Friday, August 25, 2017

The Law of Supply and Demand

Did you ever take Economics in school?  I'm not talking about personal finance, I'm talking about Economics--the study of money.

One of the topics studied in Economics is the law of supply and demand and I thought I'd take a look at that law today.

Basically, the law of supply and demand is the way prices are set in a totally free economy.  Let's take something simple--I make these really cute Christmas ornaments out of craft sticks, hot glue and glitter. All my Girl Scout parents say how cute they are so I decide to go into business.

I can buy craft sticks on Amazon for about 3 cents each, and I use 5 of them to make the ornament.  I also use about 10 cents worth of glitter and glue.  I figure I can put up a free website to sell them, and will take payment via Paypal.  How much should I charge?

Well, I've got about 25 cents worth of raw materials in each one, and the mailer and postage, hypothetically will cost me about $2.00 each.  Paypal will take a cut of every sale.  It takes me between 5 and 15 minutes  to make each one (less time per item if I'm making a bunch and can do them assembly-line style, rather than getting everything out, doing one, waiting for it to dry between steps etc.) I think my time is worth $30 per hour and I am going to average the time and say it takes me 8 minutes to make each one.  Therefore, I am going to price them at $6.25.  Makes sense, right? 

First, as I'm sure many of you realize, I'm going to find out pretty quickly that an isolated free website isn't going to bring in any business, so I switch to Etsy, which does have fees.  Does that mean I get to raise my price? Maybe, so let's say that per item the Etsy fees work out to $.50.  Now my ornaments are $6.75.  That's a  price that pays me for my time, buys my materials and pays for selling and shipping.  That's fair, that's right, and that's what they should sell for, right?

In a controlled economy, $6.75 would be the price of my ornaments if the government functionary in charge of holiday decorations agreed with my reasoning about my time value; conversly if that person thought crafters were only worth $10 per hour, the price of my ornament would be set at $4.08.  Which is right?  Which is fair?

Free economies are not concerned with "right" and "fair".  In a free economy I now have an Esty site with my lovely ornaments for sale.  Since I know I'm going to be a great success, I've already made 100 of them, and I'm practically counting my money already--though at this point the only money is mine, since it cost me $25 to make them. At this point, one of three things can happen:

Nothing:  Hot glue, 5 craft sticks, glitter, Girl Scouts....hmmm...are you getting the mental picture I am?  All of us parents have plenty of those types of ornaments, and those who haven't chosen to be parents are glad they do not.  For some reason no one is buying them.  My supply of these creations exceeds the demand for them.  Since I have $25 invested, I want it back.  I decide to lower the price, and do so by $.25 per week, but how low can I go?  If I price them below $2.25, I go further in the hole, since it costs me that much to mail them and pay Etsy, so I'll put them on my tree, give them as gifts or throw them away before I do that.  In this case, the market has told me that my creations are not worth what it costs me to produce and distribute them.

They sell, at least some of them do.  Ok, maybe there is a market for my artistic creation.  I sell three or four of them a week starting right after Thanksgiving.  I tried lowering the price one week, but sales were the same as the week before, and when I raised the price back to the "regular" price, I again sold about the same number.  In this case, my price is about right.  People who want my ornaments are willing to pay that much for them, and lowering the price did not seem to increase demand for them.  After Christmas however, no one was buying them.  I didn't want them here all summer so I lowered the price to $2.50 and that increased the demand enough to get rid of the last ones.  Since I have not found a great demand for my ornaments in February, I am not making any more.  The supply goes down.

They fly off the shelves.  Of course this is what I hope happens.  I open that Esty shop and the first day, I have twenty customers, each of whom orders two ornaments.  At this point the demand for my ornaments outstrips the supply. I do what any reasonable business woman would do--I raise the price.  I watch my numbers.  I still have lots of orders, so I raise the price again. Then someone realizes that I'm charging (and getting) $25 for 25 cents worth of craft sticks, glitter and glue and decides that he can do it too.  He opens his Etsy shop and only charges $20.  My business slows, and I just bought a lot of supplies, since I was doing so well. I need to move them, so I lower my price to $19.50.  We end up in a price war, and eventually those ornaments are back down to $6.75.  He doesn't lower his price below that, because I guess he thinks his time is worth something too.  As the profits on the item increased, so did the competition (supply) which then drove the price down.  Supply and demand.

Supply, Demand and Lending Club

Supply and demand comes to mind because I just finished checking my Lending Club account, and found that my returns are still dropping.  A couple of years ago, investors were complaining that the number of people who wanted loans was lower than the number of people who wanted to invest.  Lending Club worked to increase the demand for its product by lowering credit qualifications and interest rates.  Now, the supply of loans is up, and the demand for them is decreasing, at least among some people, like me.  Lending Club is trying to woo us back by raising interest rates.

As an investor, I want to make money.  Over the last year, my Lending Club account has averaged about a 2% annual yield.  To me, given the relatively strong economy, that's not good enough.  I'm lending money.  Right now, while there are people who are losing their jobs, in general, the economy is good.  If I can't make money on Lending Club loans now, what makes me think I could make money on them when layoffs are rampant?

Supply, Demand, and Dividend Stocks

Supply and Demand are very evident in the stock market.  When you buy shares of stock,  you are buying part of a business.  While the business owns some things that are easy to value, like land and machinery, it also owns a stream of income and goodwill.  How much is that worth.  Every day when the stock market is in session, traders make that determination.  During the course of a day shares of the same company may sell for very different prices, based on supply and demand.  

Of course, most people want to buy the stock that is priced below what they consider its value to be.  They do that buy studying the company and finding reasons to disagree with the consensus in the market about the company (or by dumb luck). 

One type of stock that is very popular today is dividend-paying stocks.  When companies have profits that they do not need to invest to grow the business, those profits are distributed to shareholders as dividends.  These dividends can provide a source of income to the stockholder. Generally speaking, companies that pay dividends are established and profitable.  Since the dividends are generally determined by the profits of the company rather than by the cost of the stock, if the price of the stock goes up, the percentage yield for the dividend goes down.  Because of the popularity of dividend-focused investing the price of the stocks has increased, and therefore the dividend yield has decreased.  

Realizing that the law of supply and demand is alive and well can help you evaluate your investments and figure out why the price has change.  

*Part of Financially Savvy Saturdays on brokeGIRLrich.*

1 comment:

  1. Great example with the ornaments. I wonder about other peer-to-peer lending platforms and whether they are having some of the same issues.