This means that there is even greater competition for consumer business than before. Not only do consumers have many sellers to negotiate with, those existing sellers face the threat of new competition if they charge excessively high prices. This should obviously work to the consumer's favor by allowing them to negotiate lower prices for their purchases. This also implies it is more difficult for firms to make money. Any time sellers make high profits, others will enter the market in hopes of making similar profits. However, the more firms that enter the market, the less each firm makes.
Consider a peculiar service: a professional line-stander. If you wanted to hear a controversial Supreme Court case (like the March, 2012 case regarding Obamacare, shown here), but you make too much money to waste standing in line, why not simply pay someone else (whom I will call a stander) to stand in line for you? They cost no more than $13 per hour, and often less. The interactions between the buyers and sellers of the service will result in some equilibrium price. It won't be zero, and it won't be $100 per hour. The price will be somewhere close to the wage the standers could earn elsewhere. That next best option is essentially the cost the seller pays to provide their service. If they give up an $8 per hour wage to stand in line for you, it costs them $8 to provide standing services, and if they can negotiate a price higher than $8, they make money.
Let us assume there are many, many people who could work at an $8 per hour wage or could stand in line for you if you make it worth their time. When you pay more than $8 per hour, dozens want to stand for you. If you offer less than $8, no one does. Thus, you will end up negotiating a price equal to or slightly higher than $8 per hour. The price equals the cost of providing the service. In constant cost industries, price always equals (or is very close to) the cost of production.
There is something disturbing about this result that prices will ultimately equal their marginal cost of production—before one understand what this really means. If price equals cost, then there is no way to make money, no way to "get ahead", right? No. For the standers, this cost equaled what they could get in their next best option. Those resigned to being standers do not have the skills necessary to command a high salary, and there are many of them. So, why should they be paid any more than the thousands of other people with the same skills? Moreover, why should you be forced to pay someone more than thousands of others just like him? You shouldn't, but know that you are not holding them down by paying this competitive price.
If Jim gets tired of jobs like standing in line, he can acquire skills (education, work experience) that will increase his value to other employers. When others are willing to pay him a higher salary, he now has better opportunities then standing in line. His cost of being a stander is greater than price, and he is no longer a stander. Observe that price equals the average cost of those who are active standers, not people with better opportunities. The cost of Mark Zuckerberg standing in line is thousands and thousands of dollars per hour, but the price of standers will still be $8 per hour.
Notice that this fierce competition for consumer business also ensures the people who need that job the most will get it. By allowing people to offer lower prices to be a stander, it gives that job to those with the least alternatives elsewhere. After all, the reason they offer a lower price is that they have a greater need for the job, whereas those who insist on a high price do so because they have ample opportunities to work elsewhere.
Prices always return to their average cost of production, but sometimes its return is fast and sometimes very slow. For standers, if buyers offer a higher wage then potential standers will quickly flock to him, allowing him to negotiate a lower price, and price returns to its average cost quickly. The price of some goods takes much longer to adjust. The length of time in which price may depart from its average cost depends on how fast production of the good can be altered.
(inflation adjusted price in red)
The graph above shows how the price of corn varied between 1981 and 2011. It is clear that the average price (stated in 1981 dollars, to adjust for inflation) is around $2.25, yet there are periods which price is greater and less than this average. Periods of high prices will induce farmers to ramp up corn production, but this can take years. The same can be said for low prices, where it takes farmers significant time to determine whether they should alter their planting strategy, and if so, what to plant instead. If corn could be grown and then replanted in a week, prices in this graph would be much closer to $2.25.
This harmony of price, where market forces will always force price towards the average production cost, does not mean price will always equal average cost. Instead, we say that corn prices are heading in the direction of the $2.25 average cost. Think of a thermostat in a house. If the thermostat is set to 70 degrees, at no place in the house will it actually equal 70 degrees precisely (assuming a thermometer has many decimal places). Yet we know that if the temperature is 75 degrees the AC will turn on to bring price down, and if the temperature is 65 degrees the heater will kick-in to bring the price back up.
In reality, there is no single average production cost for any good that stays constant over time. Supply and demand is a useful, conceptual model, not a statement about reality. Productivity in most things improves over time, reducing the average production cost. Some manufacturers find themselves facing higher input costs, like if the price of land rises as more arable cropland comes under cultivation. In these instances the average cost of crop production may be rising or falling, and land prices will be rising or following in its track. Prices still have a harmony about them, but it is a moving target. The job of market analysts is to make judgment calls about when a high price is coming down towards the same average production cost, or if price is high to reflect a higher average production cost.
Using our discussion thus far, the video below shows that the supply curve in a constant cost industry is a horizontal line, and in an increasing cost industry has a positive but gentle slope. To understand supply and demand curves in a long-run setting, see this video.
When we think of slavery in the southern U.S. states that existed before the Civil War, we think of southern plantation owners receiving enormous benefits from the little expense their slave labor costs them, relative to northern states where labor must be negotiated with the workers. Given this article, should we rethink this? Certainly, slave labor reduced the cost of growing cotton. At the same time, the cotton industry was very competitive, as there was plenty of arable land for new farmers to cultivate for cotton. If this is the case, then we would expect the cotton price to be drive down to equal the average production cost. Plantation owners still made money, but no more than they would in their next best option. As a result, perhaps the plantation owners benefited very little.
Someone surely benefited from slave labor, but who? I argue it was primarily the consumers of cotton products, located mostly in the northern U.S. states and the United Kingdom. Market forces drove price down as far as it could go without causing farmers to plant a plant other than cotton. Although they thought themselves to have clean hands, the cheap cotton clothes they were able to purchase made them equally guilty in this sinful, horrid institution called slavery.
A previous graph showed the behavior of corn prices in the last few decades. It was argued that the average cost of corn production is around $2.25, and although it may take corn prices years to adjust production in response to changing prices, it seems as if corn prices are always heading towards the $2.25 value.
Suppose it is February 2011, and in the graph it appears corn prices are very high. We know this implies that corn prices will eventually fall, but what exactly will happen to make them fall? To understand the harmony of prices we must not only know that price will equal average cost, we must know why.
At these high prices, farmers make a profit, which means they are making more money raising corn than their next best option for work—which is probably planting some other crop. As a result, farmers will begin converting soybeans to corn, or plow ground that was once idle for the sake of corn production. As this new corn comes to market, price will have to fall to induce consumers to purchase more corn products. Corn prices fall, but so long as it remains above $2.25, more corn will hit the market and price will have to keep falling until it hits $2.25 and we are once again at our equilibrium.
Study this graph and discuss whether you believe gasoline prices have a constant long-run equilibrium, or if you believe price is trending upward or downward. Use the lighter line, which is adjusted for inflation.
Our discussion makes it seem as if price will always, eventually, reach the equilibrium
where price equals average cost. But if the market is not in equilibrium, why? In the real world markets are constantly being shocked by new events. In regards to corn, new production technologies are constantly introduced, lowering production costs. Manufacturers develop new uses for corn, like corn ethanol. Consumer tastes are always changing, like when news articles suggest high fructose corn syrup is unhealthy. Because production costs and demand for corn constantly changes, the market equilibrium always changes, and market prices attempt to hit a moving target but once it gets close to the target the equilibrium shifts once again.
A precise, steady equilibrium never exists, but sometimes the equilibrium doesn't change drastically over the years. Sometimes it will, like with computers whose production costs are always falling. Remember our metaphor of the thermostat for an equilibrium. Air conditioners and heaters will be turned on and off in an attempt to bring the house temperature to its thermostat setting, but new events in the house constantly change the internal temperature. A door opens, and the cold air rushes in. A mother turns on a stove, heating the kitchen. The summer sun is harsh, heating the air around windows. Yet if you want a best guess of what the house temperature is, you will guess whatever the thermostat is set to. If you want to know the best prediction for a market price, you will guess the average production cost.
One day John Paulson's wife retrieved some money out of her ATM account, and assumed it had to be a mistake when the account balance said $45 million. But it was not a mistake. John Paulson was one of the very few people who believed house prices were too high, and he made millions betting that house prices would fall, and his argument betting against houses was based on his knowledge of long-run supply and demand.
