We cannot escape economic theory wherever we turn. We are bombarded by it when we turn on the radio, watch TV or pick up a paper. However, what we are fed at best shows ignorance and at worst is meant to mislead. Today, with gasoline prices dropping like a rock, we continue to hear the mantra of supply and demand as if this is driving the price increases. Whenever the increasing price of any item draws the public ire, reporters, commentators, and politicians all wring their hands and blame it on supply and demand. I wonder if they are all that ignorant or is there a concerted effort to mislead the public. Everyone needs a basic course in economics and how the price is set for any product or service.
It makes no difference if we are talking about a raw material, a finished product, a service, or employee compensation there are only three ways a price will be set. All prices are determined by one or a combination of these three; Cost Plus, Supply and Demand, and Value.
Cost Plus may seem simple to understand and implement but is almost never used in today’s society. Logic tells us that the price of any item must be set higher than its production cost but there are many examples where this isn’t so. The farmer who must sell his products at or below his production cost at times of overabundance simply to recover some of his expenses, an example of supply and demand, the retailer who sells a product at a loss to attract business, an example of value, or the employee who will work for wages that cannot provide an adequate standard of living. Cost Plus was most effective when used in two areas. First, contracts between the government and private companies when based upon a cost plus formula and with adequate oversight provided amazing innovation, and quality products. The contracts assured the companies a profit while eliminating most financial risk and they provided the people through their government growth, innovation, quality goods, and services at a fair price. Second, Cost Plus was effective when setting prices in the industries that were considered vital to national or state interests. Certain industries were regulated because of their potential impact on the growth of the economy or the security of the country. Their ability to maximize profit was secondary to the security of the public. They were guaranteed a small but stable profit in return for providing necessary goods and services with no financial risk. These industries were, transportation, fuel, communications, and power. All of these industries have been deregulated in the belief that giving the private sector the ability to maximize profit will provide the incentive for growth and innovation. Often I wonder if we are better off today or forty years ago.
Supply and Demand is the reason given for prices that seem to be out of control, but it is also held up as the lynch pin of free market capitalism, making this country great. Capitalism has made this country great but free market capitalism has proven to be a failed philosophy. Everywhere you look people point knowingly to supply and demand as the reason for this or that problem but in fact supply and demand have a limited impact on prices. The idea of supply and demand is a delicate balancing act between supply, demand, and price. As long as supply equals demand the price will remain constant but if supply is increased and demand is constant the price will decrease, not a good thing if you are a provider. Now if demand increases the price will increase and in theory encourage more production to again bring supply and demand into balance. A provider must work to maximize profit on a daily basis therefore investing to increase the supply presents a risk that does not exist when additional profit can be gained by simply letting the price increase. It should be obvious that for a consumer having supply and demand in balance or having supply outweigh demand are both good things while the only good relationship from a provider point of view is to have demand outweigh the available supply.
Value is the reason we pay two dollars for a tube of toothpaste, three dollars for a gallon of gasoline, or five dollars for a gallon of water. No product or service has an intrinsic value yet there is a perceived value to any item. The value is determined by the provider and to a much lesser extent, the consumer. Value is also a balancing act but more simple then supply and demand. Here the only question that must be resolved is “at what price will consumers stop purchasing the product?” Marketing organizations constantly attempt to answer this question. It is important to recognize that most products and services are not necessary to health and safety, therefore the consumer can choose not to purchase when prices rise beyond a certain point or income must be directed to other resources. Advertising efforts are devoted to convincing consumers of the value of certain products over others. Now we come to the products and services that are vital to our personal or corporate health and wellbeing. The value of these items is virtually unlimited because without them our personal or financial health is threatened. A major problem for our economy exists when an ever-increasing percentage of income must be directed to these vital products reducing the amount available to support the overall economy. These vital products and services are medical care, transportation, fuel, communications, and power.
Capitalism has and can encourage growth and innovation but free market capitalism is just as likely to produce uncontrolled greed. Examples abound in recent business history where ethics were abandoned in favor of unconscionable profits. When governments abdicate their responsibility to provide oversight and regulation they do so at the nation’s peril. Approximately forty years ago this country started down the road of free market capitalism with the deregulation of the fuel industry, today we live in a world where free market capitalism is the guiding principle.
Previously I wondered if we are better off today or forty years ago consider this, if you are in your sixties or above you were most likely raised in a one-income household, if you are in your forties or fifties you were raised in a two income household, and if you are under forty, a three income household.
A. Darden