Demand for Dummies
In recent months, I've noticed that many people who attempt to explain "demand" don't know what they are talking about. They'll say things like, "demand is decreasing for gasoline".
When I hear things like that on the radio, TV, in print, wherever; I feel like tearing my hair out because they just don't seem to understand what demand is, and even what supply is.
So, for the sake of my own sanity, and to clarify for everyone who is also subjected to this generalized misunderstanding of demand, I offer the quick course:
Demand
Demand general refers to the total number of something that would be sold during a certain period of time given some particular price.
For example, if the X-Box 2 is priced at $399, how many units could be sold during 2009?
If the price of oil were magically fixed at $50 per barrel, for ever and always, how much would be purchased and used?
This is demand. It is how much would be used at a given price.
NOW comes the craziness that we always hear about:
"U.S. fuel demand dropped to the lowest since January 2007" reads one line today from Bloomberg.
Now this is a crazy thing for Bloomberg to write. Does anyone honestly think that we DEMAND less fuel now than in January?
In January, gasoline was about $3.04 per gallon in the USA. If gasoline had remained at that price, and was expected to remain there forever, would be be burning LESS now than in January?
Of course not. Our DEMAND is higher now than in January because we are WILLING and ABLE to buy more now at that $3.04 price than we were in January. DEMAND has increased.
Now that gasoline is something like $4.25 per gallon, OF COURSE we are buying less. We would have bought less in January as well if the price had been that high. In fact, if the price had been $4.25 in January, and had been fixed there since then, we'd certainly be purchasing MORE now than we did in January... because we like to drive around in the summer, and all the high school and college drivers suddenly are on the road.
Demand is generally thought of as not just how much would be bought at $3.04, or at $4.25, but how much would be bought at ANY price... $5, $20, $2, $1, $100, etc. The higher the price, the less would be purchased (at least in most normal cases, there are exceptions). This entire picture is the DEMAND for that "something" -- X-Box 2, gasoline, widgets, what-have-you.
This set of all prices can be plotted out on a nice graph, with the price along one axis and the amount that could be sold on the other. This generally forms a nice smooth curve, and is called, not surprisingly, the "demand curve".
DEMAND, then, is really the demand curve. If DEMAND goes up, than that means that MORE (of whatever) would be purchased, no matter the price. Maybe a big news story is that the Prius actually gets 100 miles per gallon, and the reported figures were all wrong. Suddenly, the DEMAND for the Prius would increase, and no matter what the price were, more COULD be sold.
A decrease in demand is just the opposite. No matter what the price is, less would be sold. For example, there is less DEMAND for F-series pickup trucks right now. No matter what the price, less would be sold now than would be sold AT THAT SAME PRICE a year or two ago.
Consumption
This Bloomberg article is a bit unique because it actually corrects itself only two sentences later.
"Consumption for the week to June 20 slipped 5 percent from its peak of 21.3 million barrels a day on Jan. 4, data from the Energy Department shows."
Okay, now here is what is really going on. Is it any surprise that if the price of something is 40% higher that LESS would be sold? Duh! Of course less would be sold, that doesn't mean that DEMAND is less, we would be buying MORE than January if it were still $3.04.
This corrective sentence clarifies that it is not DEMAND that has decreased, it is CONSUMPTION.
In most cases, I believe this is what the reporters and others are trying to say, but they mix up the terms, either thinking that the American public doesn't know the difference (perhaps true) or not knowing the difference themselves (perhaps also true).
This leads us to a related point, the very scary, "demand destruction".
Demand Destruction
Now, first of all, I think that "demand destruction" is a made up term, that must have been coined somewhere a few years back, and is slowly making its way into the mainstream.
It is usually used like this in the press, "the high prices of gasoline have led to a round of demand destruction which may lead to lower future prices". Hogwash.
In this case, DEMAND now is most likely higher than last summer. In other words, if gasoline were currently selling for $3.06 (where it was last June), then we would be buying more. After all, there are MORE of us, and we all like and want to drive our cars, SUV's, etc.
Is the demand for gasoline less than a year ago? Short answer, no.
Is less being purchased? Yes.
Are these two statements in any way contradictory? No.
We want to buy more, but at this higher price, we are willing to buy less.
So, in most cases, when the term "demand destruction" is used, it really means that price is higher on something, so less is being purchased.
NOW, that is not to say that DEMAND can't go down on something. Take those F-series pickup trucks again. Yes, the DEMAND for new F-series trucks is lower now than last year. It is no surprise given how personal incomes/expenditures have changed over the past year.
Is this the elusive "demand destruction"?
First of all, why the word "destruction"? Why not just say that demand has decreased? Do we now have to say "DEMAND DESTRUCTION, duhm, duhm, DUHM!!!" everytime that we notice that DEMAND for something has decreased? Demand goes down for stuff ALL THE TIME. Demand for this model is down, demand for that model is up. Demand for new Ford Excursions is down, demand for the Prius is up.
Perhaps we should now use the term "demand CREATION" everytime we are willing (collectively) to buy more of something at a particular price? Hogwash (again).
Oil
So, now, I had better talk a bit about what is going on with oil.
DEMAND for oil is increasing. And what I mean in particular is that the oil that is for sale on the global market, well, more would be sold NOW at say $50 per barrel, than a year ago at $50 per barrel. DEMAND has increased.
Why has the price increased then?
Because the SUPPLY, that is, how much is available to be sold in the first place, is exactly the same this year, as it was last year.
So, we DEMAND more oil, but the SUPPLY is the same.
Now, if this were Toys-R-Us on the opening day of the X-Box 2 sales, and they had 100 units in stock for that $399, but the DEMAND at that price, for that store, on that day, was 300 units, then... well, there would be a SHORTAGE... which is to say, they would run out, and 200 folks who would have plopped down their credit card have to go away without their coveted distraction toy-of-the-day.
In the case of oil, we REALLY don't want that to happen. We do not want shortages. What we want is the price to INCREASE so that we will BUY less. That doesn't mean we DEMAND less. In fact, we may our DEMAND may (and is) higher. It just means that we aren't willing and able to buy as much at $150 as we were when the price was $50.
Lucky for us, oil is sold at a sort of auction, where people get to basically bid up the price, so that no one goes home empty handed. That means that if DEMAND increases, while SUPPLY remains the same, that the PRICE increases as well. In fact, there is a simple mathematical relationship between these three -- demand, supply, and price.
Uh, Oh
The situation we are currently, which I will refer to just this once as the "Uh, Oh" situation, is that not only is worldwide DEMAND for oil increasing, but the amount of oil that is available, the SUPPPLY, is actually decreasing...
Hmmm, you say... What does that mean...
Ponder for a moment...
Yes, if the DEMAND is increasing... the price will rise. And if the SUPPLY is decreasing... the price would also rise. And in this case, both the DEMAND is increasing, and the SUPPLY is decreasing, which results in the price rising extremely rapidly for oil... which ends up causing all the other shifts in prices throughout the rest of the economic system.
"Uh Oh" is right. Particularly because the amount of oil that is being offered up for sale is starting to rapidly decline. As the supply shrinks to zero, the price will increase to... well... not infinity, but close enough that buying it will no longer be possible. I could give you a figure, but you probably wouldn't like it, or believe it. Let me just be extremely conservative and tell you that $1,000 per barrel oil is not only possible, but it WILL happen, and probably faster than most people imagine.
Good ole USA
So, then, let's look a moment at the oil predicament that we find ourselves in, here in the USA.
The amount of oil that is available for export will be less each year. Right now, something like 50 million barrels per day is exported. (I'm not counting here oil that is exported/imported as sort of a swap between to adjacent countries, only the "net oil exports".) So if 50 million barrels are available, and the price is now around $150, and demand is increasing everywhere... What happens to the price as the export supply goes from 50 to 49... and from 49 to 45... and from 45 to 40... and from 40 to 25... and so on?
Well, a rather startling figure came out the other day which noted that for every one percent increase in DEMAND for oil, there is a 20% increase in price. What this means in reverse is that when the export supply drops from 50 to 49, a 2% decrease, that the price will rise by 40%.
But recall, DEMAND for that exported oil is also rising. Based on figures from the 90's, the increase in demand was about 1.5% per year. So, if that continues to hold, then a 50 to 49 decrease in supply, will actually cause a price increase of 3.5 times about 20%... or 70%.
Hmm... Let me look at those numbers on a spreadsheet in Excel for a few minutes.
....
Uh oh.
Let's just say that the numbers get very large, very fast. We're talking about a 70% per year increase in the price of oil in this scenario, and oil would be above $1,000 per barrel in under five years...
First note, a bit of a surprise, we don't have to know the amount of the total net oil exports, only that they are decreasing by a certain percentage. So, whether the actual net exports right now are 50 mbpd or 40 mbpd makes no difference.
Second note, a 2% rate of decrease is actually the wrong number to use in the calculation. In reality, the number will go down something like 0.5 million barrels per day the first year, then 0.7 million barrels per day the next year, and so on, until the amount available for export reaches zero. Let me look at that for a moment...
Uh oh, squared.
In reality, again, I don't think that net exports would be able to go to zero. At least one oil extracting/producing country would be willing to sell some if the price were high enough. Unfortunately, the price gets very high, very fast.
Demand Revisited
Demand is the amount of something that would be purchased, during a certain window of time, given the various prices that this "something" could be priced at. Demand is rising right now because there are 77 million more people in the world, every year, and they desire and are willing to pay money, do work, etc. to get things.
When the price on something changes, it is very easy to start comparing apples to oranges, and to get confused that, in reality, it was simply that there would naturally be a change in the amount of sales ANY TIME that the price changed. That is to say, that just because less gasoline was sold in June than in January does not mean that there is less DEMAND, because the January (apples) price and the June (oranges) price were different, and thus of course there was going to be a difference in the sales.
I hope this clears demand up just a bit for you, dear reader, and help both you and I listen and read critically when someone tries to explain what is happening with demand.
When I hear things like that on the radio, TV, in print, wherever; I feel like tearing my hair out because they just don't seem to understand what demand is, and even what supply is.
So, for the sake of my own sanity, and to clarify for everyone who is also subjected to this generalized misunderstanding of demand, I offer the quick course:
Demand
Demand general refers to the total number of something that would be sold during a certain period of time given some particular price.
For example, if the X-Box 2 is priced at $399, how many units could be sold during 2009?
If the price of oil were magically fixed at $50 per barrel, for ever and always, how much would be purchased and used?
This is demand. It is how much would be used at a given price.
NOW comes the craziness that we always hear about:
"U.S. fuel demand dropped to the lowest since January 2007" reads one line today from Bloomberg.
Now this is a crazy thing for Bloomberg to write. Does anyone honestly think that we DEMAND less fuel now than in January?
In January, gasoline was about $3.04 per gallon in the USA. If gasoline had remained at that price, and was expected to remain there forever, would be be burning LESS now than in January?
Of course not. Our DEMAND is higher now than in January because we are WILLING and ABLE to buy more now at that $3.04 price than we were in January. DEMAND has increased.
Now that gasoline is something like $4.25 per gallon, OF COURSE we are buying less. We would have bought less in January as well if the price had been that high. In fact, if the price had been $4.25 in January, and had been fixed there since then, we'd certainly be purchasing MORE now than we did in January... because we like to drive around in the summer, and all the high school and college drivers suddenly are on the road.
Demand is generally thought of as not just how much would be bought at $3.04, or at $4.25, but how much would be bought at ANY price... $5, $20, $2, $1, $100, etc. The higher the price, the less would be purchased (at least in most normal cases, there are exceptions). This entire picture is the DEMAND for that "something" -- X-Box 2, gasoline, widgets, what-have-you.
This set of all prices can be plotted out on a nice graph, with the price along one axis and the amount that could be sold on the other. This generally forms a nice smooth curve, and is called, not surprisingly, the "demand curve".
DEMAND, then, is really the demand curve. If DEMAND goes up, than that means that MORE (of whatever) would be purchased, no matter the price. Maybe a big news story is that the Prius actually gets 100 miles per gallon, and the reported figures were all wrong. Suddenly, the DEMAND for the Prius would increase, and no matter what the price were, more COULD be sold.
A decrease in demand is just the opposite. No matter what the price is, less would be sold. For example, there is less DEMAND for F-series pickup trucks right now. No matter what the price, less would be sold now than would be sold AT THAT SAME PRICE a year or two ago.
Consumption
This Bloomberg article is a bit unique because it actually corrects itself only two sentences later.
"Consumption for the week to June 20 slipped 5 percent from its peak of 21.3 million barrels a day on Jan. 4, data from the Energy Department shows."
Okay, now here is what is really going on. Is it any surprise that if the price of something is 40% higher that LESS would be sold? Duh! Of course less would be sold, that doesn't mean that DEMAND is less, we would be buying MORE than January if it were still $3.04.
This corrective sentence clarifies that it is not DEMAND that has decreased, it is CONSUMPTION.
In most cases, I believe this is what the reporters and others are trying to say, but they mix up the terms, either thinking that the American public doesn't know the difference (perhaps true) or not knowing the difference themselves (perhaps also true).
This leads us to a related point, the very scary, "demand destruction".
Demand Destruction
Now, first of all, I think that "demand destruction" is a made up term, that must have been coined somewhere a few years back, and is slowly making its way into the mainstream.
It is usually used like this in the press, "the high prices of gasoline have led to a round of demand destruction which may lead to lower future prices". Hogwash.
In this case, DEMAND now is most likely higher than last summer. In other words, if gasoline were currently selling for $3.06 (where it was last June), then we would be buying more. After all, there are MORE of us, and we all like and want to drive our cars, SUV's, etc.
Is the demand for gasoline less than a year ago? Short answer, no.
Is less being purchased? Yes.
Are these two statements in any way contradictory? No.
We want to buy more, but at this higher price, we are willing to buy less.
So, in most cases, when the term "demand destruction" is used, it really means that price is higher on something, so less is being purchased.
NOW, that is not to say that DEMAND can't go down on something. Take those F-series pickup trucks again. Yes, the DEMAND for new F-series trucks is lower now than last year. It is no surprise given how personal incomes/expenditures have changed over the past year.
Is this the elusive "demand destruction"?
First of all, why the word "destruction"? Why not just say that demand has decreased? Do we now have to say "DEMAND DESTRUCTION, duhm, duhm, DUHM!!!" everytime that we notice that DEMAND for something has decreased? Demand goes down for stuff ALL THE TIME. Demand for this model is down, demand for that model is up. Demand for new Ford Excursions is down, demand for the Prius is up.
Perhaps we should now use the term "demand CREATION" everytime we are willing (collectively) to buy more of something at a particular price? Hogwash (again).
Oil
So, now, I had better talk a bit about what is going on with oil.
DEMAND for oil is increasing. And what I mean in particular is that the oil that is for sale on the global market, well, more would be sold NOW at say $50 per barrel, than a year ago at $50 per barrel. DEMAND has increased.
Why has the price increased then?
Because the SUPPLY, that is, how much is available to be sold in the first place, is exactly the same this year, as it was last year.
So, we DEMAND more oil, but the SUPPLY is the same.
Now, if this were Toys-R-Us on the opening day of the X-Box 2 sales, and they had 100 units in stock for that $399, but the DEMAND at that price, for that store, on that day, was 300 units, then... well, there would be a SHORTAGE... which is to say, they would run out, and 200 folks who would have plopped down their credit card have to go away without their coveted distraction toy-of-the-day.
In the case of oil, we REALLY don't want that to happen. We do not want shortages. What we want is the price to INCREASE so that we will BUY less. That doesn't mean we DEMAND less. In fact, we may our DEMAND may (and is) higher. It just means that we aren't willing and able to buy as much at $150 as we were when the price was $50.
Lucky for us, oil is sold at a sort of auction, where people get to basically bid up the price, so that no one goes home empty handed. That means that if DEMAND increases, while SUPPLY remains the same, that the PRICE increases as well. In fact, there is a simple mathematical relationship between these three -- demand, supply, and price.
Uh, Oh
The situation we are currently, which I will refer to just this once as the "Uh, Oh" situation, is that not only is worldwide DEMAND for oil increasing, but the amount of oil that is available, the SUPPPLY, is actually decreasing...
Hmmm, you say... What does that mean...
Ponder for a moment...
Yes, if the DEMAND is increasing... the price will rise. And if the SUPPLY is decreasing... the price would also rise. And in this case, both the DEMAND is increasing, and the SUPPLY is decreasing, which results in the price rising extremely rapidly for oil... which ends up causing all the other shifts in prices throughout the rest of the economic system.
"Uh Oh" is right. Particularly because the amount of oil that is being offered up for sale is starting to rapidly decline. As the supply shrinks to zero, the price will increase to... well... not infinity, but close enough that buying it will no longer be possible. I could give you a figure, but you probably wouldn't like it, or believe it. Let me just be extremely conservative and tell you that $1,000 per barrel oil is not only possible, but it WILL happen, and probably faster than most people imagine.
Good ole USA
So, then, let's look a moment at the oil predicament that we find ourselves in, here in the USA.
The amount of oil that is available for export will be less each year. Right now, something like 50 million barrels per day is exported. (I'm not counting here oil that is exported/imported as sort of a swap between to adjacent countries, only the "net oil exports".) So if 50 million barrels are available, and the price is now around $150, and demand is increasing everywhere... What happens to the price as the export supply goes from 50 to 49... and from 49 to 45... and from 45 to 40... and from 40 to 25... and so on?
Well, a rather startling figure came out the other day which noted that for every one percent increase in DEMAND for oil, there is a 20% increase in price. What this means in reverse is that when the export supply drops from 50 to 49, a 2% decrease, that the price will rise by 40%.
But recall, DEMAND for that exported oil is also rising. Based on figures from the 90's, the increase in demand was about 1.5% per year. So, if that continues to hold, then a 50 to 49 decrease in supply, will actually cause a price increase of 3.5 times about 20%... or 70%.
Hmm... Let me look at those numbers on a spreadsheet in Excel for a few minutes.
....
Uh oh.
Let's just say that the numbers get very large, very fast. We're talking about a 70% per year increase in the price of oil in this scenario, and oil would be above $1,000 per barrel in under five years...
First note, a bit of a surprise, we don't have to know the amount of the total net oil exports, only that they are decreasing by a certain percentage. So, whether the actual net exports right now are 50 mbpd or 40 mbpd makes no difference.
Second note, a 2% rate of decrease is actually the wrong number to use in the calculation. In reality, the number will go down something like 0.5 million barrels per day the first year, then 0.7 million barrels per day the next year, and so on, until the amount available for export reaches zero. Let me look at that for a moment...
Uh oh, squared.
In reality, again, I don't think that net exports would be able to go to zero. At least one oil extracting/producing country would be willing to sell some if the price were high enough. Unfortunately, the price gets very high, very fast.
Demand Revisited
Demand is the amount of something that would be purchased, during a certain window of time, given the various prices that this "something" could be priced at. Demand is rising right now because there are 77 million more people in the world, every year, and they desire and are willing to pay money, do work, etc. to get things.
When the price on something changes, it is very easy to start comparing apples to oranges, and to get confused that, in reality, it was simply that there would naturally be a change in the amount of sales ANY TIME that the price changed. That is to say, that just because less gasoline was sold in June than in January does not mean that there is less DEMAND, because the January (apples) price and the June (oranges) price were different, and thus of course there was going to be a difference in the sales.
I hope this clears demand up just a bit for you, dear reader, and help both you and I listen and read critically when someone tries to explain what is happening with demand.