You’re watching the news when someone says, “Higher gas prices should lower demand.” How do you evaluate a statement like that? This guy is on television, so he must know what he’s talking about, right? Don’t be so sure. Many intelligent individuals throw around economic arguments using economic terminology and may even sound convincing, but there is a lot of bad economics going around! To have a good understanding of economics, you must have a grasp of supply and demand. The concepts are central to even the most complex of economic arguments, yet they are easily understood.
Markets are places that bring together buyers and sellers. However, markets do not have to be physical places. Markets exist whenever and wherever buyer and seller interact, be it a physical location, via mail, or over the Internet. Several conditions must be met in order for markets to function efficiently. Typical conditions for an efficient market include a large number of buyers and sellers acting independently according to their own self-interest, perfect information about what is being traded, and freedom of entry and exit to and from the market.
Economists disagree over the efficiency of markets. Some argue that the market price effectively captures all of the available information about the product. Others argue that prices do not reflect all available information. They argue that this information asymmetry undermines market efficiency.
A large number of participants in the market ensures that no one buyer or seller has too much influence over the price or the amount traded. It is obvious that if there is a single seller or single buyer, they will be able to exercise considerable influence over prices. For example, Walmart has what is called monopsony power over several producers. Because Walmart is the sole retailer for these producers, it is able use that power to influence the price it pays. In competitive markets, no one producer or consumer exercises that level of influence.
A monopsony is when there’s basically only one buyer for a product. A monopoly is when there’s basically only one seller for a product.
Perfect information implies that both buyer and seller have complete access to the costs of production and perfect knowledge of the product, and no opportunities exist for arbitrage, which is buying low in one place and selling high in another. Contrast that condition with the experience of buying a car. Chances are the seller has the bulk of information about the cost and specifications of the vehicle, whereas you deal with limited information at best in making your purchase decision.
Freedom of entry and exit into the market also increases the market’s efficiency by allowing the maximum number of buyers and sellers to participate. Licensing requirements are an example of a barrier to entry. By requiring licenses to sell or produce goods and services, the government limits the potential number of sellers, resulting in less competition and higher prices.
A variety of factors affect supply and demand, which in turn affect price and quantity. Changes in the market for one good will create changes in the market for another good. This happens as price changes are communicated across markets. This phenomenon should be considered when policymakers attempt to influence markets, or unintended consequences can result.
How might driving an SUV contribute to starvation in Southeast Asia? Several years ago gas prices suddenly began to climb. As a result, there was considerable political pressure to alleviate the squeeze placed on the pocketbooks of many Americans. Instead of driving less or commuting, many wanted to continue their lifestyle of driving an inefficient vehicle without having to pay higher prices. According to Thomas Sowell of the Hoover Institution, politicians and many people are fond of ignoring the aphorism “there is no such thing as a free lunch.” So, here is what happened.
As gas prices increased, demand for alternative fuels increased. This increase in demand for alternative fuels was popular among corn growers who had a product called ethanol. In order to provide ethanol at a lower cost, corn growers lobbied Congress for greater subsidies. This resulted in more land being placed into corn production at the expense of other crops, namely wheat. As wheat supplies decreased and wheat prices rose, the price of the substitute crop, rice, also rose because there was now more demand for rice. This led to the price of rice increasing to the point where people in South and Southeast Asia were unable to afford their basic staple. Starvation quickly ensued. Markets talk to each other. No one intended for starvation to occur, but when people ignore scarcity, unintended consequences can and do occur.
Do you remember the first time you learned about atoms in science class? The teacher probably drew a sketch on the chalkboard that looked like a model of the solar system: a big nucleus in the middle orbited by a tiny electron. Later you probably learned that atoms do not actually look like the drawing on the board, but the model your teacher showed you helped you to understand atoms. In economics, when studying markets, you begin by learning something that is somewhat unrealistic, but a simple model of perfect competition will help you to understand real-world conditions.
Certain conditions are necessary for the functioning of an efficient market: a large number of buyers and sellers each acting independently according to their own self-interest, perfect information about what is being traded, and freedom of entry and exit to and from the market. Add to this list that firms deal in identical products and that they are “price-takers” (that is, they are unable to influence price much), and you now have perfect competition.
Identical products mean that there are no real differences in the output of firms. They are all making and selling the same stuff. Think of things like wheat, corn, rice, barley, and whatever else goes into making breakfast cereal. Wheat grown by one farmer is not significantly different from wheat grown by another farmer.
Why are perfectly competitive markets preferable to other types of market? Perfectly competitive markets are what economists call allocatively efficient. Consumers get the most benefit at the lowest price without creating any loss for producers. Perfect competition is also productively efficient because in the long run, firms produce at the lowest total cost per unit.
Economists refer to firms as “price-takers” when a firm does not set the price of its output, but instead sells its output at the market price. Remember, one outcome when markets have many different small buyers and sellers is that none are able to influence the price of the product.