In "Demystifying Economics" (Ironwood Publications, 2000), Dr. Allen W. Smith writes: "Although economics has a greater impact on our daily lives than any other academic subject, it is not a general education requirement for a college degree. The net result is that the majority of college-educated Americans know very little about basic economics." It happens that my understanding of economics was also negligible.
As a retired teacher (Ph.D. in nuclear physics) I am one of many who lost a big chunk of savings in recent months. This prompted me to start studying economics. I am learning from several introductory economics books, including the one written by Professor Smith. In so doing I discovered what seems to be an error repeated in all textbooks I consulted. I know that it is silly for a person like myself to make a claim that the law of supply and demand is not properly described in most introductory textbooks. Perhaps there is a mistake in my reasoning; perhaps I am missing something. Where am I wrong? That is my question.
On one hand authors of textbooks state that market participants are selfish; they act to maximize profits. On the other hand, the authors seem to ignore the "maximum possible profit law" when it comes to predictions of prevailing prices. A prevailing price, for a given product in a classical market, they say, is the one at which the law of demand line and the law of supply line cross each other. One author wrote that the interception point is special because when "demand equals supply, both producers and consumers are content. Economists call situations like this, where everybody is happy, equilibrium. That is because with everyone getting everything that they want, nobody is going to cause any changes." My claim is that prevailing prices, when calculated according to the "mutual satisfaction" model, are not the same, except coincidentally, as prices calculated according to the "maximum possible profit" model. What follows is an illustration.
A typical textbook illustration
A hypothetical law-of-demand line, for a particular product, is red in Figure 1 below. Consumers are willing and able to buy more products when prices are low, and vice versa. The price is plotted horizontally because it is an independent variable. A hypothetical law-of-supply line, for a particular supplier of that product is blue on the same figure. The two lines cross each other at the price of $2.65 per item. Each item, in my mind, is a chicken sold at a classical market and the supplier is the owner of a chicken farm. But this is irrelevant.
Figure 1 supply and demand
Calculating the most profitable price
Now let me pretend to be a supplier. I know the demand line (from a published marketing research project, or from intuition). What price is the most profitable for me? The answer to this question depends on my ppi, profit per item. Suppose the ppi is zero at a price of $2.00 and then rises linearly up to $1.00 at a price of $9.00--in other words, zero profit below the price of $2.00 and very little profit at prices above $7.00 (because not too many items will be sold). Knowing the ppi values at different prices I can calculate my total profit, for any given price from a simple formula
Total profit = ppi X demanded quantity.
Suppose the price is $5.00. The ppi value for this price is $0.50 and the demanded quantity is 2,700. The expected profit for that price is $1,350. Repeating this calculation for different prices, and using the known demand curve, one can plot the dependence of the total profit on the price. The result is shown in Figure 2. The most profitable price, in this particular situation, happens to be close to $4.50 per bird, as illustrated in Figure 2. The most profitable price is much higher than the price at which supply and demand are equal.
Figure 2 supply and demand
For another supplier in the same market, the most profitable asking price might be higher or lower, depending on his values of ppi. Some suppliers are expected to ask a little more and others a little less. Other hypothetical distributions of ppi used to calculate profits confirmed that, in general, the most profitable price is not the same as the price determined on the basis of Figure 1, as claimed in economics textbooks. Am I right or am I wrong in making this observation? In classical markets, according to Adam Smith, participants are selfish. Each producer and each consumer does what is best for him and his family. The driving force of a classical market is said to be competition. Yes, the $2.65 price does make the supply and demand equal. But the $4.50 price is more profitable. That is why I think it would prevail, for the market characterized in Figure 1. Where am I wrong in making this prediction?
The illustration below has nothing to do with my question about classical economy. But it has a lot to do with my attempt to understand our economy today. It is an illustration I created; feel free to use it.