The Determination of Prices

0:00To sum up quickly what we've done so far, we have the law of diminishing marginal utility, the fact that you increase the more, the greater your supply, do you have any product, lower the value of each unit, and that we solve the value paradox, why there seems to be a difference between use value and exchange value, there really isn't, and we've got the concept of the elasticity, we've got the falling demand curve, like so, we've got the The concept of elasticity of the demand curve and what it means, so that if the demand curve is very inelastic, it means that total revenue will decline as the price goes down and go up as the price goes up. If you have a flattish or more elastic demand curve, that means as the price goes down, total revenue goes up, and vice versa, total revenue will fall when the price goes up.

0:56So, that's the basic concept. What happens to total revenue when price changes? Okay, we now, that's the summing up we've done so far. We now go from that to the key point of microeconomics. I mean, how are prices determined? Why is the price what it is? Why is the price of oil whatever it is? Why is the price of Wonder Bread whatever it is? Why is the wage rate, as we'll see later on, what it is? All prices on the market, and There are millions of exchanges and each exchange has different terms of exchange. Each exchange has a price. There's money, two cents a nail, 50 cents for a Dove bar, $180 for a TV set, whatever happens to the data, these are prices. And so now we've got to the question of what determines prices. In contrast, people don't know any economics. It's not chaotic. It's It's not purely, it's not arbitrary, it's not chaotic, there are definite reasons, factors that determine prices, and it's basic, basically you've got two things, you've got, here's price on the y-axis, so any particular good or service, quantity on the x-axis, you have your falling demand curve, which we've already talked about, which all we know about is it's falling, it might be inelastic, it might be elastic.

2:20And then we have supply of the good. In other words, how much is there? Forget about the textbook of the rising supply curve. The supply is vertical. In other words, at any given time, at any given moment, at any given freeze frame, we've got a certain amount of stuff there. Why it's there, we'll get into later. Let's say there's 100,000 loaves of wonder bread right now in New York. I don't know how many there are, but let's say 100,000 We need to be sold. In that case, we don't know how many there will be next week or next year. We'll talk about that later. But right now, at this moment, we need to be sold. There's a supply of 100,000 loads. So this is a vertical supply line. In this case, 100,000. Of course, this quantity is going. It increases as you go to the right. This is zero.

3:09And it keeps increasing as you go this way. So now we have a vertical supply line, we've got a demand curve which is falling, and we have an intersection point. And what I'm going to prove now, I'm going to make this statement, I haven't proved it, I'm just going to make a flat statement. What I'm going to prove now is the single most important thing in the course, namely that the price of anything, the price of any good or service at any day, at any time will will tend to be the intersection point of the demand curve and the supply line. If it isn't at that point, it will tend rapidly toward it. So this is what I'm going to demonstrate. Alright, supposing this is anything. It's wonder bread, it's fish, it's high-fi sets, it's nails, it doesn't make any difference.

3:58Let's say at any given day, we start the day with this point. Let's say the price is, let's say it's $1.50 a loaf, it starts at $1.50 a loaf, I'll add $1.50 a loaf, this much will be bought, that's where we already determined that. The bank card tells you, excuse me, how much the consumers will purchase or the buyers will purchase at any given price. At this point, let's say they purchase $70,000. Well, they've produced $100,000. $100,000 low is ready to be sold. They're only selling $70,000. In other words, what you've got is a gap between the supply ready to be sold and the amount purchased, the demand.

4:49This is unsold surplus. In other words, at this price, the supply is greater than demand. The amount of goods available to be sold is greater than the amount purchased. There's anything businessmen don't like. Businessmen are motivated here by one, two very simple motivations, actually one, to make as much money as they can and to avoid losing any money. In other words, to maximize their profits and avoid losses or minimize losses. They're losing money by not selling this thing. They've bought the bread, the retail stores have bought the bread. They ain't selling it. How do you sell an unsold surplus? Well, they try it. They lower the price a little bit. And by God, if they lower the price, they find they're selling more Wonder Bread.

5:36Or whatever else it is. Gear Shifts or Apples or whatever. As they keep selling it then, they find out the unsold surplus is gone. And so, they keep lowering the price until they get to this point here, the intersection point. And as they do that, they sell the unsold surplus. The only point at which the quantity supplied, if you're supplying 100,000, this is exactly how much consumers are willing to buy, 100,000. In other words, you eliminate the unsold surplus, a terrible headache for any businessman, by lowering the price until you get to this point. You have a built-in mechanism, so to speak, in the market, free market, a built-in mechanism and driving the price down to the intersection point because the higher the prices, the greater the unsold surplus.

6:26And as I say, as you keep lowering the price, you find out by trial and error, you find out very quickly as you lower the price, you sell more to find the unsold surplus is eliminated. On the other hand, supposing you start off the day with prices below the equilibrium price, let's say this is a dollar, say you start at 75 cents, okay, supposed to be a at 75 cents, surely you can sell a whole 100,000. There's something else happening here. People are willing to buy now because you have a falling demand curve. They're willing to buy 120,000 lobes. They're trying to buy 120,000 lobes. They can only find 100,000. In other words, you have a situation of demand being greater than supply, which is also called excess demand. You have people trying to find the stuff and it ain't there. In other words, you have a phenomenon of empty shelves.

7:18Where's my Wonder Bread? Gee, we sold out at 11 o'clock this morning. So, what happens then is the so-called shortage.

7:30So what you have then is a shortage. In other words, all of a sudden, my god, we've sold out. The businessmen realize, my god, if we can sell out at a cheap price, let's raise the price. Why are we losing money on this thing? We're forgoing a lot of money. And they find out that as they raise the price, the shortage is getting progressively eliminated. So what you have then in the market, every place in the market, the entire market economy, the reason why it works, I mentioned it I think before last week, it always works, it always works meaning there's never any shortage and there's never any surplus, in other words, there's never any surplus.

8:16Unsold surplus running like the time, disappears very quickly, never any shortage because it disappears quickly. The reason is the prices are flexible and the motivation to arrive at this intersection point is trying to increase your profits and trying to avoid losses. And by doing that, the free market economy is such, it always wipes out and very quickly wipes out all shortages and all surpluses, that you always wind up at this equilibrium equilibrium point. It's called an equilibrium point. The intersection point, the intersection price is called equilibrium price. The reason it's called equilibrium, once again an analogy with physics, physical sciences, something is in equilibrium when it tends to stay there and if this place from that point will return to it quickly.

9:06okay so that's exactly what happens here in this case is a pretty good analogy I'm not a fan of physical analogies in economics but in this case is pretty good one namely that it tends to remain there and if it's displaced from it it goes back and goes back very quickly day-to-day basis so driven by profit motive and with a flexible free price if the price is free to change there's no legal reason not to change there's no law against it we'll get to that pretty Soon, then the market economy is such that the prices always reflect, always equate supply and demand. In other words, they make supply and demand equal, this is also called clearing the market. In other words, it clears the market of any excess supply or unsold surplus and of any excess demand or shortages.

10:01And already you see why it is that in a market economy you never have any surplus or shortage. In a so-called planned economy, in socialist economies or semi-socialist economies, one of the great features, great, one of the important features of them is constant problems of shortages and surpluses. I remember, and this is not particularly important, but it just sticks in my mind, I remember Newsweek had mentioned that many years ago, all of a sudden in Russia they had a toothbrush shortage. Why a toothbrush shortage? Well, the bristles were in omsk and the handles were in pumpsk and somehow they never meshed the two things. They forgot or whatever it is overlooked and they couldn't bring the bristles and the handles together. It took weeks or months to do it. So this is just typical, constant series and so-called planned economies of unexplained shortages.

10:53How come there's no Hershey Boris today? Who knows? Whatever. So this is, and you will see later in countries which have a lot of price control, maximum price control, which we'll get to a little later, there's always shortages too, and if you're in a price control type country, it's wise if you find anything you like on the shelf to buy as much as you can of it and hoard it, because you ain't going to see it very often. A friend of mine used to teach in Vancouver, British Columbia, and they had severe price controls. He's a great fan of Hershey chocolate syrup, which of course is very bad for you, that's another point. So anytime you see Hershey chocolate syrup on the shelves in the Banker, we buy, you know, 20 cans. If you go to visit them, you open this cupboard and there's 50 cans of Hershey chocolate syrup and almost nothing else.

11:38Anyway, we'll get to that a little later. Yeah?

11:45The Banker exists just so you can't... the mechanism isn't there to clear the market. It just stays at the controlled price. Yeah. I'll get to that a little bit later. Right now I want to point out what happens with the free market. I'll get back to that at length. They're stuck either below or above the free market price. Exactly. Then you have black markets and all sorts of other phenomenon-type places. Anyway, this is just a teaser for later on, a little bit later. Right now I just want to show what happens with the free market before we get into the government intervention. So what you see is that everybody is collaborating here to try to get at the equilibrium price. And because this is a benefit of everybody, especially entrepreneurs here, to try to eliminate shortages or surpluses.

12:35And so this is a built-in mechanism to get here and to stay there, get here once you're displacing it, back to it. Okay, so now we have the important truth, we just single, yeah? How do you reach, or how does the company reach Point of Effect 11? How do they know where the point is? They know there's no unsold surplus, there's no other word. How do they know it's in the beginning? They just want to try a product. Yeah. Oh, at the beginning? Yeah. When you find out it's trial and error. In other words, you set a price, you don't know what's going to happen. If you find out, let's say a new thing is, thing, whatever it is, thingamabob is producing, if you set the price as $8, you find out nobody buys it. You go back and you lower the price. If you finally get to the point where people only buy at a price below cost, then you're out of business.

13:23I know you're making minimal losses and that's it. If, on the other hand, you find a lot of people buy for $5, then you're happy to get a $5. If you sort of test it, you find out, gee, the shelves are running out. All of a sudden they disappear at $5 and you raise it to $6. There's no magic formula here. The thing to keep emphasizing is, it's not like in the textbooks where you're given the demand curve. Nobody knows what the demand curve is. They're trying to find out, especially with a new product that's very difficult. Of course, you have competitors and they're trying to find that, and you wind up in this kind of process where you settle on an equilibrium point. But I'd say there's a great test, immediate test, namely if you find out nobody has a big unsold surplus, you know the price is too high. If you find out there's a shortage, in other words, a thing disappears quickly, then it's

14:08obviously a signal that you can raise the price without any problem. So that's the immediate feedback you get, whether the stuff is not being sold. This is true not just for consumer goods, but for also producers' goods, you know, down the line, if you're producing raw material or something. If you find out you're not being sold, you have to lower the price. Yeah? Will better companies just have a high total revenue if we have surplus, rather than a few million points? Let me say before, the demand curve is that they might have a high total revenue even though they don't have surplus

14:56They'll benefit by any sale of it. I mean, maybe in the future they'll say, well, Jean, we're not going to produce less. We'll tap a higher revenue. But once you've produced it, then you're stuck. I mean, you've already spent the money on this thing. You try to get sell-off as much as you can. Nobody's going to benefit by piling up unsold Wonder Bread or unsold TV sets. What you're talking about is a future decision of how much to produce in the future. Right now we're talking about a day-to-day situation. Once given the amount produced, what happens? How does the price set? We'll get to that later on, how you decide what's going to be, how much to produce for the next year or next time period.

15:40So we have this built-in mechanism for arriving at the free market price, and it will be the intersection point.

15:54And then the question is, well if this is true, I think it is, why do prices ever change? Why isn't every price the same forever? Now obviously the reason why prices haven't changed for one or two reasons, or both, namely either the demand curve changes or the supply changes. The only way in which any price can change over time is a change in one of these two underlying factors, or both, because in order to analyze both you have to analyze each one, Let's look then at what happens with supply changes easier. For example, let's say usually about every five years there's a big frost in Brazil, which is our major coffee producer, and a big frost and it kills half the coffee plants. So there's a big drop in the supply of coffee, in other words, how much coffee comes on the market say next month or whatever.

16:47So the supply curve shifts to the left. I'm making this dash in order to show the change here. So you have a drop in the, a lowering of the supply of this product. What happens? It means that the old price, the old equilibrium price, let's say it used to be, it used to be a dollar a pound back in the good old days, not too long ago. It means that the old price, the supply has suddenly lowered, so it means that with a new supply, you now have a shortage. In other words, demand, which used to be that demand and supply were cleared at a dollar a pound, all of a sudden you find since the supply has been lowered, that the shortage has opened up.

17:34There's a shortage, there's now a situation where people can't find the product at a dollar a pound, so the price goes up. The price is bid up by the buyers, so finally it reaches whatever, say $1.50 a pound, and the new equilibrium price again clear the market. In other words, demand again becomes excess demand, and demand and supply are now cleared at the higher price. So a higher price clears the market. This demonstrates the two functions that the price system performs in the market. Most people understand one function, they don't understand the other. One is the incentive function, we'll get to that later on. In other words, if the price is higher, people will produce more over the longer run.

18:23If you offer, well, just to give you an idea, they used to be, 1948, I think it was 1948, when there was only one atomic energy consumer, namely the US government, and I think it was called the Atomic Energy Commission, they were trying to find uranium, there was a quote, uranium shortage, couldn't find any uranium, they were going crazy, you can't get, uranium is gone, we can't produce any more atom bombs, the world is going to come to an end or whatever, Aside from whether or not they should be producing more atom bombs, it's another philosophic question. Some economists down there finally said, look turkeys, double the price you're offering. There's only one buyer, the US government, they're offering whatever it was per ton of uranium. Double the price and see what happens. They double the price, and all of a sudden everybody's out there with that Geiger counter, the famous uranium boom. Out on the west with the Geiger counter.

19:14By God, there was no uranium shortage. They found lots of uranium, and all they had to do was double the price offer The stuff is out there. Whatever the stuff is, you have to offer a higher price to induce them to go out and look for it. Most people sort of understand this. Not everybody understands this. If you offer a higher price for something, you'll probably get greater supply and vice versa. The thing they don't understand at all is what you can call the rationing function. In other words, the reason why everything has a price at all is because it's not unlimited. The universal fact of scarcity, everything is scarce. Some things are scarcer than others. If something were unlimited, it'd be free, like air, presumably. Water used to be before water shortages. So they're quote free unquote, almost close to it.

20:04But coffee is not free, coffee is scarce, like everything else and the things that produce coffee are scarce. If they get scarcer, that means the pricing performs a rationing function. Pricing of anything performs a function of squeezing out the sub-marginal buyers, people who don't want to spend a buck a pound, they'll only drink coffee if it's 20 cents a pound. If it's not a pound, they'll drink something else, water or cocoa, whatever it is. So the point is that prices perform a rationing function. If the thing becomes scarcer, the prices have to ration even more. And so, by the price going up, it performs the function of squeezing out marginal buyers, marginal buyers, those who are close to the edge of buying coffee. What happened a few years ago, the prices of coffee doubled, almost overnight, because of the big drop in supply, big increase in price, and people started buying, they bought less coffee, almost permanently. They cut the amount of coffee they drank, some people shifted permanently to tea,

21:00And the result of all this was they voluntarily restricted their purchases. Some people bought the same amount of coffee, some people were coffee freaks and said, how will I spend more money on it? Others, however, are only marginal coffee buyers and they cut their consumption. So the result of all that is a voluntary rationing process. The alternative to voluntary rationing is government rationing, which we'll get to later too. In World War Two, the government orders, gives you, issues tickets, personally hires hundreds of thousands of people to issue ticket books, and of course all this stuff, ration books, which they did during World War Two, and everybody's can, you know, you have only ten coupons a week to buy coffee, ten pounds a week or something, and then there's a whole hassle, and in addition to paying for the coffee and money, you also have to pay the ration tickets, a total mess.

21:48At any rate, but there is compulsory, it means you would buy more than ten, whatever it is, A drop in supply of x leads to an increase in the price of x.

22:22Okay, the opposite happens. In economics, almost all laws are symmetrical. Look at the other side of the coin. Okay, here we have coffee flowing back in, you have a big increase in coffee production, the climate's better, whatever it is, right, so you increase fertilizer, different techniques, so the supply of coffee goes up, this means that at the old price, where demand and supply are equal, all of a sudden you have a bigger supply now, you have sort of X amount of coffee, you have more than that, this means that at the greater supply, at the old price you now have the excess surplus, the unsold surplus of supply here, because supply has increased, it's still up at this price. It means in order to induce people to buy more than whatever 100,000 pounds of coffee, whatever it happens to be, in order to induce people to buy more, you have to cut the price. And as you cut the price, they're now willing to buy the

23:40excess, the increased supply. And so the price falls to get back to a new equilibrium point where supply and demand are again equal. So this is, in other words, you eliminate the excess supply and you wind up with supply and demand being equal. So we conclude that an increase in the supply of X will lead to a drop in the price. And this is what happens. Of course, the coffee thing is a beautiful example. This happens all the time. The coffee, the frost in the coffee, in Brazil, Drop in supplies, an increase in price, and a couple years later the source is gone Supply increases and the price drops again So this is almost a textbook case, but it happens all the time all sorts of products Agriculture is a good example because in agriculture you have full, actual full supply, you don't have that much in other things in most things supply increases over time with agriculture, of course, it's more in the lap of the gods than other products

24:46but in general supply increases, in general you have an increase in supply of almost everything in that case, if that's true, which it is, you should have generally falling prices in other words, over time supply increases price falls By the way, this is not to lead to lower profits, because costs fall also, as we'll see later on. In other words, there's a general increase in productivity and costs fall, and so it doesn't mean you're squeezing firms or anything like that. So you've got, then, a situation where most prices should be falling, and yet, and yet, of course, as we all know, prices are almost always going up. Even now, and it's supposed to be the end of inflation, this is a macro, we discuss this in macros, there's only a macro concept, but uh... even now when the inflation is supposed to be over, it's still going up, prices are still going up about three or four percent a year this is when the inflation is supposed to be over

25:44uh... it's over only in the sense of five, six years ago prices were going up by fourteen percent a year so if it's true that supply usually goes up, how come prices are going up? and that's a good question, the answer is there's nothing to do with this good stuff, goods are going up, increasing the answer is with money and the fact that the manures are always going up because the government is printing money and pouring it in And in fact, in general, from the beginning of the Industrial Revolution, in other words, from about 1780, let's say, or 1800, until 1940, prices fell all the time, every year prices would fall a bit, except during wartime, during the War of 1812, the Civil War, World World War I and World War II, the government printed a lot of money in order to pay for the war effort.

26:37Of course, prices went up. All the other times, that was during peacetime, prices generally fell. The difference now is there's a different money system that's come in since the 1930s. A totally inflationary monetary system has now taken over of the government's printing factory, printing press, counterfeiting printing press factories down in Washington. For example, all of you are probably alive to this, namely, computers, of course, computers start off extremely expensive and now are very cheap, they keep getting cheaper, for a while they're getting cheaper every week. Calculators, which I remember the first time I saw a hand calculator, it wasn't too long ago, maybe 10 years ago or something, and I think it was about 10-12 years ago, right? It was on the elevator here and one of my One of my friends in the EE department, and he said, look, we have this magic thing, a new product, and all we have to do is to punch these buttons and multiply them and all that.

27:37I said, Jesus, that's fantastic. He said, yeah, it's only $500. I got a discount. So the capital assistance is so fantastic that right now we have a lot better calculators for $18. So this is what happens when the economy is given its head, so to speak, with very little interference. And you have a fantastic increase of production, productivity, increase in quality, and a huge drop in price. Same thing happened with TV sets. The first TV sets were around 1948, 1950. They were murky, not only were they black and white, they were, we can hardly see anything. Very murky images. Of course, there's no cable either. and of course about 2,000 bucks, the whole neighborhood is sitting around gazing at these little flickering images so now you have, even with inflation, even the fact that the dollar is worth one-fifth, let's say what it was in 1948 even so the prices are fantastically smaller and much higher quality, normally you have to take price per unit quality

28:42This is what can be done in a free market system, even with, as I say, the government printing press, which turns on, which makes prices in general, higher. So in other words, with the supply changes, you don't have supply increases, you'll have a supply drop, you have an increase in price, and supply increases, you have a fall in price. And now one thing I'm going to stress here, which I always, every micro teacher always stresses on this, and always makes the point, and always says that half of students at least will get this wrong on a test, and they're always right, even though it seems to be a simple point.

29:38It seems to be something which can be very difficult to get through to the head of students. namely, a difference between when you increase supply, for example, you're going down the existing demand curve. The demand curve is defined as a locus of responses to price. In other words, given the price of so-and-so, how much will be purchased? That's what the demand curve is. So therefore, the one thing which can't change the demand curve is a change in price. The one thing which can't change the demand curve by definition is a change The demand curve is constructed, defined as, or constructed as, responses to price. So if you have an increase in supply, it does not increase the demand curve, it increases the quantity demanded going down the existing demand curve, okay, because this is the curve itself.

30:26As the supply drops, you're going up the existing demand curve, the demand curve as a whole doesn't shift. You're going up, you're decreasing the quantity of money because you're going up the same demand curve. We haven't gotten to the shifts in the demand curve yet. That's the next step. I just want to point out that the change in price will only go up or down existing given the demand curve by definition. Okay, that's a change in supply. The other thing which can change is the demand curve. In other words, the demand curve can shift. So why would a demand curve shift? Well, it doesn't shift because of the responsive price, as I said. There's one thing you can't shift in response to, because that's how it's defined.

31:12It can shift because of the inflation. In other words, if a government prints more money and spends it so everybody gets more money, they'll have more money to pay and buy on everything. That means the demand curve as a whole will shift. Every demand curve will shift upward. In other words, at any given price, everybody will spend more money or try to buy more goods at any given price. In other words, the man-curve of the whole shifts upward and to the right. So this is an upward shift. In other words, everybody is willing to spend more for any given price because everybody's got more money. Let's say the government prints twice as much money and gives it to everybody. One of my favorite examples I call the Angel Gabriel model, which is David Hume, a similar model, he didn't call it the Angel Gabriel model, but anyway, essentially he said what happens if an angel comes at night and doubles everybody's supply of money, by magic, and everybody's got twice as much money, they go and of course they spend, everybody's now willing to spend a lot more on everything, so the man curve shifts upward and to the right, of course prices will then double more or less on the end of it, but that was Hume's point.

32:23We don't get into that part of it here. It's, again, a macro point. But again, the situation is that the man curve as a whole, if everybody's got more money in their pocket, the man curve will go up. If the other half people have less money in their pocket, the man curve will shift downward. In other words, downward and to the left. It will spend less money on any given item. This will also happen, for example, if taxes go up, if the big income tax increase, just looking at the tax payers, they'll have less money in their pocket, all of the demand curves will shift, they'll go downward and to the left, they won't have the money to spend, very simple.

33:08If there's a big tax cut, the demand curve will shift upward. Again, we're not going to go too much into that because that's a macro point, but I'm I'm going to point out that demand curves, part of the thing that influences demand curves is how much money people have in their pockets. Okay, for individual goods and services, demand curves will shift on the basis of value scale changes. So that these value scales change all the time on the basis of fashion, preferences, whatever. For example, in the United States in the last 40 years, there's been a big shift in values of preferences by consumers on the wine and whiskey front. A big shift out of so-called heavy liquors and into so-called light stuff, either because people want to lose weight or whatever it is.

33:57In other words, there's been a big shift away from bourbon, and scotch, and especially rye whisky. As a matter of fact, when I was growing up, everyone was drinking blended whisky. Almost nobody makes blended whisky anymore. Blended. So these things are going way down. The man curves have shifted way down for those. On the other hand, vodka and gin have gone way up. The wine front has been a big shift away from red wine, and a big shift in favor of white wine. Enormous. So you have so-called yuppies, for example, known as the white wine and quiche set.

34:42So as a matter of fact, it's been a shift away from alcohol until we had white wine all together. Huge increase in wine. Forty years ago, nobody drank white wine because it was almost unheard of. So at any rate, these things reflect, this means of course, in the man curve front, which you have is a, means to say bourbon, the man curve for bourbon goes down, means people are now, means that the old prices will fall, that the old prices are, there's now a surplus, unsold surplus applied greater than the man, The price will have to fall immediately. On the other hand, say with vodka or white wine, there's a big increase in demand curve, the whole demand curve shifts upward, and it means the old price is now a shortage, so the price will go up.

35:37So, in other words, an increase in demand curve for X, where the whole curve shifts upward, and when we just use the phrase of the word increase in demand, it means the entire demand curve. It does not mean this thing here when supply goes up, say, and your quantity of demand increases. If you just use the phrase increase in demand, it first means the entire curve. It means that at any given price people will buy more of it than they did before, that's what it means, okay? So it means that the entire demand curve goes up, from here to here, and an increase in demand for X will yield an increase in price of X. On the other hand, a drop in the demand for X, say for bourbon, will yield a drop in the price.

36:29If people will not buy the same amount, they'll buy less at any given price, they'll not buy at the old price, they'll buy less than they did before, they'll unsold surplus. The result of this, the impact of this, these demand changes, will result in changes in supply. Now we get to what causes people, producers, to produce a thing in the first place. So far we've been talking about supply being given. Supplies 100,000 loads or whatever and that's it. Let me begin to talk about what the determinants apply. Why do producers produce 100,000 to begin with? How do they determine how much to produce? The next step we'll get to is how these demand changes impact on that. Okay, let's take a 10-minute break and we'll go back. Let's turn to the first step, namely, why are decisions made to produce as much as are being produced?

37:15Why do they decide to produce 100,000 loaves of Wonder Bread and not 50,000 or 200,000?

37:26Okay, let's see what happens here, fire please, price, quantity, supply, demand, let's take a situation where demand changes, demand increases for vodka or whatever, white wine, whatever happens to be. So is a permanent, well first of all businessmen have to decide is this a glitch in the system And that's something that has to be done by insight until the price goes up because of the increase in demand. The new equilibrium price is now higher. And it has to be decided, for example, the guys are lucked out into cabbage patch dolls.

38:11People have been producing dolls for 80 years, and nothing much happened. All of a sudden a cabbage patch doll hits. Unbelievable. Tremendous demand for it. Remember, one guy, the great thing is one guy from Pennsylvania actually flew to London to get it at a, to get it, it was a big shortage, and the question is, the cabbage patched off, people had to decide in the following year, is this a temporary thing, a blinding blaze which will be going on next year or not, while it still continued a certain, you know, fell off a little bit, so they had to decide, is this sort of a permanent thing, okay, with white wine, they figure vodka, yes it is, and so what then happens is, Well, this is going to be a permanent increase in demand. Tastes are changing, basically, etc., etc.

38:56Then they will gear up and produce more vodka for the future. In other words, they start changing the situation, getting white grapes instead of red grapes for the white wine, and they gear up. And how long this takes depends on the technological situation, depends on how long it takes to produce more vodka, more white wine, or more calculators, or whatever. So the length of time depends on the technology of the product. At any rate, it means that over time, because the increase of price means more profits, it means that there's a greater price per product being sold than before. They gear up and they produce more of it. So over the years, supply curve will then shift. In other words, next year's supply line will be higher, to the right, shifting to the right, et cetera, et cetera.

39:43You wind up, let's say, after about a few years, with a permanently new supply curve, which is now, which reflects the increase in demand for vodka. In other words, so this means you have a time period situation where, in year one, let's say, the price goes up. The first thing that happens, the demand curve for X goes up, this increases the price. A year later, the supply goes up a little bit in response to that, and so you have the price going down a little bit. Increase the supply of X, a drop in the price, and so forth and so on, until you get, say, to here, where the price is down, somewhere in between the initial one here and up there. And so, as the supply goes up, the price of it then falls over time.

40:32So what you have is a series of vertical increases of supply going like that, so finally you get a new final equilibrium point. In other words, this is a long run equilibrium point. It takes four years to five years, depending on how long it takes to gear up for all of this. So what you have is you wind up eventually with a permanent increase in supply and reflecting this permanent increase in demand for, say, white wine or vodka. On the other hand, let's take the falling demand. Bourbon, let's say, it was a fall in demand for bourbon, man curve for bourbon, and so they have a deep prime, the new curve goes like that.

41:20First you have a big drop as the surplus from the previous prices now, unsold surplus, you wind up with a lower price, a new equilibrium price is much lower. Then if the winemakers, the whisky makers believe this is going to be permanent, this reflects a permanent change, you drop it in half a red wine or bourbon, then over the years they will supply less of it, they will shift away from red wine into white wine, which of course is exactly what they've done. Much less red wine is being produced now than it used to be, much more white wine. It doesn't mean all red wine disappears, there's always a margin. It's a question of marginal changes. Less bourbon, more vodka. So what you have is a lower supply each year, and as the supply drops, the price goes up again until you wind up somewhere in the middle.

42:12So you have then over time, in response to the lower demand for red wine, You have a much lower supply, you have a lower price and a lower supply that allows you to wind up with a permanently lower supply as a response to the lower demand. In other words, over time, production of when entrepreneurs produce something, they're doing it in anticipation of selling it to the consumer, in anticipation of demand. If the demand rises and they realize they expect it, then they will produce more to meet that demand. If the demand falls, they realize and expect that means they'll produce less in response to that It means over time, consumers decide how much will be produced of everything If they like a product and they go for it in a big way, calculators, computers, or whatever a lot more will be produced, this huge shift of resources, land, labor, and capital into this new industry Even if, on the other hand, they don't like a product, they go away from it

43:10resources will flow out of the industry, out of red wine into white wine and why out of bourbon and into vodka and whatever. Of course you have, for example, before the calculator, I don't know if any of you have seen this, this is a technological museum somewhere, when I was going to college and taking statistics, they had what was called, I think multiplying machines is the name for it, I believe, and they were big bruisers, huge, very heavy, and you punch, they have a whole bunch of keyboard, and it took a long time, it took only slightly less time than doing it by pencil and that had a statistical lab which would take you hours to use these losers and they were obsolete, they were totally obsolesced by calculators and computers and so they should have.

44:01Some of these companies I think are no longer here, they are no longer producing that stuff, Burroughs, Frieden, those are the big names in these calculating machines. I guess they were cool. And so, less of them is produced. Right now, I guess zero is produced of that stuff. And they shift other, better products, which are demanded by consumers. In some cases, like the horse and buggy, there used to be millions of carriages being produced every year. There ain't no carriages except for the handsome cabs in a separate park. There's still a few. So over the long run, and the long run is that long, consumers decide by their demand curves, by their value scales and demand curves, how much should be put in, where resources should go into, where land, labor, capital, science, whatever, engineers, where they should focus their money.

45:03And it's decided by the price system, through the price system, through the man curves and profit and loss system, who's going to make profits where, and this reflects the intensity of demand by consumers. That's how the system works. That's how resources get funneled out of bourbon and into vodka, out of red wine and into white wine and so forth, out of calculating machines and into calculators, etc., etc., etc. Okay, so this is the, so the demand curves, prices can change either by an increase, either by change in supply or change in demand, if the supply increases, the price will fall, if the supply decreases, the price rises, if the demand curve increases, the price rises and will, if considered permanent, induce a greater increase, a long run increase in supply After the man-curve falls and is considered permanent, it will induce a long run stoppage supply.

46:03Now if you take this, any given product, and take this vertical curve, and if you look at, if the man-curve increases, And how much will, what will happen to supply as a result, and you wind up, let's say, here. If the main curve falls, what happens to supply as a result? It'll keep dropping until here. And if you connect these, if you connect these dots, you get what the textbook has as a forward-sloping supply curve. That's where that comes from. But this is a long-run supply curve. It reflects what happens if the price settles at any given point for a long period.

46:53This is how much will be produced. If the price settles at $1.50 a loaf of bread, I'll produce more of it. If the price settles at $75 a loaf, I'll produce less of it over the long run. The long run supply curve then is not the same thing as the man curve. It doesn't belong on the same graph. That's one of the basic problems with it. The man curve is instantaneous. It's a freeze-frame situation. Any given day, this is what the man curve is, is how much would be purchased at any given price. The vertical supply line is the equivalent, that belongs on the same graph, that's the freeze frame, that's essentially today's supply, how much is available at the store to be sold today. The long run supply, the long run upward sloping supply curve is a third dimension thing, it incorporates time in it.

47:39It's a long run situation which tells you how much will be produced. In other words, if over time, a lot more will be produced at a higher price, it'll be like that, if it'll only be a small increase in production at a higher price, it'll be something like that. It doesn't belong in the same graph. It's an interesting thing, but it's not relevant to immediate price determination. That's the problem with it. Also, the elasticity of supply doesn't make that much difference, but there's some interest. Most supply is elastic. I mean, if you offer a higher price, you'll get more, as I said, with uranium. But it hasn't got the same importance as the elasticity of demand, because total revenue doesn't depend on it. Of course, if you sell more at a higher price, you get a higher total revenue.

48:27You never have a lower total revenue at a higher price, with a supply curve. So it doesn't really have the same importance. So that's why when dealing with day-to-day demand curves, immediate real demand curves and supply curves, I deal with the vertical, whereas the forward sloping one is the long run, looking over time for different products. One thing is, which you can deal with right now, is there ain't almost no such thing as a vertical supply curve. Of course it's true in the long run. Rembrandt, there's not going to be any more Rembrandts being produced, because Rembrandt's dead, it's very simple. So the supply of Rembrandts is not only vertical right now, it's fixed forever. Except that you might lose a Rembrandt and it will go down.

49:12There's no way in which the supply of Rembrandts can increase, except if somebody forges a perfect forgery. It's very difficult, because the technology of detecting forgery for art is enormous. You have x-ray equipment, pigments, this is the whole science of architecture. There are very good forgers in the sense that they paint as well as Rembrandt does. They can forge it, but they can't really get away with it technologically. So the other things on the hand are usually much more, you can increase the supply if you want to do it. And there's plenty of stuff, and we'll get to this later on until we get to energy. Since 1890 there have been so-called experts in the field of oil who claim that in 10 years oil will run out, there ain't going to be no more oil left.

50:00They've been saying this since 1890, in other words the experts in 1890 said by 1900 there's going to be no more oil. Why do they say that? Because they take, it's very simple, I mean you can use mathematical models, but basically it's very simple. Very simple, what they do is this, they take proven reserves underground, okay, so proven reserves, I don't know, I haven't got the figure, let's say proven reserves are a billion barrels, alright, and then they say, well, they look at the annual use of oil, annual consumption of oil, they say, well, it's a hundred million barrels a year, annual consumption, so they conclude that, okay, it's very simple, they conclude in ten years the world's running out.

50:46It's a very simple extrapolation. The problem with it, and the same people more often have been saying this since 1890, the problem with it is that proven reserves don't mean a damn thing. Proven reserves are only what they've already mapped. They know exactly where the stuff is. There's plenty of stuff down there which you haven't mapped yet. And so when the price goes up, let's say for example, Let's say here's oil. Let's say we get to energy and detail later on, but let's say the supply starts going down for oil, and as the supply goes down, we know now what happens. Price goes up. As the price goes up, you have two effects now, the incentive effect and the rationing effect. The rationing effect means that people will buy less oil. The marginal oil buyers are going to disappear.

51:32That's of course exactly what happened in the late 70s. The price goes up, they start conserving, quote-unquote, they just buy less of it, they find ways to do it. You know, they say, gee, well, remember if we can't buy less of it, oil is essential in modern economy and all that stuff. This says nothing marginally, you can always buy less of something, just like with a subway, you can always have one less subway ride a week. And this adds up if you have a million people do it. So, the price goes up, you're going down the same demand curve, up the demand curve, in other words, with a lower quantity demanded, and with the price going up, there's more incentive to go out there and look for oil. Ah, the price of oil is higher, we're going to go start looking for it, and they go looking for it, and by God, they find it. There's lots of oil down there, just a question of price. It costs money to go and explore it, go for it, drill it, and all that sort of stuff.

52:19And as the price goes up, there's more incentive to go for it, and by God, they find it. And so what's been happening since 1890 is proven reserves keep going up even with the annual consumption Even with the annual consumption, there's enough proven reserves magically keep increasing And the reason why technologists tend to overlook this, and they did that, the famous flopper rule on this was the famous, was the Global 2000 Report I think it was submitted to President Carter in the mid-70s who claimed that by 1980 or 1985 oil would disappear, plus everything else. They used computer models and big-shot technology. The problem was there wasn't any money economists in the lot. And they forgot about the price system. But Marx, everybody, is not an economist.

53:05They forget about the price system. They assume that prices are not important. And so they assume that demand has nothing to do with prices and supply has nothing to do with prices. And so, what happens in real life is, as I say, when the price of oil goes up, people start buying less of it, and also they start looking for more of it. And so the supply keeps increasing. And this is exactly what happened, and refutes all these doom and doom forecasters, are constantly being refuted for that reason. We'll see later on, this is exactly what happened to OPEC. OPEC finally cut its throat. It took some years to do it, but they finally got to the point where non-OPEC countries were finding and producing more oil, like Britain and stuff like that.

53:52At any rate, this is now your arm, you see. You're a technologist who is now armed with economic knowledge, which most technologists don't have. I'll give you already a leg up. The next guy says the oil is going to disappear in ten years. Remember, you've heard that they've been saying this for a hundred years now.

54:22There's also, by the way, I'm not going to take any position on this because this is not my area. I just want to point out to you that there's apparently a maverick, big shot astrophysicist who's also big in geology and everything else, And now, who claims that oil is not produced from fossil fuels, does not come from vegetable or animal sediments, but the hydrocarbons really come from other stuff, non-organic matter. So if he's proven right, this means there's a lot of oil, particularly natural gas, way down deep. And so long probes will find a lot of stuff down there. If they do, then all the stuff gets shot to hell, because then there's almost no shortage ever. Especially natural gas. Anyway, Sweden is now having a deep probe, which will apparently test this theory. So it should come up in a year or two to find out whether this is true or not. Apparently, meteor, but his basis of thinking, one of the things he says is that

55:27Okay, so we now see how prices are determined by supply and demand, and how in the long run they're determined by supply and demand, how increases in demand will pull resources into areas, decreasing demand will take resources away from those areas. And so that consumer demand is sort of a king and queen of the economic system. Consumers determine what will be profitable and therefore what will be produced, and what will make it on the market and what won't.

56:16The famous example, some writers claim that, intellectuals claim that demand is determined by advertising. All you have to do is advertise something and people will buy it. Advertisers wish that were true and make their life a lot easier. It not only doesn't always work. You need advertising in order to sell something, especially a new product, but advertising is no panacea. It was, of course, the famous example of the etzel, the flop-a-roo of the etzel car, which had lots of advertising, lots of clapper items, a total flop-a-roo. Right now the etzel is fairly heavily in demand as a collector's item, by the way. That's And you get to the point where it's a collector's item. Another famous flopperoo was originally when shoes were, there's a big thing with shoes that were made out of Corfan instead of leather.

57:06I think Corfan has made a comeback in a sort of a mixed system. Anyway, the idea was Corfan's shoes were so invasive that the shoe never wears out. Which is undoubtedly true, except the problem was the feet wore out. So nobody wanted to wear those damn things. is again a total flop-a-roo, something slightly forgotten by the technologists who were crazy about Corfan. At any rate, so these things, and by the way, one of the examples of how the man is not determined by advertising is the existence of a huge market research subculture in the United States, a whole bunch of market researchers, it's also a good part-time occupation by the for people who want to spend a few hours a week at this thing, and what they do is the businessmen are desperately trying to find out will consumers buy this product, will they buy this ad, will they go for it, and obviously an indication is they can't determine anything, they're just trying to find out, which will they like better, which will they dislike more, they're constantly trying to find out desperately courting the consumer, trying to figure out what the consumer will like or won't like, it's hardly a determined process.

58:18And then one thing about, and sometimes of course intellectuals gripe about the stridently of advertising, of advertising, but you have to realize it's a great world, it's a great system where consumers are courted, even stridently, for trying my product, you have to get the consumer's attention first, the consumer's bombarded by all sorts of stuff. These people are busy, they've got lots of things to think about or whatever, and so why should they worry about some product, why do you have to sort of catch the attention of the person, hey, here's my product, fantastic. In socialist countries, they don't worry about consumers. Consumers are pain in the neck. There's not much advertising as a result. There's no courting the consumer. Consumers are, as I say, are a burden. It's a much worse system to be a burden, a consumer to be a burden than to be courted, I'll tell you that. In socialist countries, in countries where government is in the saddle instead of consumers, then it's considered,

59:09anytime anybody uses something or consumes something, you're wasting the social product, quote unquote. You're a consumer, you're wasting this. The government, the bureaucrats own the thing, and they're reluctant to have anybody use it. Making it shorter. That's the thinking that goes behind it. You can see here, we'll get to the water shortage, the alleged water shortage later on, but you can see here when the water shortage hit. The whole attitude on the part of the, here's the government which essentially municipalized the water industry. The water industry used to be private way back, and now you have all government water companies, water services. The whole attitude on the part of these guys is the consumers are a pain in the neck. They're using water. Stop using it. That's their attitude. Great attitude. Stop using everything. You'll never have any shortage if nobody eats, drinks and does anything else.

59:58So they immediately start blaming the consumers. The water shortage is because consumers are drinking too much, they're showering too much, whatever. They're washing their cars. And a private enterprise, in a private firm, they don't blame consumers. They're trying to get their custom. They try to get their custom. They try to get people to use the product. They don't consider it a pain in the neck. They consider it great. They're trying to find ways to get people to increase the consumption of the product. They don't blame them. As a matter of fact, if you have a private water company, they try desperately to get more water. They try to get the water, enough water, try to get the reservoirs and pipes and pipelines and all sorts of stuff in such a way that people can have plenty of water to use. It's only when government supplies it that the whole thing is a pain in the neck, because government doesn't live by profit, they don't care about profits, they don't go bankrupt

1:00:44if they have deficits, they just tax the people more than they get to make up the money. Uncle Sapp, in other words, the tax payer, pays the difference, so that's a totally different attitude, plus the different economics, totally different attitude of government officials in this thing. There's no incentive for them to supply water, a lot of it, or efficiently or anything else, The whole thing becomes something to get on the payroll, get your guys, your organization people on the payroll, and also get the taxpayers to keep funneling money into it. So, you never have a private firm saying, well, stop using New York, it's your fault. You're drinking too much water, you're showering too much. That's not the attitude. That is the attitude, of course, of the same with government. We'll get to, when we get to water shortage later on, we'll see how the pricing system has a big effect on that.

1:01:32But as a general attitude, you can see right away the difference between courting the consumer, trying to get people to buy more of your stuff, considering consumption, or you as just sort of a pain in the neck, necessarily evil at best. We now have each individual price of each individual good, how each individual price is determined by the intersection of a falling demand curve and a vertical supply line for any given time period and how it changes over time, either by change in supply curve or change in demand curve, which then becomes a resource pulling effect, in other words, which then increases or decreases resources going into the particular product.

1:02:21What we now have to look at is the relationship between different goods. In other words, what we've been doing so far is talking about each good at a time. And now we have to start talking about what the relationships are between different products. Some goods are close substitutes. Every good in a sense is a substitute for a consumer dollar, in which you can spend more of something. The money you have is fixed. If you spend more on good X, you might necessarily be spending less on good Y, that's a general situation But more than that, you have some goods which are close substitutes

1:03:12And some goods which are not And close substitutes have a different relationship between their demand and supply curves For example, let's get to the coffee case Coffee. Coffee supply falls because of a big frost, and price goes up. There are substitutes for coffee, which are going to become intimately related to this thing. In other words, when When people started buying less coffee because of the increased price, they shifted to other things like cocoa and tea. In other words, this is tea, which is a close substitute of coffee, the demand curve for tea went up in response, in other words, people were willing to buy tea, increased purchase at any given price because the demand curve went up in response to the higher price for coffee.

1:04:19In other words, the chain of cause and effect works like this, an increase, a fall in supply of X, in the words, coffee, raises the price of X, but since X and Y are co-substitutes, an increase in the price of X brings about an increase in demand for Y. because X is not more expensive, coffee is more expensive, a lot of people say why the heck would coffee, I'm shifting to tea, you're only a marginal coffee drinker, you're going to shift to tea, as you shift to tea, like that, the price of tea begins to go up, how much it goes up we don't know, it all depends on the tea market, the coffee market or whatever, but the point is, there's now an increase in demand curve for tea which leads the price of tea to go up also eventually.

1:05:18to some extent. So we now have demand for Y increases the price of Y. In other words, in response to the more expensive coffee, demand for T goes up and the price of T becomes also more expensive, or how much it does we don't know. It's not a quantitative law, it's a qualitative law. So we have a situation where two things are competitive as a drive here toward when the supply changes, as a drive toward making the price of the other one also competitive by this kind of process. It becomes more expensive, people then turn to tea because it's cheaper, relatively cheaper than coffee now, and tea becomes more expensive eventually too.

1:06:04So competition then cuts not only within each product, also between close substitutes, the same way for cocoa, the same process occurred for cocoa. We have a cocoa, we have a man for cocoa going up, man for Z increases the price of Z.

1:06:40Let's look at the other way around now. Increased supply of coffee, coffee now crosses over, price goes down, and the fact that coffee Coffee is now cheaper, the demand curve for tea drops, so the demand curve for tea falls because coffee is cheaper, people are willing to buy less tea at any given price, and so the price of tea then drops in response to that.

1:07:26In other words, you just reverse the signs here, an increase in supply of x will lead to a fall in the price of x, in which the term will lead to a drop in the demand for For y, the substitute, and this will lead to a drop in the price of y. Similarly for z, the demand curve for cocoa falls, the price of cocoa falls along with it. That's the close substitute. This happens all throughout the market, of course, not just for coffee and tea, but for everything. Substitutes for raw materials, substitutes for machinery, metals, all sorts of things. Iron, Aluminum, whatever, Aluminum and Magnesium, all these things are substitutes in one way or the other. They're not perfect substitutes, but they're close substitutes and they affect each other's market, the impact on each other's market.

1:08:21Let's see what happens when there's a...

1:08:26That's what happens when there's a change in supply. Changes in supply will cause a change in the price and a similar change in prices for the other substitutes. On the other hand, something different happens when there's a change in demand, because a change in demand usually reflects a change in the value scale between, say, coffee and tea anyway. Let's say this is the coffee market, and this is the tea market, and let's say people begin to shift from tea to coffee. As a matter of fact, originally in the United States, we drank mostly tea. Coffee was sort of the late edition. So there's a big shift from tea to coffee.

1:09:13The demand curve for coffee goes up, and eventually supply increases in response to it. The demand curve for coffee for tea goes down, and the price falls, and eventually the supply will fall in response. But when you have this kind of a shift, in other words, when you have a shift reflecting changes in the value scales of the consumer, then there's an opposite change in price. In other words, the coffee price goes up, at least in the short run to reflect the increased demand for coffee, and the price of tea goes down to reflect the fall in the demand for tea. So in this case, in the case where the value scales shift, the prices move in opposite directions instead of the same direction, because now you're having a difference in values in the consumer. They don't want tea anymore, they shift away from it, the price of tea drops in response to that, they want more coffee and the price of coffee goes up in response to that.

1:10:06Moving in the opposite directions in response to opposite changes in values. When there was a supply change, then it was a change in the same direction, because the values remained the same, the value scales remained the same, just the different supply conditions. Now you have a shift in value scales. The value scales are all relevant to each other. One thing goes up, the other thing has to go down, because it's all ranking, if you remember. So when white wine, red wine, has been an increase When I compare it to red wine, of course there's a shift in supply, and the price drops in response to that. So then the changes in price are opposite to each other. So that's what happens with close substitutes.

1:10:52Okay, we've got a big dose here tonight, so I think I'll leave at this point.