More Economic Theory

I know this is boring to most but economic policy is one of the most important public policy arenas with day to day consequences for us all. If it is handled well we benefit. Each of us. If policy decisions are done poorly, the economy misfires and affects us all in a bad way.

The economy works in balance. This is called equilibrium. Actually the economy constantly seeks equilibrium much like water seeks the lowest level. Many variables affect equilibrium. We will look at just a few today.

Supply and demand basically controls the pricing function. Price is the mechanism that seeks equilibrium of supply and demand. When demand exists for a good or service, a price can be set for its sale to a buyer. The more a product (good or service) is perceived to be needed, or perceived to be in short supply, the higher the price can be.

If there is no competition from other suppliers, buyers will pay the stated price as long as they think they can afford to pay it. This is pricing in a monopoly situation. If only two or three suppliers exist, then pricing is more competitive but still controlled by a few. This is an oligopoly market. In a heavily supplied market, prices will be very competitive. Buyers have many alternative sources to choose from.

When a product is new to the market there is no competition due to uniqueness. Price is thus high and rewards the supplier for creating the new product and bearing all the cost of research, engineering, invention and start-up costs for production and introduction to the market.  Think Apple’s I-Phone.

These early periods could be months or years but the seller has the opportunity to recapture start-up costs and build the market. Once competitors enter the market, prices will drop somewhat depending on supplier profit margins required to first break even, and second reward the supplier sufficiently to continue offering the product.

As competition increases with more suppliers wishing to chase the profits of this product, prices will decline until a new balance is established. Pricing must cover the cost of producing and distributing the product. Sellers must feel rewarded for their investment risk and work. If not, they will exit the market, lessening competition which then results in a changing point of equilibrium.

Supply and demand. Seems simple. It isn’t because the facts of each product and market situation is highly variable. Here are some of the variables:

• Advertising or marketing creates awareness of a product’s existence
• Marketing creates interest among buyers to buy the product
• If buyer perception is high that this is a needed product, then price can be set higher
• If a product is perceived as being unique or ‘best,’ prices may be set higher
• If a product is viewed as mundane and of little difference from one supplier to another, it becomes more a commodity and is priced lower, especially if it is of plentiful supply
• If technology adds new functions or features to the product, prices can be raised
• If technology changes the need for your product, the price may drop to zero

That’s enough variables for one sitting! Let’s look at some other elements that relate to overall pricing function.

The cost to produce the product adds to the price equation. Raw materials and labor are the two largest components of product cost. As long as both are plentiful the cost to produce a product remains affordable and pricing is easy to set. As a product gains use in the market, i.e. the number of buyers willing to buy the product grows regardless of the number of suppliers in the market, supply issues are added: are raw materials still readily available at stable prices, or are supplies getting tight and higher priced? If the latter, production costs rise and pricing will need to follow to maintain profit margins.

Supply of labor and its costs follow the same supply and demand factors as raw materials. If labor costs rise then prices will need to follow.

Any producer that can produce the product at lower cost has a competitive advantage and can price accordingly. Competitors may be squeezed out of the market under these circumstances.

Additional production costs include space, utilities, distribution expense, advertising and marketing costs, sales expense and administrative overhead. The latter includes planning, accounting, research and development, engineering and executive management.

A basic understanding: if variable costs cannot be recaptured, the producer will lose profit and may go out of business entirely. Thus supply and demand is one competitive factor; another is pricing components each of which embraces their own supply and demand issues which further affect price.

We will examine later how the above factors interact in specific industries and products:  housing (real estate prices, mortgage costs and rents); automobiles; energy; agriculture; and technology-based products.

Until then examine closely why you buy a specific product. Has the basis of your decision to buy that particular product remained the same or changed? Has your need for it changed? Has your ability to pay for it changed?

More in the near future; much more. Stay with me on this topic. It is important in understanding many current events.

October 30, 2011