Supply And Demand

Economic theory is not as simple as it seems

Supply and demand is a very simple idea. If prices are high, supply will increase and demand will decrease until there is just the right amount being produced. Similarly if prices fall, demand will rise and supply will fall.

It is a perfect theoretical model for how we manage one of our most fundamental economic relationships.

It is of course simplified to the point of being meaningless in anything other than theory.

All else being equal

The idea of model building in isolation is good for instruction, but weak in application. In real life other factors intrude and while the long run equilibrium of supply and demand may assert itself, it does not happen quickly.

Take oil prices for example. If the price of oil rises, the price of gasoline rises. Do people buy proportionally less gas. Not likely. Within not huge variations in price, demand is inelastic. Demand does not change much with a price. In elasticity in respect to price appears in the consumption of cigarettes and alcohol, too.

Do you suppose governments have noticed this factor and have imposed hidden taxes?

There is another sides of the supply demand question.

Most people would not think so, but supply can be quite elastic in response to price. Suppose oil rich country A is selling three million barrels of oil per day at $100 per barrel. Suppose further the price falls from $100 to $80. Will they reduce their production? Probably not. Depending on other factors they might increase production. Exactly the thing that will make the price go lower. Not rational on the surface.

Selling good business when the market price falls is a similar issue.

Rational responses are governed by many things.

If Country A needs $300 million daily to sustain their budget, despite the price they will produce more until they get what the revenue they need. The other factors include consideration of whether they could cut the budget and remain in power and whether they will run out of oil in the near term. In your case, you might take a part time job at a lower hourly rate to make extra money for a child’s education or to pay down debt. Price is not an absolute predictor.

Eventually it comes down to marginal revenue versus marginal variable cost. Fixed costs are there in any case so even producing at less than the fully absorbed cost is preferable. Suppose the variable cost to ship a barrel of oil is $10 and the fixed costs are $80. On the surface anything less than $90 is a sale at a loss. Over the long run that might be true, but if I sell a barrel at $80 I’d recover $70 of my fixed costs, whereas, if I refused to sell at a loss, I would recover none.

Cost-price-volume problems are more complicated than mere supply and demand.

Everything else is never equal

Beware simple ideas. The world is never simple and you can miss important features of the situation if you accept the world in its abstract form.

It is easy to see the stock market as an auction market where prices are rational and objective. Auctions don’t work like that. Auctions are emotional. Value is whatever the last two bidders make it. Absent knowledge of their motivation there is no way to assess objective worth.

Do not accept theoretical models at face value.


I help business owners and others use tax efficiencies and design advantages to achieve more efficient income and larger, more liquid estates.

In previous careers, I have been a partner in a large, international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you. don@moneyfyi.com 705-927-4770

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