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Supply & Demand Reality
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0:00
If you were to ask any random person on the street what it is that they knew about economics there is a pretty good chance that the first thing that they would blurt out would be the words “Supply & Demand” The number of people out there willing and able to buy a good or service versus the number of people out there willing to sell a good or service, all individually vying to get the best possible price. If demand increases prices increase, if demand falls prices fall and visa versa with supply.
0:27
Now I know this channel is called economics explained but for most of you watching all of this should pretty much go without saying. The only issue is that this rosy picture is in no way a reflection of the real world. The price you pay for groceries, that new iPhone, or hey even the price that your employer pays you to do your job all have a lot less to do with supply and demand than you might expect. This departure from perfect economic assumptions can also tell us a lot about what to actually
0:57
expect during times of economic turbulence and properly-being able to predict how an economy works, in reality, can very easily be the difference between riding out an economic storm, or being crushed by it. So what is going on here? How are prices decided if not through supply and demand? What does this mean for regular people in the economy? How could all of this be used to make better policies and business decisions? And how does this all make the case for a zero dollar minimum wage?
1:55
Intro add Now of course if the Australian economics man wants to go after the holy forces of supply and demand he better come equipped with a big disclaimer, and that is that long term these forces do of course influence prices but not necessarily in the way you might expect. This all has to with a phenomenon knows as Sticky Prices There is no such thing as a perfect market in the real world. A market where buyers and
3:19
sellers have perfect access to information, a market with limitless competition and an endless selection of identical products. This is actually a great thing… we do not want perfectly efficient markets, because inefficient markets allow businesses to exist. To show why, consider a farmers market in an area that only grows beets. At this market, there might be 100 farm stalls and an unlimited amount of prospective buyers.
3:48
If all of these buyers is a rational consumer and has perfect access to information they are automatically going to go to the stall that has the lowest prices. Knowing this the other farmer’s stalls are going to undercut those prices in an attempt to sell their beets, and then other farmers are going to undercut them in response. Eventually it will get to a point where all of these farmers lower their prices to a point
4:12
where they are no longer turning a profit on the beets that they sell, just in order to actually well sell some beets. This sounds great for the consumers who now get to walk away with costs price beets but here is the problem. Who would bother going through all of the trouble of buying a farm, planting cultivating seeds, harvesting the crop and then selling it off all in order to make absolutely no money? Well with our assumption that all actors in this market are rational the answer would
4:41
be nobody. So no beets would be supplied and the economy would be all the poorer for it. Fortunately, however, markets are not perfectly efficient. Consumers don’t have perfect access to information and might just buy beets from the farmer that they know, other farmers might have more efficient farms which means they can lower prices further while still making a profit, or of course, one farmer’s beets might just be tastier and more nutritious than their competition.
5:08
Because of this each farmer has a chance to turn a profit, stay in business and be there to provide the world with beets next year. In this example, the forces of supply and demand gave the market a basic price to work around but the actual price that beets were being transacted at were more fine turned by things like consumer relationships, salesmanship, stall location within the market and just a little bit of good old fashioned luck.
5:35
This idea of supply and demand being a rough guideline around which prices are formed is a really great way to properly understand markets in the real world. Take something like a smartphone. If a company was to charge $5,000 for their new phone chances are not many people would buy it. That kind of pricing would fall well outside the bounds of the price dictated by supply and demand. But a retailer charging 20% more than their competitor for a functionally identical product
6:04
offering isn’t outrageous assuming that they have really good marketing. Now, of course, it could be argued that things like marketing are just influencing consumer demand and hence prices are still ultimately determined by that demand, which is true but it is a somewhat backward way of thinking about it especially if the situation in that market was to change. If the world went into a recession, causing a huge spike in unemployment and a rapid drop
6:30
in consumer confidence, (you know I am just saying hypothetically) the logical economist would expect that prices would drop right along with it but that doesn’t really happen. The classic example of this is a restaurant. Changing prices in a location like this could be expensive, it would mean making all-new menu’s updating their payment terminals and adjusting any marketing they have which includes those prices.
6:55
This is all on top of the fact that most consumers don’t even check this. Ask yourself when was the last time you checked the prices at a nice restaurant before you sat down? For most people, the first time they see what they are paying for their meal is after they get their menu’s and its normally seen as pretty poor form to walk out after you have been seated. Because of this a restaurant might incur a huge cost to change prices all for it to not
7:20
attract any more customers and make even less out of the customers that they do have. This is what is known as sticky prices, where prices have a tendency to stick in place despite external pressures trying to move them. The important thing to know about this effect is different for different products in different markets. Take something like the stock market for example, this is probably one of the closest real-world
7:46
examples we have to our hypothetical beet market. There is lots of information available on it in real-time there is no product variance because there is no difference between one amazon share over another amazon share and it’s filled with buyers and sellers who will always try to get the best price. Because of this the prices in the stock market are very unstiocky and they will react extremely quickly to any changes in the behavior of buyers or sellers. In the age of high-frequency
8:13
trading, these changes could literally take millions of a second. Even then there are rules and regulations in place that mean the stock market has some level of price stickiness. Traders in these markets have good access to information, but it’s not perfect. Things like quarterly earnings reports massively impact stock prices but they are usually released to the public a good period of time after they are finalized with the accountants that put them together.
8:39
Infact even if you did have access to this information you couldn’t actually use it to influence your buying or selling decisions without going to prison for insider trading. None the less financial markets still have their prices change on a dime as they react to shifts in supply and demand. On the other end of the spectrum are markets that are filled with a lot of emotions, bureaucracy, middle men, opaque information, and consumers looking for more than simply getting the best deal.
9:07
The markets for things like pharmaceuticals and medical treatments are almost completely divorced from our typical understanding of a competitive market influenced by supply and demand. Jake Tran actually made a great video recently on just how complex the pricing of something simple like diabetes medication can be. This is the kind of product that has extremely sticky pricing. Now overpriced medicine does cause alot of social issues but it is unlikely to do something
9:35
like accelerating a global economic crisis however there might be a market where pricing is pushed off course even further. And that is the market for work The labor market is one of the largest operating markets in the world, but it’s also one that we don’t normally think of as a market because well people don’t love the idea that they are selling hours in their day for money. None the less that is effectively what this market is, companies will pay for the services
10:03
of their employee’s and the same general rules apply. Companies will pay a premium for workers of a higher quality filled with qualifications and experience, and they will probably also pay a price premium for workers that are marketed better. Gotta make that linked in profile pop. With all of these rigidities, the same issue of price stickiness comes into play. In an economic downturn, people naturally spend less money, this is either because they
10:28
have lost their jobs so they have less money coming in, or they are fearful they might lose their jobs so they cut back on spending to try and build up a bit of an emergency fund. In response to this business revenue’s fall and they will be forced to cut down on expenses. The biggest expense normally being personnel. The problem with cutting down on staff salaries is that they are very inflexible. Employment contracts normally have a very defined set of conditions, this much will
10:56
be done, on these days between these hours for this much money. And yes yes I know employers very rarely hold up their end of the bargain around those working hours, but most people let that slide so long as they get paid the amount they were promised. If an employer tried to lower staffing costs by cutting everybody’s salaries by 10 or 20% most employees would in no uncertain terms direct them to the location where they could stick their new wages.
11:24
What this means is that the only option left for the business is to let some staff go. Effectively this is a lose lose. The business will be down on manpower and can’t create the same output, and for the people that do lose their jobs, they will be going out into a very difficult job market. And don’t think the reality is any better for the lucky employees who do get to stay on and maintain their wages. Suddenly they will need to pick up the slack of their fallen
11:49
comrades and they will have much less negotiating power around things like bonuses, or pay raises in the future. If these workers are on full-time contracts they may end up working so many additional unpaid time that their actual hourly rate would be worse than if they had just taken the pay cut. This is a very clear cut example of a market failure, the demand for labor shrinks, and the supply of available labor rises, if this were a gallon of petrol or a beet we wouldnt
12:18
think twice about the price falling, but due to arbitrary rigidities involved in employing people the price stays stubbornly high. Of course, the outcome of a market failure is a deadweight loss. Which as the name would suggest is pretty bad, go and watch our video on back market economics if you want to know exactly how they work. But even with all of this in mind ask yourself this question. Your boss walks into your office
12:44
and say you have a choice, you and your team take a 20% pay cut or you have to get rid of whoever the worst person on your team is. It’s one hard conversation vs five hard conversations so for alot of managers out there it’s a pretty easy choice to make. Now here is the big problem. Even if you can get a workforce to agree to take a sweeping paycut this will massively hinder staff morale. A study of senior personnel managers from a diverse selection of countries found that
13:17
when this strategy was implemented a whole lot of bad things happened. staff turnover increased as high performers jumped ship to competitors that were more than happy to take them on, on their previous salaries and even the workers that remained adopted a mentality that they are only been paid 80% of what they previously were so they are only going to work 80% as hard as they used to. Which you know what? Honestly fair enough.
13:40
Employment standards, unions, minimum wage regulations, employment contracts, severance requirements not to mention the emotions that come along with tinkering with peoples livelyhoods mean that the best economic decision is rarely made when it comes to employment on an individual, business or economy-wide level. But surely there are Some solutions Unemployment need’s to be carefully controlled during times of economic uncertainty, but
14:05
as we have seen silly humans with their emotions and contracts try their very hardest to create massive market failures. So the responsibility then turns to governments to try and sort this mess out while also dealing with all of the other stuff that goes along with a recession. Now one solution is to just let people out of work claim welfare, but this of course isn’t ideal. Welfare won’t maintain the quality of life that most employees normally come to expect
14:32
causing a drop in living standards and consumer demand, all while being very expensive for the government, and not actually producing anything in the economy. There is corporate stimulus, where a government can just pay to keep companies afloat in the hope that they will keep employee’s onboard but there is no guarantee this will work, and what’s the point of this anyway if the business will just go on to fail at a later
14:54
date. You are replacing one market failure for another market failure by doing this. And finally, there is the option of removing all of these rigidities from the labor market. You may have heard the argument that if the minimum wage was dropped to zero dollars there would be no unemployment because employers could pay people whatever they are worth and hence it’s worthwhile to just have lots and lots of people around, even if they are only there to fetch coffee at 20cents an hour.
15:20
Obviously, it should go without saying that this is a radical solution and big disclaimer time, it is not a solution I personally think most economies are ready for, but it is actually true a zero dollar minimum wage would leed to zero unemployment. no business would pass up on a super cheap employee so long as they don’t actively hurt the company or distract other employees. Now the obvious issue with this is that it allows low-skilled or vulnerable employee’s
15:46
to be taken advantage of. But here is the thing, businesses only employ people as an absolute last resort. People are expensive and hard to get rid of if they don’t work out. No businesses is going to hire someone even at minimum wage unless they were absolutely sure that that work was going to make more money for the business than the additional expenses they create. This is to say that most employees would still likely be able to negotiate a salary which
16:15
is at or above minimum wage but it just offers flexibility to businesses during periods of reduced cash flows. Now before the downvotes come pouring in most economists that genuinely advocate for this recommend it to come along with another form of protection. As cold-hearted as macroeconomists maybe we don’t want to see people starving while working for 50cents a day. But consider that this policy was introduced with something like a universal basic income.
16:43
Sure a business could try to hire someone at 50cents an hour but they probably won’t have much luck attracting otherwise comfortable workers unless they either offer a better more marketable wage or they are hiring a beer taster. Now, this might still sound like a pretty crazy idea, that sounds nice in theory but wouldn’t work in any developed country if it was actually tried. But consider this, there are actually developed nations in the world today that have very
17:10
similar systems in place where the government does not interfere with wage pricing. You may even be able to hazard a guess as to what these corporatized wastelands are. That's right, its Sweden, Norway, Switzerland, Iceland and Denmark. Hmmm.. Economics may purport to be a science, and maybe it is, but it is certainly not an exact science. Creating good theories, and prescribing good policies relies on realizing this fact.
17:39
Suggesting that the real world is going to produce the same results as perfect little economic models filled with assumptions and rational consumers is silly at best and harmful at worst. I have said it before and I will say it again, economics is a social study and being a good economist relies just as heavily upon understanding people and their emotions as it does on understanding rigid mathematical models. If this can be done however we are able to work through solutions to problems that will
18:07
improve the way we consume, the way we work, and the way we live. But you don’t need to wait for economists to make those improvements, you can get started right now
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