In last weeks posting we discovered that economics is the “the study of the use of scarce resources which have alternative uses” (Sowell, 2007). The internal forces of supply and demand drive the operation of markets. In addition there are external forces or externalities that affect market operation (Hackett, 2006). We also discovered that economic systems that manage these markets are either centrally controlled or operate mostly free of centralized command.
This week we will look closer at how the law of supply and demand works. The relationship between supply and demand for a product determines its price. As demand for a product increases, the price will increase in order to insure demand does not exceed the supply of the product resulting in shortages. However, if supply for a product out paces demand, the price will go down in order to increase demand and use up excess supply (Dictionary.com, 2010).
In an economic system managed by centralized control, the job of keeping supply and demand in equilibrium belongs to the controlling entity. However, if the controlling entity is a blotted bureaucracy it may not be able to react quickly to changes in the supply and demand for products and services in the market. The result if this inability to quickly react to these changes results in excess supply or shortages. In a small economic system (e.g. a small business or household), a central command structure of economic management may be able to function well. This is because the volume of economic activity will be small and manageable. However, as an economic system grows, it becomes more complicated overtaxing the central control entity, making it difficult for it to react promptly to changes in the market (Sowell, 2007).
Free market economic systems are driven by a profit motive. When demand for a product increases, the profit potential in the market for this product increases. This increase in profit potential encourages other producers to enter the market increasing supplies insuring there are no shortages. However, as demand decreases or there is a surplus of supply due to too many producers in the market, some of these producers will either go out of business or begin producing other products that are in greater demand. This natural slow down in production insures there is no excess supply (Sowell, 2007).
Opponents to free market economics point to the fact that the layoffs and downsizing that result from reductions in production brought on by excess supply or falling demand are cruel. They cite that this is why there is a need for a centralized control of the economic system to insure fairness in the system. However, creative destruction is critical to a healthy economy and society (Forbes & Ames, 2009).
Forbes and Ames (2009) elaborates by explaining that creative destruction renders old products obsolete. Some jobs may be destroyed but other jobs, and more of them, will be created. This insures that the limited resources of the economic system go where they are most needed. Creative destruction also paves the way for the introduction of wealth producing innovations. Without creative destruction the economy stagnates, living standards decline and unemployment actually increases.
The problem with a central controlled economic management system is that creative destruction is often not allowed to occur. There may be due to political pressure brought on by labor unions or other advocates that do not allow producers to decrease production. Consumer advocacy groups may also exert pressure on producers to keep prices down, not allowing a profit motive to develop encouraging additional producers or innovation. In contrast, free market systems have demonstrated an ability to thrive due to allowing creative destruction to occur uninhibited.
As an example of supply and demand in operation, let us look at what happens to petroleum prices in the market. We are currently experiencing an extremely cold winter. This is especially true in the northeast. Since many homes are heated with petroleum in this area, there is currently an increased demand for petroleum. This has caused the price of crude oil to go over $80 per barrel, resulting in higher gas prices at the pump.
With this increased price, producers of crude oil are currently pumping more crude oil. However, when the weather warms up, the demand will decrease. The producers of petroleum will then have to reduce production and the price will go down to encourage more demand so that excess supplies of crude oil are used up.
Next week, we will look at what occurs when the externality of governmental regulation distorts the market through price controls. We will be looking at the examples of rent control and farm subsidies. The book Basic Economics by Thomas Sowell is an excellent source of information on this topic.
References
Dictionary.com (2010). Supply and demand. Retrieved January 15, 2010, http://dictionary.reference.com/browse/supply+demand
Forbes, S. & Ames, E. (2009). How capitalism will save us (1st ed.). New York: Crown Business.
Hackett, S. C. (2006). Environmental and natural resources economics (3rd ed.). London: M.E. Sharpe.
Sowell, T. (2007). Basic economics (3rd ed.). New York: Basic Books.
No comments:
Post a Comment