The law of supply and demand

We have all heard of the law of supply and demand. Even by reading Asterix one learned that the law of supply and demand is what sets market prices and seems to be what generally keeps the wheels of the economy turning.1

The law of supply and demand builds on mathematician Daniel Bernoulli's insight that the price of a product should not be determined so much by its production cost, but by how useful it is to its prospective buyer. If a buyer is willing to pay a lot for it, then a cheap product can be sold at a high price. According to a saying in Finland, it is not stupid to ask a high price, but it is to pay it.

Consequently, if the same product is available from more than one vendor, the buyer gains by taking his business to the one who offers it at the best price. So, demand hikes up the price and supply brings it down, and somewhere along the line a balance is reached, and that is where business happens.

The law of supply and demand can lead to situations that seem strange when common sense is applied to them. OPEC is an organization whose members include most of the oil-producing countries of the world. The member countries decide between themselves how much oil each of them will produce in any given period. If brief reports in the news are to be believed, the Arab gentlemen of the organization essentially make one of two decisions: either to increase or decrease oil production.

And following one of the meetings in which they've decided to decrease oil production, you can bet that the news next day will announce the price of oil has gone up in the world. This is so normal, so mundane, it hardly raises an eyebrow. But let's think about it. The oil is no different to the oil that was on sale at a considerably cheaper price just the day before. It's no better or worse in quality, it's sold in barrels of the same size, it's exactly the same kind of oil, it's just more expensive. This is an example of the law of supply and demand in action. When supply goes down, the price goes up - even if all else remains equal.

  1. 1. See Obelix and co.

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