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«50 IDEAS YOU REALLY NEED TO KNOW: ECONOMICS Edmund Conway is Economics Editor of Sky News. He was educated at Pembroke College, Oxford, and the ...»

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The invisible hand underlines the fact that individuals – rather than governments and administrators – should be able to decide what to produce and consume, but there are some important provisos. Smith was careful to distinguish between self-interest and pure selfish greed. It is in our self-interest to have a framework of laws and regulations that protect us, as consumers, from being treated unfairly. This includes property rights, the enforcing of patents and copyrights and laws protecting workers.

The invisible hand must be backed up by the rule of law.

This is where Gordon Gekko got it wrong. Someone driven purely by greed might choose to cheat the law in an effort to enrich himself to the detriment of others. Adam Smith would never have approved.

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At the heart of economics and the very core of human relations lies the law of supply and demand. The way these two forces interact determines the prices of goods in the shops, the profits a company makes, and how one family becomes rich while another remains poor.

The law of supply and demand explains why supermarkets charge so much more for their premium sausages than their regular brand; why a computer company feels it can charge customers extra for a notebook computer merely by changing the colour. Just as a few elementary rules determine mathematics and physics, the simple interplay between supply and demand is to be found everywhere.

It is there in the crowded lanes of Otavalo in Ecuador and the wide avenues bordering Wall Street in New York. Despite their superficial differences – the dusty South American streets full of farmers, Manhattan replete with besuited bankers – in the eyes of the fundamentalist economist the two places are virtually identical. Look a little closer and you’ll see why: they are both major markets. Otavalo is one of Latin America’s biggest and most famous street markets; Wall Street, on the other hand, is home to the New York Stock Exchange. They are places where people go to buy or sell things.

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The market brings the buyers and sellers together, whether at a physical set of stalls on which the products are sold or a virtual market such as Wall Street, where most trading is done through computer networks. And at the nexus between demand and supply is the price. These three apparently innocuous pieces of information can tell us an immense amount about society. They are the bedrock of market economics.

Demand represents the amount of goods or services people are willing to buy from a vendor at a particular price. The higher the price, the less people will want to buy, up to the point when they simply refuse to buy at all. Similarly, supply indicates the amount of goods or services a seller will part with for a certain price. The lower the price, the fewer goods the vendor will want to sell, since making them costs money and time.

The price is right? Prices are the signal that tell us whether the supply of or demand for a particular product is rising or falling. Take house prices. In the early years of the 21st century they rose faster and faster in the US as more and more families took the plunge into home ownership, encouraged by cheap mortgage deals. This demand prompted housebuilders to construct more homes – particularly in Miami and parts of California. When, eventually, the homes were completed, the sudden glut of supply caused house prices to fall – and fast.

The open secret about economics is that, in reality, prices are rarely ever at their equilibrium. The price of roses rises and falls throughout the year: as summer turns to winter and supermarkets and florists have to source them from further abroad, the supply of roses drops and the price increases. Similarly, in the run-up to 14 February prices leap because of the demand for Valentine’s Day flowers.

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Economists term this ‘seasonality’ or ‘noise’. Some, however, try to look beyond it to work out the equilibrium price. Take house prices again: no economist has yet worked out how much the average house should be worth. History tells us it should be worth a number of times someone’s salary – between three or four times on average – but there is no way of knowing for sure.

One can learn some elementary lessons about people from the price of certain goods. A few years ago computer manufacturer Apple brought out its new Macbook laptop, and produced it in two colours, white and black, the second being a special, more expensive, version. Despite being identical in every other way to the white version – speed, hard disk space and so on – the black version was retailed for an extra $200. And yet they still sold successfully. This would not have happened without there being sufficient demand, so clearly people were happy to pay extra purely in order to distinguish themselves from their run-of-themill white laptop neighbours.

Elastic fantastic Sometimes supply and demand take a while to respond to changes in prices. If a telephone company raises its call charges, consumers tend to cut back pretty quickly on the number of calls they make or, alternatively, to move to a different phone company. In economic parlance, their demand is price elastic – it alters with changes in prices.

In other cases, consumers are slow to react to changes in costs – they are price inelastic. For example, when oil prices rose sharply early this millennium, consumers faced with high fuel prices could not switch to an alternative, nor could they necessarily afford to buy a new, expensive, electric or hybrid car to cut costs. Similarly, oil-intensive companies could do little but absorb the extra cost. Gradually, some consumers switched to 50 economic ideas text:Layout 1 16/5/12 14:24 Page 12


using public transport. Such switches are known as substitution away from expensive items to alternatives. Many families, though, had little choice but to shoulder the higher cost of fuel for as long as possible.

Of course, what goes for demand goes equally for supply, which can also be elastic or inelastic. Many businesses have become extremely adaptive – or price elastic – when demand for their products drops, laying off workers or cutting back on investment as a response. Others, however, are more inelastic and therefore find things less easy. For instance, a Caribbean banana producer might find it extremely difficult to cut back on his business if he is either muscled out by bigger Latin American producers or finds that consumers are less keen to buy his bananas.

Whether it be the Ecuadorian stallholder, the Wall Street banker or anyone else, the primary force behind economic decisions is always the interplay between prices and the buyers and sellers who determine them; in other words, supply and demand.

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