Understanding a few basic economics concepts can help you be a better saver, smarter investor and savvier consumer. In a previous column, I covered three key Econ 101 ideas: sunk cost, opportunity cost and the relationship between risk and return.
Here are three more economics terms that can help you understand how money works.
Supply and demand. The prices we pay for goods and services aren’t dictated by some central government agency. In a market economy like ours, prices are based on where supply and demand intersect.
Buyers and sellers typically have opposite motivations. All other things being equal, sellers usually will produce more of an item the higher a price it can command, while buyers usually buy less the more expensive it is. Theoretically, there’s an equilibrium point, or a price at which buyers are willing to buy and sellers are willing to sell. Big shifts in supply or demand can affect that equilibrium price. A freeze that kills the Florida orange crop, for example, can lead to higher prices for orange juice, while a surplus of rice can drive prices down for this mealtime staple. Fads can shift demand higher and increase prices, while waning trends can shift demand lower and result in lower prices.
If your neighborhood suddenly becomes fashionable, for example, your house may command a higher price. If demand suddenly drops — for homes overall because it’s harder to get a mortgage, or for your neighborhood in particular because a prison is built nearby — the price of your house will fall, too. It doesn’t matter what you paid for the house or what you think it’s worth; what matters is what sellers are willing to pay.
Elasticity. This concept describes how much demand or supply changes for something in relation to its price.
If a small price increase results in a steep drop in demand, the product is considered to be elastic. If a large price increase results in a small or no drop in demand, the product is considered to be inelastic.
Products that have lots of close substitutes tend to be elastic. People who like to buy steak, for example, may switch to cheaper cuts of meat or to chicken if the price of steak rises. Salt, on the other hand, has relatively few close substitutes, so it’s less elastic.
On the supply side, the higher the price elasticity of a product, the more sensitive sellers are to a change in price. Products can be income elastic, as well. Most have a positive elasticity of demand — people buy more as their incomes rise. Inferior goods, though, have a negative elasticity of demand, since people upgrade to better stuff.
Probably the most important idea in all this is the concept of substitution. Shoppers learned this in a big way when they turned more frequently to generic products during and after the most recent recession. You don’t have to pay a higher price if there are other, more reasonably priced options available.
Price discrimination. When sellers charge different prices to different people, they’re implementing price discrimination. Airline fares are a classic example, since two people sitting next to each other could have paid vastly different amounts for the same flight. Student, senior and military discounts are other examples of price discrimination.
Sellers benefit from price discrimination since they can reap more revenue by exploiting differences in price elasticity of demand. Last-minute travelers tend to be price inelastic — if they have to travel, they’ll pay the higher price. Leisure travelers and those who have time to plan their trips will be more price elastic, seeking out deals before they buy.
The bottom line for consumers is that better prices often exist for those who take the time to look for them.