Yes, it really is that simple…
Now what was the point of the rambling in the previous posts? Well, I had defined a Free Market as:
a Market in which the Price of a good or service is determined solely by the Demand & Supply for that good (or service).
I then told you that
The Demand for a good is the quantity of that good which people are WILLING & ABLE to purchase, at a given price.
Finally, I said that:
The Supply of Good is simply the quantity of that good that people are WILLING and ABLE to sell at a given price
Now if you put all of that together, you get this:
Umm, ok… so what? Well I drew a demand curve (for coffee), and supply curve (for manure but let’s say that was the supply curve for coffee). So what we have is a little picture which shows you how much coffee people are willing and able to buy at a given price, and how much coffee people are willing to sell at a given price.
Put them together, and they cross, at the point where the price is P, and the quantity is Q. At this point – Demand is equal to Supply. That means, that the quantity of coffee people want to buy at this price is equal to quantity of coffee people are willing to sell at this price.
The price at which the buy and sell quantity is equal is known as
The Equilibrium Price (or the Market-Clearing Price)
Question & Story: The price of toilet paper in Wal-Mart is $4. Does that mean that the Equlibirum Price of Toilet Paper is $4?
NO. The equilibrium price is a theoretical concept – it is the price at which the amount of toilet paper bought is equal to the amount of toilet paper sold. The $4 that Wal-Mart is charging you for the TP – is the supplier’s best guess at what the equilibrium price is. The supplier – Wal-Mart – wants to sell all the toilet paper it has. And it thinks it can sell all of it at $4. But let’s say that all of Wal-Mart Customers find the $4 too expensive? What happens? Wal-Mart doesn’t sell all of its Toilet Paper. It still has some leftover. So what does it do? It lowers the price of the Toilet Paper to $3. More people come and buy it, but it still has some toilet paper leftover. So Wal-Mart knows it could lower the price some more to sell more. So it lowers the price to $2. At $2, something different happens. People mob the store and anyone who can grab toilet paper is doing so, and beating each other up to grab the last remaining stack of toilet paper. Within 10 minutes of lowering the price to $2, WalMart finds that it has run out of toilet paper, it didn’t make a profit on the toilet paper sold, and there are angry customers daring to go and start buying stuff at Reliance Fresh instead of WalMart! So now WalMart can do a few things, but we will talk about the ‘easiest’ one first. Wal-Mart realises that the ‘equilibrium price’ of toilet paper probably lies somewhere between 2 & 3 dollars, so it prices its TP at $2.5o. The toilet paper that gets sold is exactly enough that people wanted, and Walmart makes a profit on the sales. This is of course a dream scenario – the supplier may never ever really discover the equilibrium price – but will try to sell s close to that level as is possible.
In this SIMPLE way, we have decided how much toilet paper to produce in the economy. Demand (the buyers of TP) didn’t sit down with Supply(Walmart) and organise a 5 year plan. They didn’t get together in a back room and decide what the price would be. The buyers walked in, and figured, based on their various circumtances that the TP was or wasn’t expensive. All the supplier wants to do is make a profit. He does that when he recovers the cost of making toilet paper (for simplicity’s sake). The supplier doesn’t care about the comfort of the buyer’s bums or whether they are nice people or not. All the supplier wants to do is make money – if that means making comfy-bum toilet paper so be it. The buyers don’t care if Walmart had to work real hard to make toilet paper. All they care about is getting their bums clean.
Basically, all of these people are Selfish bastards. All they did was think about themselves and do something for their OWN benefit. And magically, acting selfishly like this answered the question: ‘How much toilet paper should be produced?’ – by people who don’t even have degrees from JNU! Shocking! This magic act – of people acting selfishly producing a community result is called the Invisible Hand of the Market by Adam Smith. That when left completely FREE and to themselves, Market Forces work to produce a ‘Socially Optimal’ outcome. In this case, the words Socially Optimal don’t mean world peace or a ban on Rakhi Sawant. Socially Optimal in this case means that Demand and Supply are in equilibrium. Remember how I said eons ago that Economics was about distributing up that Chocolate cake? Well the Free Market basically distributed that cake in the most Fair way possible, compared to all the others.
More on this in next few posts…