

Clearly supply can be affected by lots of things.  If the factory that makes your widget burns down the supply will dwindle until you can replace that production line.  If the weather creates a poor harvest, your normal supply, designed to last until the next harvest, may be inadequate.  If your widget is replaced by something better, you may end up with an over-supply.

Demand made simple

Demand is the polar opposite, and is expressed by how many people want your product and how much are they willing to buy.  However, that market is somewhat fickle.

For example, you can anticipate demand to be present at special times.  Selling fruit cake in the summer is pretty tough, even if it's really good fruitcake.  On the other hand, during the Holiday season at the end of the year demand is more robust.

Demand can be affected by other things too.  If word gets around that the chicken you're selling is contaminated, it's likely the demand will dry up, not because people no longer wish to eat chicken, but because they decide that they don't want to eat your chicken.

Demand also fluctuates due to market forces.  If you're selling widget 4.0 and your competitor introduces his Widget 5.0 that includes more features or a lower price, the demand for your product will likely drop.

The Relationship is the Key

For nearly forever, the relationship between supply and demand was straightforward, and the effect of those two elements upon price was pretty simple to understand.  Let's look at typewriters as an example.  NOTE: If you don't know what a typewriter is (or was) I can't really help you.  I was tempted to use sliderules, but that would be even more difficult to understand.

In theory, the whole thing works like this:

When there is an adequate and stable supply, and a relatively stable demand, prices will be stable.  The only real effect on prices will come at the local level...a store wants to have a sale and they pick your product to discount.

The other thing that will affect prices...in the long run...is your cost to manufacture the typewriter.  If your raw materials cost more, eventually that will have to be reflected in the product.  The same is true if you are granting your employees raises.  The effect of those things we call Inflation, but for the moment I'm going to just ignore that.

So...how does this relationship break down?

So, business is good.  You make typewriters.  Now and then you introduce a new model that looks sleek and shiny, and maybe you add a new feature.  The market responds, and perhaps over time you stop making the older models.  Your factory is humming and life is good.

However, down the street somebody else has discovered a way to hook an automatic typewriter to a computer, and he's selling printers.  This is a whole new product, and it's not clear what it's going to do to typewriter sales.  Over time it becomes clear.  As dot-matrix printers are improved to make laser printers companies begin to decide that they no longer need typewriters.  This new "printer thingy" can do it all, and they can cut down their labor force because they don't need so many typists.  Demand for your typewriters is falling.

Fast forward a few years and we discover that the only place you can buy a typewriter is at Goodwill.  The theory of Supply and Demand worked.  When the Demand dried up, the Supply was similarly effected.  Now you don't make typewriters any more, you've shifted to making really expensive coffee makers and you've been able to create demand.

But...things are different now.  Here's how.

In the old (pure) system, supply was based upon demand, and demand was largely based upon workers having enough money to buy what you wanted to sell.  That's no longer true.

The difference is that Making Money is more important than either Supply or Demand.

Let's say I'm making widgets.  There's a stable demand.  I make good money at the current price.  There are no competitive widgets on the horizon, so Life is Good.  I can go to my stockholders and they are happy.  I get a Big Salary and a Really Big Bonus.

Since I want to keep that going, I can start to ignore Supply and Demand.  Let's say I make a new widget...widget 6.0.  It's really cool, with a bunch of new features and a really snazzy marketing pitch.  I've priced it high enough to make some Really Good Money on each one.

Now, demand ramps up.  In the past that would mean I would increase my work-force and maybe even build a new factory.  But doing those things costs me money.  That means less for me, even though it's a long term investment in the company.  I only care about short term.  I want the next quarter to look good, and I don't want to explain that earnings are down a little because we chose to expand production.  Stockholders don't care about that.  In short, demand doesn't drive me to supply.

So, I'm looking at the situation by simply asking "What makes the most money for me right now?"  Adding employees costs money.  Even if they add to production I'd still have to train them.  I could run the factory with a second or third shift, but that costs money too.  I could pay overtime, but that's an added expense.

So, since everything would decrease my bottom line (in the short term) I don't want to do that.  I'm left with only a few options.

First, I can push my employees to be more productive.  Run the assembly line a little faster.  Since unemployment is high and jobs are hard to find they'll put up with that for a while.

Second, I can stop giving raises.  Well, not to everybody, but at least I can freeze the wages of the production workers.  They'll grumble, but they're too weak to do anything about it.  I don't really care too much about them anyway.    Heck, I could increase their co-pay for medical insurance and blame it on the government.  That would save more money for me!

Third, I can raise prices a little.  Just a small nudge.  Maybe I'll raise them $10 but I'll throw in a spiffy widget case that only costs me $2.  High demand will just make my product seem even better, and if you have to wait for the next shipment that won't stop you from buying it.

As long as I make more money all the rest of that stuff doesn't matter.


So...Supply and Demand are no longer a pure link, and the most important element in any such conversation is "what's in it for me" which means MONEY!  Don't think the 1% doesn't think that way...because it's the only thing that matters to them.

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