Economics 2

 Resources are limited. Demand is not.

Imagine a time when you are really, really hungry. You have been waiting, longing even, for an opportunity to eat. Finally, you find yourself at a restaurant. You order a hamburger (because it is that kind of restaurant). It comes. You eat it. It is wonderful.

The waiter comes by and makes you an unusual offer. “I am glad you enjoyed your first hamburger. It cost ten dollars, by the way. But, we have a special deal for you. Because you are so obviously happy with our burgers, I am making you a special offer. You can have another burger if you like. What would you be willing to pay for it?

You consider the offer. The first burger was definitely worth ten dollars. You would have paid twenty for it, or more. You were really hungry. You would, in fact, still enjoy another burger, but not so much as the first. You offer five dollars. The waiter accepts and brings you back an equally wonderful burger, which you enjoy, just not quite as much as the first.

The waiter comes back a third time. “You are obviously a fan of our burgers. What would you pay for a third?”

You are no longer really hungry, but you could eat another burger. You hate to miss out on a deal, so you offer a dollar. You finish this third burger. When the waiter returns, do you accept his offer for a fourth?

Probably not. but you will have demonstrated a basic economic principle: the law of diminishing returns. Most of us only need a single burger, a single car, a single house. We might be happy to receive a second one, or a third, but not quite as happy as we are to receive the first. Eventually, our desire for an extra burger, car, or house drops to zero. We don’t want it, even if it is free.

Economists use the word “demand” to refer to things people want to buy and are able and willing to pay for. Not everything we want qualifies as “demand.” I may want a Lamborghini to drive to work every day, but since I am unlikely to be willing to pay the asking price, I am not actually contributing anything to demand for Italian sports cars.

Within the American economy, there are millions of things people want to and are able to buy. Groceries, cars, decks of playing cards, Power Macs, new furniture, college educations . . . . (We could go on for a very long time. Let’s not.). Some cost a great deal of money. Others—vegetables, rolls of paper towels—are necessary but cost very little. It is not just that there is greater demand for some things than others. The demand for milk in the United States is enormous. Americans consume it in enormous quantities and collectively spend billions of dollars on milk and milk products. But for all that, and considering the complexities of removing milk from cows, processing it to make it safe, packaging it, and putting it onto grocery store shelves—is complicated and involves the work of a huge number of people, from dairy farmers to advertising agencies (Got Milk?) For all that, milk is still pretty cheap.

Lamborghini cars are decidedly not cheap, but demand for them is small—about ten thousand cars a year, in large part because prices for a new Lambo begin at half a million dollars. The cost of a perfectly nice Honda is a bit less.

To explain what is, perhaps, a bit self-evident, economists use a variety of graphs to illuminate what is going on with these three interconnected phenomena: supply, demand, and price.

Supply, Demand and Price: a story in three curves.

Let’s start with the graph itself. The Y axis (the one going up and down on the left) represents the production of things of value: milk, sports cars, avocados, whatever.

For an example, let’s imagine a pizza restaurant opening in a busy neighborhood near a college campus. The restaurant takes a while to get started and during the first few weeks can only make 50 pizzas a night. In order to attract customers, they sell these pizzas at a low price.

The low price attracts customers. As more customers want to buy pizzas, the store owner faces a choice. She can raise the price of each pizza which will make it possible to increase production and serve more customers but at the same time will discourage some customers from buying any pizza at all.

Higher prices will tend to increase supply but decrease demand.

Or, she can keep prices low, which means that she can only afford to bake fifty pizzas a night, disappointing customers and limiting her profits.

Lower prices tend to decrease supply but increase demand.

The supply and demand chart suggests a solution. Where the demand curve (the red line) and the supply curve (the blue line) intersect, demand and supply are the same. If the store owner sets prices at that point, she will also know how many pizzas she is likely to sell.

Naturally, life (and economics) are more complicated than this. Notice that the chart has two blue curves, D1 and D2. The D stands for “Demand—how many pizzas will be sold at a given price. If we let D1 intersect the Supply Curve at ten dollars per pizza, and follow the broken line down to the Quantity line, we can see how many pizzas can be sold at that price (Q1).

But pizza makers cannot control everything. If the pizza restaurant is in a beach town (like Myrtle Beach), the Demand Curve is likely to be different in the summer than in the winter. On our graph, Q2 represents an increase in demand, as might happen every year around Spring Break in Myrtle Beach. A lot of hungry people show up looking for a large pepperoni. What do you think is going to happen to the price of pizza at Q2? How is this reflected in the graph?