Making Sense of Supply and Demand

I recently started reading Thomas Sowell’s Basic Economics. Before starting, I would have never realized how much this book would make me think and questions things. Just recently, it made me realize how much I did not understand supply and demand—something that you’d think is a simple idea!

Before Sowell

My previous understanding of supply and demand was: the more the demand, the higher the price. The more the supply, the lower the price. Like, if more people are asking for it, just raise the price to make more money. If less people are asking for it, then lower the price in order to make sales. Similarly, if there’s a lot of it, then people have lots of options, so prices are likely lower.

But look at the typical Supply & Demand graph, you’ll see that that understanding of it is complete baloney!

My own drawing 😜

My Thoughts when Reading Sowell

Here’s what I read in Basic Economics:

There is perhaps no more basic or more obvious principle of economics than the fact that people tend to buy more at a lower price and less at a higher price.

Ok… So good so far. Then he goes on:

By the same token, people who produce goods or supply services tend to supply more at a higher price and less at a lower price.

Wait… I thought it was the opposite? Am I reading this right? Then he throws this line:

With goods in general, the quantity supplied varies directly with the price, just as the quantity demanded varies inversely with the price.

I don’t know about you but this got really confusing to me.

Making Sense of Supply and Demand after Reading Sowell

For me, abstract ideas often don’t make sense unless I can tie in an example to it. I always try to do that because if I can’t, that means I do not understand it. Thankfully, Sowell writes with a bunch of examples all the time.

First, let’s clarify Supply and Demand.

Demand → “commitment”

I believe the confusion with demand is that it seems to say, “how much people are asking for this”. No, what demand really means from the point of view of a customer is, “if the product is sold at price X, I will pay for it.” Really, it’s like a customer signing a contract that binds them to pay for that product if the price gets to X. In a way, it’s not really a “demand” but more of a “commitment” to pay for the product if its price is X.

Then, when you see it that way, it’s makes a lot of sense that more people will buy it if the price decreases. If a MacBook Pro cost $10 (instead of like, $2000), I bet you almost everyone would get a MacBook Pro.

And now, you can probably see where I was confused. I thought that price responded to “demand”, but really it’s the other way around. Price dictates what the demand will be.

But hold on a second, doesn’t “demand” influence price too? For instance, just recently when the Playstation 5 (PS5) was released, an insane number of people wanted it. Like, they “demanded” this console, and this led poachers buying it in bulk early and then selling it for over double the price!

Technically, yes, but not in the way you think (I think). Let’s go back to the “commitment” analogy. In this case, Sony said they’d release the PS5 console for $499 and PS5 digital for $399. However, a subset of people probably had already “signed” the “commitment” that they would purchase a PS5 “no matter the cost” or “up to $1000”, and that subset was a big one! So, poachers saw this as an opportunity to make profit because if Sony is selling them at $499 and they could buy it and resale it at $1000, they’d make a profit of $500 from this large subset of customers, and many of them did. Before I continue, let’s get to supply!

Supply → “Commitment”

Again, commitment really works well to understand these concepts. For supply, I used to think of it in terms of “if there’s more of it out there, then it will cost less because people are usually after rare things”. Again, I made the same mistake I did with demand, which is that I thought of prices responding to supply instead of the other way around.

Instead, supply is really a commitment that a supplier makes. They say, “if I can sell this product at price X, I will supply Y of them”. It’s a bit more complex on the supplier side because they make the calculation that there exists a “demand commitment” of at least Y products if each one is priced at X. Overall, this is a gamble that the supplier makes, and that’s where we get into “shortage” and “surplus”; I’ll explain each with examples.

Going back the PS5 example, I think what happened was this: The supply of PS5 sold by Sony for $499 (let’s ignore the $399 version) was much smaller than the “demand commitment” for PS5 at $499. Like I mentioned above, many were willing to pay over $1000 for it. This created a shortage of PS5, and it is in conditions of shortages that poachers can absolutely take advantage of the the situation and sell the product second hand at a higher price because they know that many customers are committed to buying this product—even at that higher price.

So, the demand didn’t “influence” the price of PS5 to go up. What really happened was that Sony miscalculated how much people would be committed to paying for a PS5 at $499 (much higher than the supply they had, even today as the console is still sold out over almost 2 month after it was released!). In mis-pricing the PS5, Sony created a shortage, which created an opportunity for poachers to sell the console at a “fairer” market price that matches the “demand commitment”.

Fair market price? Are you kidding?!

I don’t like admitting this, but it’s true. Sony would probably have made a higher short term profit if the PS5 was sold at a higher price, and there probably would be less poaching for it.

In terms of “fairness”, we get into the other concept that Sowell talks about in this chapter, and it’s that there just isn’t a concept of fairness in prices, thus why I put it in quotations.

What I really mean is that the price for PS5 for the supply that was created would have sold at equilibrium (the price point at which supply meets demand) if it was higher. Additionally, if this price was higher, Sony would have supplied even more PS5s. This would have allowed *more* people to purchase the PS5 (albeit at a higher price but they would be *okay* with that price because they committed to it already!), and the result would be a much happier customer base that gets to enjoy their PS5s. Instead, we got a bunch of unhappy customers complaining on Twitter.

In my personal opinion, I think it’s better to have more happy customers than unhappy customers, and that’s why I say it’s fairer! Do you disagree? Feel free to leave a comment!

Another Example: Home Prices

I mentioned that I’ll get into shortage and surplus, and I’ve already explained shortage. So, let’s get into surplus with the home prices example.

This example is coming from the book, and it goes like this:

When a large employer goes bankrupt in a small community, or simply moves away to another region or country, many of the business’ former employees may decide to move away themselves from a place that now has fewer jobs—and when they numerous homes go on sale in the same small area at the same time, the prices of those houses are likely to be driven down by competition.

Why did the prices go down? This was because of surplus! There’s actually a lot of variables here, but we primarily want to show that (1) there was a surplus of homes on sale and (2) that drove the prices of homes down.

Surplus of Homes

Let’s assume before the large employer goes bankrupt, everything was at equilibrium, and that (again for me) meant that the entire market was the happiest it could have been and that was fair. Then, the employer goes bankrupt.

What happens next is: supply of jobs factually goes down! Now, with lower supply of jobs, we get a shortage of jobs. The shortage of jobs means more people need to find jobs elsewhere, so what do they do? They go find other jobs in another town. In that town, that creates a surplus of jobs. That probably means that these people might be getting paid less (because with the surplus of jobs, the pay for jobs goes down). These people, now in another town, decide to sell their homes. Because a lot of people are selling their homes at the same time, there is a surplus of homes at the price that the homes are. But why is there a surplus?

There is a surplus because the fact that people are leaving this town (since there is a shortage of jobs) leads to less people wanting to live in that town. That is, previously people were committed to pay X to live in that town, and now they are only committed to pay Y (where Y < X). The people who left the town were probably still selling their homes at price X, but soon they realize that not enough people are committed to buying a home at that price. So, they have to lower the prices to meet the demand, thus reverting back to equilibrium.

The outcome of that is that old town goes back to being the happiest it can be!

Conclusion

If like me you were confused by supply & demand (or you thought you understood it but really didn’t), then I hope this article helped clarify the concepts! If you already understood it, I hope the examples in the article helped solidify your understanding of supply & demand. To be honest, I’m still a bit confused myself, but writing this has helped clarify things for myself. But anyways, thanks for reading!

NOTE: I usually proofread, but I didn’t proofread this one. So, excuse my typos if any 😆

I’m a human, living on earth, and doing Software Engineering. I enjoy reading thoughtful posts, and I even write sometimes! So, here we are.