If you’re the only person selling water in the desert, you can pretty much charge whatever you like. If you’re selling sand, you’d better be selling it cheap.
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The Economy and Your Money: All You Need To Know
Like gravity is to physics, the law of supply and demand is the bedrock principle of all economic theory. It determines where the price of a product or service intersects with the willingness of people to buy it or sell it. It never changes and it affects virtually everything you buy, sell, do and earn.
There’s the Law 0f Supply and the Law of Demand
In an unimpeded market, supply and demand determine the value of a product or service. Supply represents the amount of something that producers are introducing to the market. Demand represents the amount of that thing that consumers want to buy. When more people want it and fewer people have it, the price goes up. When fewer people want it or more people start selling it, the price goes down. There are two forces at work:
- The law of supply: If everything else remains the same, demand drops when prices rise and it grows when prices fall.
- The law of demand: If everything else remains the same, producers will supply more of something when the price of that thing rises. When the price of that thing falls, they stand to earn less profit per unit and therefore produce less of it.
The Laws Are Universal
Barring outside intervention, the laws of supply and demand will dictate all producer/consumer relationships. The laws apply the same way to things, people and even entire countries. In the 1970s, a coalition of Arab states caused gas prices in the U.S. to soar just by reducing the supply of oil they put on the market. When an excess of homes are listed for sale but there aren’t a lot of interested buyers, the sellers have to lower their asking prices to compete and the regional housing market cools off. Heart surgeons drive Ferraris because lots of people need heart surgery but only a tiny percentage of people know how to do it. Both Ferraris and heart surgeons are expensive because they’re in high demand and short supply.
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But the Laws Are Often Bent or Broken
The laws of supply and demand presume perfect market conditions where sellers compete to meet consumer demand free from the influence of outside forces. If that were the case, cigarettes would cost much less. They’re in lower demand than ever and they’re cheaper to make than ever. The government levies heavy taxes on cigarettes to keep prices artificially high in an effort to discourage tobacco use. The law of demand, after all, says that when prices rise, willing buyers dwindle.
That’s just one example. Government regulation controls the price of things like gasoline, energy and insurance. In other cases, the laws of supply and demand are circumvented by subsidies, like the kind the government pays to farmers to compensate for low crop prices. Other times, governments protect vulnerable sellers with price floors to guarantee revenue. Governments use trade tariffs to artificially boost the price of imports to help domestic producers compete. Monopolies avoid the laws of supply and demand by removing competition. Socialist policies, like publicly funded police and fire services, exist outside the laws of supply and demand.
Without outside influence, however, a few truths are certain. Producers will get as much as they can for whatever they’re selling, buyers will pay as little as possible, and in the end, the laws of supply and demand will determine the numbers on the price tag.
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