The world of economics is full of confusion for most people, and leads many to make the wrong assumptions about how governments should make decisions.
Price is determined by the market, and is based solely on supply, and demand.
In January 2020 Swedish 17-year-old climate activist Greta Thunberg spoke to world leaders at the World Economic Forum in Davos, Switzerland. The teenager has somehow been anointed one of the decade’s most important stars of the environmental movement as the world combats climate change — but this time she was in over her head.
Thunberg, speaking for environmental activists, demanded the world stop using and investing in fossil fuels.
Asked by reporters about Thunberg’s call for the world to divest from fossil fuels, then-U.S. Treasury Secretary Steven Mnuchin, questioned how Thunberg could lecture them about how divestiture should work. “Is she the chief economist? Who is she? I’m confused,” he joked. “After she goes and studies economics in college, she can come back and explain that to us.”
Thunberg later retorted on Twitter that it doesn’t take a college degree to know the world is missing its climate targets. That is true, but she missed Mnuchin’s real criticism: that her lack of knowledge in economics left her unprepared to explain how divestiture from fossil fuels would actually work in real life.
Setting aside the problem of climate change, here is the lesson from Greta: don’t let economics unravel all your great ideas about the world!
In current news White House press secretary Jen Psaki made some pretty bold claims about the causes of skyrocketing gas prices. Earlier this month she blamed American oil producers for not developing their unused drilling permits. A couple days later she turned to blame Russia’s President Putin as the most important cause of rising gas prices.
She wasn’t the only one. Many in the media accused the oil and gas industry of price gouging, blaming the war in Ukraine. But like with Greta, we wish that such opinion leaders in our society would have a basic understanding of economics.
Americans’ lack of understanding of pricing starts at the grocery store. When we go to the grocer, we walk through the aisles of merchandise and see that the merchant has already set the prices for everything. And in America, we don’t haggle at the checkout stand about how much the Oreos should actually cost.
The merchant-pricing tradition we are used to is a convenient one. But the problem with this model is that it gives Americans the impression that merchants and suppliers are the ones to set prices on everything. But that is not how prices are set.
Price is determined by the market, and is based solely on supply, and demand.
When demand is higher than supply, prices rise. When there is more supply than what people want, prices fall.
To help this idea of market pricing settle in, you need to forget the idea of merchants pricing their goods.
Instead, you need to think of market pricing like one giant auction — a marketplace where sellers and buyers come together to transact business. Sellers ask for an asking price, and buyers bid. And the sale goes to the highest bidder. It is that transaction that sets the price.
In the housing market people understand this intuitively, especially as the recent record-low supply of houses on the market has led desperate buyers into bidding wars to bid substantially higher than the original asking price.
Supply and demand also determine the prices of stocks on the stock market, and the price of commodities like wheat and crude oil. When you log in to buy a stock, you can actually see the price of the stock changing in real time before you push the “buy” button. The psychology of this is fascinating (and I say this with a little introspection), that as the price is falling, I wait for it to fall farther, and when the price is rising, I buy quickly, further driving the price up. This behavior causes stock prices to whipsaw.
Commodities prices fluctuate just like stock prices — and are based on supply and demand, as sellers ask, and buyers bid in the big auction.
In March of 2020, when COVID shut down the economy, the price of a commodity called “lumber” tanked. In fact some lumber mills cut production and staff because they didn’t know how long the pandemic would last, and when people would start building again. But only a few months later, mills were caught off guard as the unexpected happened: all America’s home-bound public was actually spending their free time at Loa Builders Supply, buying everything. Lumber, which had normally traded on the open market for between $300 and $400 per thousand-board-feet, spiked to over $1,500 in April, 2021, only to crash below $500 last August. Currently it’s back up over $1,100.
Right now it’s the oil price that is on everyone’s mind. Prices have come off their highs from a couple weeks ago, but the markets are still seeing volatile swings in prices.
The fluctuation of oil prices has often mystified my friends. A decade ago one friend didn’t understand why the diesel price was so much higher than unleaded. “Isn’t diesel just a byproduct of refining oil?” she asked. But whether it’s a “byproduct” or not is irrelevant in pricing: what really matters is that people want it.
Demand for the world’s crude oil is not just from your typical SUV driver. It is burned to heat homes and generate electricity; it is used to manufacture plastics and synthetics, and to fill your party balloons with helium.
Oil is even unwittingly used by people who hate the oil and gas industry. Just a year ago, for instance, outdoor gear manufacturer North Face rejected an order for 400 jackets from a Texas oil and gas company because North Face didn’t want their enviro-friendly brand to be associated with the dirty and immoral oil and gas industry. In response to perceived hypocrisy, the Colorado Oil and Gas Association bestowed its first-ever “Extraordinary Customer Award” on North Face for their abundant use of oil and gas in the manufacturing of most of their products.
While real-use demand of crude oil remains fairly stable (barring another shock like COVID), oil prices do more than their share of price swings because of one other demand source people don’t think about: traders buying up oil futures.
We won’t get into the lengthy details of how futures work and why they are important, but the open markets which allow oil producers and oil buyers to come together so efficiently also allow third parties (like you and me) to buy and sell the future delivery of oil. That is why crude prices started to surge on February 25 even though Biden didn’t ban Russian oil until March 8.
You might think it’s unethical there’s a group of traders out there “manipulating” oil prices like this, but you need to think of it this way: believing that Biden might cut Russian crude, those traders were buying what crude they could while it was still available at a good price. There’s nothing wrong with that. You did the same thing three weeks ago when, knowing gas prices were going to surge, you made sure to keep your gas tank topped off with yesterdays “cheap” gas, storing against tomorrow’s expensive gas.
So while oil producers, lumber producers, farmers and ranchers don’t set the prices for their goods, they do benefit when the markets set the prices high. They also get punished when the markets set prices low.
All free markets are like a big auction. Sellers ask for a price, and buyers bid.
There is more to this story of course. The effects of government intervention in pricing, regulation and cartels are just some of what you’ll learn about when you go to college to take that economics course with Greta.
And next time you are in the grocery checkout line and think they didn’t price the Oreos right, please don’t try to negotiate with them. The bewildered checkout clerk will remind you he has no authority to bargain, saying, “I just work here.”
– The Byway
Feature image caption: Who can set prices? This is a confusing question for many Americans, and it shows.