Hey folks! I’m diving into economics again today. As it turns out, my own classroom teaching often fuels content for a post, and given my shortness of time, I might as well kill two birds with one stone. This is a description of how consumer demand drives prices, and though it seems logical enough, most of us don’t even think about this until someone actually walks us through it.
Until Carl Menger, the founder of the Austrian School of Economics, really started the Marginal Revolution in the latter half of the 1800s, it was generally accepted that prices were more or less based on the value of their inputs (land, labor and capital). Carl Menger revolutionized the conception of prices with his explanation that it is not the value of inputs that ultimately determine prices, but consumer demand. And as an extension of that, the value of inputs (the factors of production: land, labor and capital) themselves are determined by consumer demand for finished goods.
Let’s try to explain this with an example. Let’s say that in the year 2019, Widget X becomes a major hot product; everybody wants it (or almost everybody). Let’s say that to make Widget X, it takes a very rare resource which we will call Lamboviam. Lamboviam, in our example, is as rare as diamonds, but it not used for any other product other than in Widget X. Suddenly, as the demand for Widget X spikes, the price for Widget X will go up. The producers of Widget X, excited about the profit they can make, will want to now make even more. Other entrepreneurs will also start to make Widget X, hoping to capitalize on the profits.
Of course, all this means that they will need more—much more—Lamboviam. So the demand for Lamboviam goes up, which will push its price up. Guess what that means. It becomes more profitable to mine Lamboviam. So more mining companies will be drawn to mining Lamboviam in the Lamboviam mines of northern Canada (we’re making this all up…) because they can make more money mining Lamboviam than they could mining other things (which is why they start mining more). That also, by the way, pushes up the wages for the miners themselves, because the demand for their labor has gone up.
In that way, consumer demand for Widget X not only drove up the price of the Widget, but also the price of all the inputs.
To see how this really works from another angle, now let’s look at the year 2020, when suddenly nobody wants to buy Widget X anymore; the new cool fad –Widget Y—has replaced it. As it turns out, Widget Y does not use any Lamboviam. So in 2020, nobody is buying Widget X (demand drops to 0), so what demand is there for Lamboviam? Again, none. So what demand is there for the miners of Lamboviam? None. What can a Lamboviam miner now earn? Nothing. It doesn’t matter if Lamboviam mines are incredibly dangerous and the work seems like it should be compensated with high wages for such dangerous work; if nobody is buying Lamboviam to make Widget X, nobody will pay a worker to mine Lamboviam.
(Of course, how much Lamboviam is available—ie, supplied—can push prices up or down, but demand is the ultimate driving factor, because supply is meaningless if consumers don’t first want to buy something in the first place, which is the whole point of this description.)
And in this example, we can see how it is not the value of inputs that determine price, but the demand for the finished goods that then ripples out to all the inputs, and that includes labor, as many people seem to forget.
Now just replace Widget X with something more familiar, like diamond rings. If nobody wanted to buy diamond jewelry, the demand for diamonds would be much lower (but not gone completely, as I’ll explain shortly), and hence the demand for diamond mines would be much lower, and the wages of diamond miners would be much lower. Incidentally, even if nobody wanted diamond jewelry, diamonds are also used in high-precision cutting of glass, for example, so there is industrial demand for diamonds in addition to consumer demand. But we can see how it is demand for diamonds that ultimately drives the prices for the diamonds themselves, and the other inputs.
So, you might ask, what about the dangerous conditions of diamond mining? Doesn’t that push prices up for diamonds? Yes, it does, but my main point doesn’t change. In order to attract diamond miners, diamond mining companies have to offer higher wages. (We’ll set aside right now the real issue of involuntary mining; there is some of that globally.) But why is it worth it to the company to offer higher wages to attract workers to dangerous work? Because the profit potential is still high enough that they are willing to pay more. If demand for diamonds slackens and there is not as much potential for profit (so mining companies have to pay less or fewer people in order to keep making a profit), they will not be able to attract as many miners to the dangerous work, and so will see fewer people applying to work for them (or people leaving for safer and/or higher paid work). But again, this is not ultimately based on the level of danger of the work, but from those who want the diamonds and are thus willing to pay more for the labor. Still confused? Imagine how much the dangerous work of diamond-mining will pay if nobody wants to buy diamonds anymore. $0.
I would highly recommend you watch the following video, at least from 50:38 to the end.
Want to join the rest of us nerds and learn the history of economics? Economist Bob Murphy has an entire two-part series on just that at LibertyClassroom.com.
Excellent summary about pricing and consumer demand!
Thank you so much!