Download Supply and Demand

Supply and Demand
"Prices are to the market economy what red cells are to the human body - they
both direct vital life-giving resources to the right place at the right time, with
little interference or direction."
Overview
Prices are a central feature of our lives, and sharp changes in prices can have a direct bearing on our well-being
as well as the economic health of industries and entire nations. In fact we can summarize the secret to financial
success very succinctly: "buy low, sell high." If the price of something rises significantly, you benefit if you own
it. Think about the wealth created for investors by dramatic increases in the price of stock in the late 1990s, or
the wealth created for homeowners by the meteoric rise home prices in the early 2000s. There was also the rise
in gas prices that dominated news in 2007-2008 and greatly concerned my students as they filled up at $4+ a
gallon. It was painful, most so for those with those gas guzzling SUVs. While we suffered, money flowed into
the oil producing countries such as Saudi Arabia, Venezuela, and Russia. They got rich, and some would say
these new riches helped finance terrorism and rebuild the Russian military that marched into Georgia in 2008.i
Rising food prices in 2008, meanwhile, had a devastating impact of many of the world's poorest, triggering riots
in some countries and prompting others to restrict exports of grains.
Prices also have an enormous impact on the choices we make in our lives. Many of you are enrolled in college
because the "price" of college-educated labor has been rising, and chose URI because it is a public university and
its price is lower than that at private universities. Those who major in Pharmacy or Business overwhelmingly do
so because of they believe it brings higher earnings, while those gas-guzzling car owners will trade them in for
more energy efficient cars when the price of gas rises.
To understand prices economists rely on the Supply-Demand model. For example, look at the following
headlines of stories on prices for a minute. All of them are essentially variations on the same theme – prices are
affected by the behavior of market participants –buyers and sellers – and when the behavior of either changes
then prices change.
The good news is that you are already probably “wired” to understand prices. Experience has shown that
students generally are good at reconstructing the story based on the headlines.
"Natural Gas Prices Rise on Nuclear Outages."
"Biofuels causing food price rises"
"NY power prices rise on plant outages."
"Ivory Coast unrest causes cocoa's price to climb."
“Nursing shortage eases with higher pay and a weak labor market”
“Marines miss January goal for recruits”
Natural gas and food prices are rising because of increases in demand: demand for natural gas rises as firms seek
to replace nuclear power with gas powered plants, while an increase in demand for biofuels has increased
demand for corn. NY power and cocoa price increases, meanwhile, are the result of decreases in supply: the
closure of power plants in NY has reduced production of electricity, while unrest in the Ivory Coast, a large
supplier of cocoa, has lowered world supply of cocoa. The shortage of nurses and Marine recruits also reflect
changes in supply and demand when prices are not free to move. A nursing shortage is simple another way of
saying that the price of nurses is too low, and this shortage will be reduced by allowing the price to rise.
Similarly, in 2005 as things were going badly in the Iraq war, the supply of new recruits dropped, which resulted
in a shortage of recruits prompting the services to offer “perks” and lower standards.
The bad news is that once the supply and demand curves economists use to explain prices, students tend to lose
their intuitive understanding of prices. It does not have to be this way, however, since it is not that difficult to
master supply & demand curves. In fact it can be no more difficult then making dinner - you just need to follow
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the directions. In a later section you will find the “Cookbook Approach” – a set of guidelines you should follow
if you are to find your experiences with supply & demand as successful as my experiences with cooking. First,
however, we will look at a few instances where the prices generated by markets are wrong.
When prices are not quite right
The market system is one of the wonders of the world, solving society's scarcity problem with markets sending
signals to decision makers. Some times markets fail to send out the correct signals, and when the signals are
wrong, the results can be quite bad.ii A wonderful, yet painful example, of where markets got it wrong was the
housing boom-bust in the first decade of the 21st century that you can see in the graph below.
This is a picture of a classic price bubble - a situation where markets clearly send the wrong signals, and where
those wrong signals lead to real hardships in the Great Recession of 2008-2009. What makes it worse is we
should have recognized this as a price bubble earlier, before much of the damage was done. We certainly have
seen speculative real estate bubbles before, so you would think we would have seen it coming. There were
"substantial property crashes with widespread major repercussions in Athens (333 B.C.); Britain (1773); Chicago
(1837); France (1838), Germany (1870); Vienna (1873); Southern California (1880s); Britain (1890s); Florida
(1925); Japan (1990)."[Dick Pidcock, "The A-Z of Crashes"] And those in Rhode Island had their own bubble in
the late 1980s and early 1990s that was big enough for the governor to shutdown the state’s credit unions.
And there is nothing unique about real estate. It was a dramatic collapse in stock prices in 1929-1930 that
ushered in the Great Depression in the US, a stock market bust in the late 1980s in Japan that ushered in a
decades long recession, and the collapse of the .com bubble in the early 2000s that ended the roaring 1990s in
the US. There was also the bubble in gold prices in the late 1980s and the collapse of exchange rates in a number
of Asian countries in 1997 that triggered the Asian Crisis.iii The "pictures" of four price bubbles appear below the boom-bust cycles in the price of gold and the price of cotton, the price of stock in Japan, and the price of the
baht, Thailand's currency.
Speculative Bubbles
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It turns out price bubbles are not all that rare, especially in asset market such as real estate, stocks, and currencies
where purchases are based on expected changes in price. Niall Ferguson, in The Ascent of Money, sees these
cycles as a reflection of the human psyche that is prone to bouts of greed and fear, and there is nothing to suggest
that we will overcome either greed or fear. So when you find yourself in the middle of the next speculative
bubble, and you will, you can expect to hear "this time it is different," and when you do, think seriously about
getting out of that market.iv
Bubbles and large price swings are not, however, the only potential problem with market prices. On a number of
occasions politicians and economists have acknowledged that market prices may be inappropriate for equity
reasons. In the US we have imposed rent control and minimum wages to “correct” market prices by raising
wages and lowering rents. We also raise the price on some goods such as cigarettes to reduce demand, while in
numerous poor countries governments have established ceilings on food and oil below market rates. In each case
the market interventions occurred because of a belief that market prices did not adequately take into account
social considerations, and in the last section of this unit we will examine government market interventions.
Another potential problem with market prices would be the fact they may not reflect all costs, an issue we look at
in detail in the externalities unit of ECN201. Later in this unit we will also look at some instances
When markets are wrong
In addition to the ideological debate over the adequacy of markets in “solving” society’s scarcity problems and
generating acceptable prices, there is also a debate about the limits of markets. It may be perfectly OK to let my
wage as a university professor or the price you pay for a watch to be set in a market, but what about a price for a
pound of horsemeat, a kidney or a sexual encounter being set in a market? It turns out there are a number of
goods and services for which markets are thought to be entirely inappropriate, although the list varies across time
and space. There are some things like charging interest on loans and buying life insurance that were at one time
thought to be immoral and now perfectly acceptable, although even today not everyone accepts interest
payments. Some things like slavery that were once accepted, meanwhile, are now thought to be immoral There
are also some jurisdictions where markets for sex are accepted, while in others it is banned.
One of the factors that has been identified as affecting the acceptability of markets is “repugnance” – people are
simply turned off by the concept and want it banned.v One example is the ban in California on horsemeat in
restaurants. Neither safety nor health considerations noted in the ban; it is simply banned because some people
find it repulsive, even though it is entirely acceptable to have it in dog food and to serve it in restaurants in
Europe. Here are a few other potential markets for you to think about: should they be allowed? What would be
the good, the bad, and the ugly that would come from creating markets for the following?
1.
2.
3.
4.
5.
6.
7.
Advertising space on the sides of school buses
Dwarf tossing (a large person throws a small person)
Pollution
Prison cells
Children
College athletes
Votes
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What about legalizing pot? I thought this would never happen, but production and consumption as of 2013 was
legal in Washington and Colorado. The rationale for support from a former opponent sounds like it was right out
of the 20s Prohibition era: “At some point you have to say, a law that people don’t obey is a bad law.”vi This
does not, however, suggest support for a free unregulated market where unregulated marketing would drive up
consumption considerably. The market for pot would look like the market for booze and butts, highly regulated
and highly taxed.
And one final market: what about a market for body parts? How do you feel about a market for human organs?
There is a substantial shortage of organs, which creates considerable pain and even death for some of those in
need of a transplant, and while economists tend to agree the establishment of a market would reduce the
shortage, these markets do not exist. As you think about a market for organs, as well as markets for the items
listed above, it is useful to consider three aspects of the transaction.
Concerns about the monetization of transactions fall into three principal classes. One concern is
objectification: that is, the fear that putting a price on certain things and buying or selling them might
move them into a class of impersonal objects to which they should not belong. The sociology literature
has shown a longstanding interest in how the introduction of money changes many kinds of social
relationships and their meanings (as a starting point, see Simmel, 1990). A second concern is that
offering substantial monetary payments might be coercive, in the sense that it might leave some people,
particularly the poor, open to exploitation from which they deserve protection. A third concern,
sometimes less clearly articulated, is that monetizing certain transactions that might not themselves be
objectionable may cause society to slide down a slippery slope to genuinely repugnant transactions.vii
For those who want to see some interesting examples of markets, you might want to check out Iowa Electronic
Markets, Hollywood Stock Exchange, or InTrade.viii It turns out though that some markets are seen as
unacceptable, and we’ll look briefly at this issue.
Now let’s look at the approach you can take to make those supply and demand curves manageable.
The Cookbook Approach
As we begin our work here you should keep in mind my view on this S&D model: if I can cook, you can do
supply and demand analysis. All we need to do is follow the "rules" that show up in a cookbook, and in this unit
we look at each of the steps in the S&D cookbook. The 6 steps in the approach are outlined below.
Cookbook Approach
1.
2.
3.
4.
5.
Identify the market (what is it that is being bought or sold)
Identify the participants (who are is buying and selling?)
Identify the determinants of behavior (why do buyers and sellers do what they do?)
Identify the appropriate curves (why do they look like this?)
Identify the type of problem
a. disequilibrium - wrong price
b. comparative static - price change
First, you must identify the market, which is not always easy. For example, we could look at the impact on the
car market of an increase in the price of gas. As you can expect the impact will be very different if we are
looking at the market for SUVs or hybrids, so be careful in specifying the market.
Second, you must identify the participants in the market - the buyers and the sellers. Think about a market for
something you are familiar with and try to identify who demands it. If we are talking about gasoline, it is people
like us who want to drive our cars, or transportation companies needing gas to run their trucks. If were are
talking about single family homes it will be individuals looking for shelter as well as speculators hoping to resell
the house at a higher price that will be demanders, and the home-builders will be the suppliers. If it is the market
for college-educated labor, then it will be the human resource managers at some of our nation's largest
corporations who are demanding the services of college grad, and you would be the suppliers of that labor. In the
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labor market the demanders are the businesses who hire workers and the sellers are individuals like you and me
looking for work.
Third, you must identify the factors that influence the behavior of buyers and sellers. What will affect the
demand for automobiles in the US? Since you are likely to be a buyer of an automobile, you could probably
come up with a pretty good list of factors by assuming other people would behave like you. Now let's look at
what affects demand.
Determinants of demand
Price: The most obvious factor affecting demand would be price. We expect a negative relationship between
price and quantity demanded - an increase in price would cause a decrease in demand.
Demographics (Number of demanders): Demographics means people - the size and composition of the
population – and the importance of demographics is evident in the number of times you hear about certain
population groups such as the baby boomers, Hispanics, or the elderly. For example, two economists, Mankiw
and Neil, created quite a furor in the 1980s when they suggested the housing market was driven by demographics
and the aging of the baby boomers would result in a long-term decline in demand for housing. A decade later the
ageing of the baby boomer generation was linked to the rise in the stock market as those boomers, with their
newly empty nests, were investing in stocks. And let's not forget demand for seats at the nation's universities. In
2008 it was tough to get in many schools because demand was high, driven by a record number of high school
graduates.
Income and wealth: Demand is not about wishes or dreams. It is about how much people are willing AND able
to buy, so ability to pay affects demand. Income - how much you earn - is thus an important determinant of
demand. You will be likely to cut back on your purchases if your paycheck drops, or buy that new gadget if you
get a raise. In China the Chinese people see their incomes rise as, they will trade their bicycles in for autos and
purchase those household appliances that will increase electricity demand. They will also want electricity to
power the lights, televisions, refrigerators, and air conditioners they will buy with their higher incomes.
Wealth also affects demand: if wealth increases, demand will likely increase. Examples of the effect of wealth on
demand would be the stock market boom in the late 1990s and the housing boom in the early 2000s. In both
cases the increases in wealth showed up surges in spending on automobiles, vacations and just about everything
else. In fact in 2005, the spending spree was so large that it actually pushed savings rates negative - Americans
were spending more than they were earning because they were using their houses as debit cards.
Other prices: Demand also depends on other prices - the price of substitutes and the price of complements. If the
price of Hondas increases, then you expect to see demand for Toyotas or Fords that are substitutes for the
Hondas to increase. If the price of computers (hardware) falls, then you expect an increase in demand for
software that is a complement to the machines. In 2008 we saw a painful example of this when gas prices rose
sharply. Demand for SUVs dropped sharply while demand for public transportation rose as people searched for
ways to cope with the higher gas prices.
Expectations: if you expect a price rise in the future, or your financial situation to improve, then demand is likely
to increase today. An example of this would be the home heating oil "crisis" in early 2000 in Rhode Island. The
price of heating oil began to rise creating the expectation of further price increases, which prompted consumers
to increase their purchases of oil before the price rose any further. A second example would be the situation in
Japan in the 1990s when Japan was experiencing deflation - prices were actually falling - and the Japanese
consumers responded by cutting today's spending because they expected prices to be lower in the future.5
Determinants of supply
Who are the suppliers in a market - and what influences their behavior? If we are talking about gasoline, it is the
major oil companies extracting the oil and then processing and distributing the gasoline, while if were are talking
about single-family homes it is the builders and developers who assemble the permits and workers to build those
homes. If we are talking about the market for college-educated labor, you will be supplying the labor. To
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understand supply you need to "get inside" the heads of the sellers, and here are a few of the things we find that
affect supply.
Price: As with demand, we start with the price of the product. If the price rises then a seller will earn more,
which should prompt them to bring more to the market. A farmer deciding what crops to grow would look at
prices. When the price of corn increases farmers will increase the land devoted to growing corn, which means
more corn brought to the market. This is exactly what happened in 2008 as farmers converted acreage to corn in
response to sharp increases in corn's price. Similarly, as interest in Californian wine has grown and driven up the
price of that wine, more land has been devoted to the cultivation of grapes and increased the supply of California
wine. When the price of SUVs fell in 2008 as people shifted from the SUVs because of higher gas prices, the
auto companies cut production of sport utility vehicles - and increased production of hybrids. A final example
can be seen in the title of the book Small Wind Turbines Sprouting as Power Prices Rise. As the cost of energy
rises more companies are finding it profitable to build wind turbine farms - exactly the positive relationship
between price and quantity the model of supply specifies.
Price of inputs: If you happened to be a high level manager at Apple or Dell, what would happen to your supply
of computers if the price of the computer chips fell? If you are GM, what will happen to the supply of autos if
the price of resources such as steel and electricity rose? Apple and Dell should be able to sell the same
computers at a lower price if costs are down, while GM would be in a position of having to charge a higher price
to cover additional costs associated with the wage increase. In the first case we would be talking about a
decrease in the price of the input resulting in an increase in supply, while in the case of GM we would be talking
about an increase in the price of inputs resulting in a decrease in supply.
Productivity (change in technology): An increase in productivity, which very often occurs because of an
investment in technology, means a firm can produce the same output with fewer inputs. This allows a firm to
expand output with no increase in costs, or the cost of supplying each product would decrease because fewer
inputs were needed. Regardless of the interpretation, the increase in productivity would increase in supply.
Number of sellers: When we are talking about the number of sellers we are talking about market structure - a
main topic in the microeconomics course. At this time we can make the simplifying assumption that an increase
in the number of sellers will increase the supply as the new firms' output arrived in the market.
The fourth step is often the most difficult because you will be doing some translating when you turn your
analysis into a picture - a graph. Once you have followed the first three steps, you will need to turn your
analysis into a picture - the infamous supply and demand graphs. The supply curve (S) is the visual
representation of suppliers, while the demand curve (D) is the visual representation of buyers. Now let's look at
these curves with the help of a simple example of the market for seats at a local college - RIU.
The Pictures: Supply and Demand Graphs
Demand: Below is a table with the results of a survey of potential students at RIU. As you would expect, there is
a pronounced negative relationship between the price (tuition) and the number of people willing and able to
apply. At a price of $9,000, there were 16,600 people willing to pay the tuition, while at a price of $12,000 there
were only 15,900 willing to pay. In technical terms, the increase in the price of school (tuition) by $3,000 caused
a decrease in the quantity demanded by 700.
The graph of this relationship between the price (tuition) and quantity (number of applications) is called the
Demand Curve, and it appears next to the table. At a price of $15,000, there are 15,200 applicants to the
university, and when the price is $21,000 there are 13,800 applicants.
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Original Survey
Tuition
$3000
$6000
$9000
$12000
$15000
$18000
$21000
$24000
$27000
# of Applicants
18000
17300
16600
15900
15200
14500
13800
13100
12400
Now take a moment to make a short list of the factors that would have influenced the decisions of those in the
survey. The answers most likely would have been different if RIU's reputation were improved, if the stock
market was booming and people were feeling wealthier, if the costs of other universities was higher, or if RIU
had gotten national exposure when its basketball team had made it to the NCAA finals. In each of these instances
we would expect a survey to reveal that at each price there would be more applicants. In more technical terms,
we would say that there was an increase in demand for seats at RIU, which shows up as an outward shift in the
demand curve. Now at a price of $15,000 there are 17,200 applicants, where before there were 15,200.
Note: there is a difference in how we demonstrate the impact on demand of price changes and any other
"shocks." To see the impact of a change in demand we simply move along the demand curve, and we call it a
change in quantity demanded. Any other "shock" - a change in any of the other determinants of demand - shows
up as a shift in the demand curve, and we call it a change in demand.
Supplementary Survey: Increased Demand
Tuition
# of Applicants
$3000
20000
$6000
19300
$9000
18600
$12000
17900
$15000
17200
$18000
16500
$21000
15800
$24000
15100
$27000
14400
Supply: Below you will find a table containing the results of an interview with RIU's president and VP for
finance that were given the same survey, but they were asked how many students they would accept at each
tuition rate. They indicated more applications would be accepted as tuition went up because they could open up
some unused space on campus and pay more to bring in additional faculty and staff. At a price of $12,000, RIU
could make space for 17,800 applicants, but if the price (tuition) were $6,000, there would be only16,600 seats.
In technical terms, the $6,000 increase in tuition (price) caused an increase in the quantity supplied of 1,200. A
graphical representation of the relationship, what is called the supply curve, appears below. At a price of
$15,000, the university will supply seats for 18,400 students at the university.
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Original Supply Survey
Tuition
$3000
$6000
$9000
$12000
$15000
$18000
$21000
$24000
$27000
# of Applicants
16000
16600
17200
17800
18400
19000
19600
20200
20800
As for the factors you would expect to have influenced the administrators' decision, their answers would have
been different if faculty had received a salary increase, if energy costs were higher, or if some new technology
greatly reduced the cost of administrative work. If costs of running the university were lowered, we would
expect the president would make space for more applicants. In more technical terms, the university increased
supply as a result of lower production costs, and as you can see from the graph below, an increase in supply
shows up as an outward shift in the supply curve.
Supply Survey with Lower Costs
Tuition
$3000
$6000
$9000
$12000
$15000
$18000
$21000
$24000
$27000
# of Applicants
17000
17600
18200
18800
19400
20000
20600
21200
21800
Note: there is a difference in how we demonstrate the impact on supply of price changes and any other "shocks."
To see the impact of a change in supply we simply move along the supply curve, and we call it a change in
quantity supplied. Any other "shock" - a change in any of the other determinants of supply - shows up as a shift
in the supply curve, and we call it a change in supply.
The Market: Now it is time to bring suppliers and demanders together in the table and graph below containing
the results of the initial surveys that you have seen before. If the tuition were $6,000, there would be 17,300
people looking for slots at the university, while the university would make 16,600 slots available. At this price
there would be a shortage of 700 seats. Similarly, at a price of $24,000, the university is willing to make 20,200
slots available while only 13,100 slots are being sought. At that price there is a surplus of 7,100 seats. At neither
of these prices do we have an equilibrium where the number of individuals seeking acceptance equals the
number of slots being made available. Somewhere between $6,000 and $9,000 we will find the equilibrium.
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Original Survey
Tuition
$3000
$6000
$9000
$12000
$15000
$18000
$21000
$24000
$27000
Demand
Supply
18000
17300
16600
15900
15200
14500
13800
13100
12400
16000
16600
17200
17800
18400
19000
19600
20200
20800
You can also see the same information graphically. At a price of $15,000 there is a surplus, which shows up as
the gap between the two curves, and at a price of $5,000 there is a shortage of seats. The real "power" of the
market is its ability to "eliminate" the surplus or shortage. If the price was $5,000 and there was an excess
demand (shortage) the seller would likely raise the price, while if the price was $15,000 and there was an excess
supply (surplus), sellers to lower their prices. The equilibrium exists where the two curves intersect because this
is the only price that will last since at any other price there will be pressure to change price. The prices and
consumption (quantity) we see in the market are equilibrium prices and quantities. In this example we would
expect the market to generate a price of approximately $7,000 and 15,000 seats, and anything that would change
either the S or D curve would change the equilibrium.
You are now ready to move onward to look at some details of the graphical analysis. We will look at the slopes
of the curves and at shifts in the curves caused by market "shocks."
The Details
Slope of the curves
The slope of a curve conveys to the reader information on responsiveness. In the case of S and D curves, the
slope reveals how much demand changes when price changes. To see how this works, let's look more closely at
slope by looking at two demand curves. The first demand curve is quite flat, which means demand is quite
responsive to price. In this example, a relatively small change in price (P0 to P1) generates a substantial change
in quantity demanded (Q0 to Q1). This is likely to be the situation facing a Mobil gas station at a busy
intersection where there are three gas stations (Mobil, Shell, and Citgo). If the Mobil station raised its price,
customers would pump gas at the other stations so we would expect a price rise to substantially lower demand.
In the second diagram we have a relatively steep demand curve indicating demand is less responsive to price
changes: a relatively large change in price (P0 to P1) generates only a small change in quantity demanded (Q0 to
Q1). This is likely to be the situation facing the gasoline industry. If the industry raised its price, customers
would still need to pump gas so the price increase would have a minimal impact on demand.
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Most markets would have a downward sloping demand curve, but not all of them. Two extreme cases would be
when the curves are horizontal and vertical. A vertical demand curve is called a perfectly inelastic demand,
which happens when demand is completely independent of price. Demand is what it is and a change in the price
will not change demand. A horizontal demand curve is called a perfectly elastic demand, which means demand
is completely dependent on price. Buyers will buy any amount at a specified price, but at any higher price they
will buy nothing.
The same interpretation can be applied to supply curves. A steep curve indicates supply will not respond
significantly to price changes while a flat curve indicates a price change will substantially alter supply.
Shifts of the curves
Supply and demand curves are meant to be visual representations of the behavior of buyers and sellers and how
their interaction produces an equilibrium price and output level. We should expect anything affecting behavior
will be reflected in the supply and demand curves, that any shift in these curves will cause changes in price and /
or quantity. Now let's go through the four possibilities.
Shifts in Supply or Demand
Increase in demand is represented by an outward shift in the curve (from D to D+) that moves the equilibrium
(intersection of S and D curves) up and out. If you compare the two equilibriums (intersections) both the
equilibrium price and quantity have risen.
Decrease in Demand is represented by an inward shift in the curve (from D1 to D-) that will move the
equilibrium (intersection of the S and D curves) down and in. The new equilibrium price and quantity are both
lower than the original.
Increase in Supply is represented by an outward shift in the supply curve (from S to S+) that will move the
equilibrium point (intersection of the S and the D curve) down and out. If you compare the two equilibriums
(intersections) the price falls and the quantity increases.
Decrease in Supply is represented by an inward shift in the supply curve (from S to S-) that will move the
equilibrium point (intersection of the S and the D curves) up and in. If you compare the two equilibriums
(intersections) the price rises and the quantity falls.
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Shifts in Supply and Demand
This usually happens when there are two "shocks" to the market - one that affects suppliers and one that affects
demanders.
Increase in Supply and Demand is represented by an outward shift of both curves that moves the equilibrium
point from the intersection of D & S to the intersection of S+ and D+. Below are two diagrams describing the
potential impact of the supply and demand increases.
There is a significant difference between the two possible results. The left-side diagram depicts the situation
where the increase in demand is greater than the increase in supply, while in the right-side diagram the increase
in supply is greater than the increase in demand. In both cases consumption increases (Q1 > Q*), but there is a
difference in the price effect. When the demand shift is larger [left-side diagram], the upward pressure on price
dominates and price will rise [ P1 > P*]. When the supply shift is larger [right-side diagram], the downward
pressure on price dominates and price will fall [ P1 < P*]. When supply and demand move in the same direction
we can forecast the change in consumption (quantity), but we cannot forecast price changes. When supply and
demand increase we can forecast an increase in consumption, and when there is a simultaneous decrease in
supply and demand, we can forecast a decrease in consumption.
Decrease in Demand and Increase in Supply is represented by an inward shift in the demand curve and an
outward shift in the supply curve that moves the equilibrium point from the intersection of D & S to the
intersection of S+ and D+. Below are two diagrams describing the potential impact of the supply increase and
demand decrease.
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In the first diagram the supply shift is greater than the demand shift, while in the second diagram the shift
demand shift is greater. In both cases there is a decrease in price (P1 < P*). What we cannot be certain about is
the projected change in quantity. When the supply shift is larger than the demand shift, it will be the upward
pressure on quantity that dominates and consumption will rise (Q1 > Q*). When the demand shift is larger it will
be the downward pressure on quantity that dominates and consumption will decrease (Q1 < Q*). This example
shows that when supply and demand move in opposite directions we can forecast the change in price, but we
cannot forecast quantity changes.
Now let's summarize all of the conclusions in a few tables. The first table summarizes the situation where there
is only one shock that affects only one curve. In this situation you can predict what will happen to the price and
quantity. An increase in demand is expected to push prices and output higher, while a decrease in supply will put
downward pressure on output and upward pressure on price.
Shifts in Supply or Demand
Shock
Demand (Inc)
Demand (Dec)
Supply (Inc)
Supply (Dec)
Price
Price (Inc)
Price (Dec)
Price (Dec)
Price (Inc)
Output
Quantity (Inc)
Quantity (Dec)
Quantity (Inc)
Quantity (Dec)
When both curves shift, things look a bit different because you will not be able to predict both the quantity and
price effect. If both Supply and Demand increased, we would not be able to specify the direction of the price
change until we knew something about the magnitudes of the shifts. We can, however, forecast an increase in
quantity since both the supply and demand increases tend to increase output. In the table below you will see a ?
in those situations where we cannot predict the direction of change in price or quantity unless we know more
about the relative size of the shifts.
Shifts in both Supply and Demand
Shock
Demand (Inc) & Supply (Inc)
Price
Price - ?
Output
Output (Inc)
Demand (Inc) & Supply (Dec)
Price (Inc)
Output -?
Demand (Dec) & Supply (Inc)
Price (Dec)
Output -?
Demand (Dec) & Supply (Dec)
Price - ?
Output (Dec)
Two Examples:
Oil
The price of oil affects the lives of nearly
everyone, and because of this, changes in oil
prices have a substantial effect of the macro
economy – and on elections. As someone who
lived through the 1970s, I remember well the
dramatic price increases of 1973-74, when prices
doubled, and 1979-80, when they quadrupled
and triggered a recession that wreaked havoc on
Jimmie Carter’s attempt at a second presidential
term. The history of oil’ price also offers us a
wonderful example of the workings of S&D, so
before you read on, check out the graph below
and make a note of the significant price changes.
What was behind these price changes?
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The short answer is supply and demand. In fact you know what must have been behind those dramatic price
increases in the 1970s and the 6-fold increase between 2001 and 2008; it waas either an increase in demand or a
decrease in supply. With a little research you would find those 1970s’s price spikes were due to supply
restrictions imposed by the Organization of Petroleum Exporting Countries (OPEC) cartel that show up as a
leftward shift in the supply curve. So did the big spike in 1990 that coincided with the first Gulf War that
reduced Iraq’s supply of oil. The run up in oil prices that ended in 2008, however, was driven by Asia’s booming
economy that increased world demand for oil that would create an outward shift in the demand curve.
You can also see the impact of recessions, which show up as the shaded areas in the graph. Oil prices fall
because demand for oil drops as incomes fall and unemployment rises in recessions, which shows up as an
inward shift in the demand curve. There was also the sharp price drop in 1998 that reflects the collapse of a
number of Asian economies in the Asian Crisis. For those interested in explanations for the other price
movements you might check out the DOE web site.
Housing
A second price that has an outsized impact on our lives is the price of homes because for the majority of
Americans the home is their most valuable asset, which is why the 2008-2009 economic crisis was so
debilitating. Real estate prices began to rise in the late 1990s, which prompted increasing numbers of people to
buy homes to cash in on the rising prices. It was a great game that went something like this. Mary lived in a hot
real estate market where houses were rising 20% a year and she wanted to borrow $160,000 at 7% interest for 30
years to buy a $200,000 house. This gave her a monthly payment of $1,064 that she could not really afford, but
the bank was happy to lend her the $160,000 because they could always repossess the house worth $200,000 if
Mary stopped paying the mortgage. Mary did not worry either since that $200,000 house would rise to $240,000
in a year. By just sitting at home Mary's wealth increased by $40,000.
Then two things happened. First, Mary, feeling quite wealthy, decided to go on a spending spree. First, she went
to the bank and said something alone the lines of "my house is now worth $240,000 so please replace my
$160,000 mortgage with one for a $200,000." Fortunately for Mary, the standards for mortgages had been
changed in ways that allowed many people like her to now qualify for mortgages. The bank, happy to get the
business because it charged her refinancing fees, says yes, so Mary gets one of those subprime mortgages.
Second, the government helped out by pushing interest rates down so mortgage rates fell to 5%. Mary gets the
check for $200,000, which she used to pay off the existing $160,000 mortgage and $5,000 closing fees and then
pockets the remaining $35,000 AND her monthly payment is only $1,074. Mary goes out and spends her new
money - new clothes, furniture and appliances, a car, and the vacation to the British Virgin Islands she had
always wanted and this generated new jobs and higher incomes that showed up in a rapidly growing economy.
These were the best of times as Mary had turned her home into a credit card, and as long as housing prices rose,
Mary could simply get the banks to increase her limits and live off the increase.
Needless to say, when word got out about what was happening, many others jumped in and bought houses. This
drove sales and prices higher - and higher - and higher – and the impact of the changes can be seen in the
diagram below of indexes of home prices at the low, middle, and high-priced segments of the market in San
Francisco. In all three housing segments prices increased substantially from the late 1990s to 2006, with the
biggest increases in the low tier. This is what you would expect for two reasons. First, these are the houses being
purchased by the most at-risk borrowers, the ones who traditionally would not meet borrowing standards. Also,
as housing prices rose, increasing numbers of people would have trouble paying the price so they would move to
lower priced homes. In both cases this would increase demand for those homes – shift the demand curve to the
right - and this would drive up their prices faster. At the low-end, between 1999 and 2006, home prices more
than tripled (from 80 to 280), while at the high-end prices more than doubled (from 80 to 180), but less than
tripled.
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Just as it looked like real estate was a "sure thing," however, interest rates started rising so those monthly
payments increased, which made housing a less attractive investment. Demand for homes began to fall - the
demand curve shifted inward – and home prices began to fall. Now Mary's refinancing program no longer
worked, so she was forced to cut back on her expenses dramatically - no new car, and certainly no exotic
vacation. The US economy slipped into a recession as others followed Mary's belt tightening strategy. Car sales
dropped forcing the car company to the verge of bankruptcy, and eventually after Mary joined the ranks of the
unemployed she stopped making his mortgage payments and her home was added to the list of homes being
foreclosed. Just as prices had risen earlier, now they were falling rapidly – and falling most rapidly at the lowest
tier where the owners were the most vulnerable to the slowing economy.
Government Intervention (ECN201 only)
What happens when the market is 'forced' away from its natural equilibrium because government officials decide
natural market prices are unacceptable? A few notable examples would be the government's control of prices
(minimum wage, agricultural supports, and rent control), its control of quantities (taxi medallions), and its
imposition of taxes.
Price Floors (minimum wage)
There are times when officials believe the market price is too low and the sets a price floor below which prices
cannot go. Two examples are the minimum wages and agricultural price supports, both of which originated in
the Great Depression of the 1930s when the biggest concern was falling prices and incomes. Price floors for
agricultural products originated in the Agricultural Adjustment Act of 1933, while the first federal minimum
wage was established in 1938 at $.25 an hour. In 2014 there was a federal minimum wage and state minimum
wages for most states and some for larger cities, and this was a year of considerable debate about raising the rate.
President Obama urged an increase from $7.25 to $10.10, but it never made it through Congress and in a few
states and cities there were increases to at least $10.10 an hour. The map below of is of state minimum wages as
of 2014 and at that time there were five states, all in the Southeast, without minimum wages (Mississippi…),
four with minimum wages below the federal level, twenty-one states with minimums above the federal level, and
the rest set at the federal level. RI had an $8 an hour rate that is set to rise to $9 in 2015.
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Part of the push for a raise in the minimum wage is that it has not kept up with inflation. It was in the 19650s and
early 1960s that the ‘real’ value of minimum wages increased sharply, the period when union were growing
stronger, and they began to fall behind inflation in the early 1980s when Reagan was president and union
membership began a steep decline.
Now let’s look at this with S&D graphs. In the graph below you see the market price is P* that is deemed to be
too low, so a price floor is established at Po. At Po there is a surplus since supply (S*) is greater than demand
(D*). Normally competition would drive down the price to equate supply and demand, but if the government
does not allow the price to fall, then there is a surplus. If this were the labor market the surplus would show up in
the unemployment rate since (S*-D*) represents the number of people who would like to work that would not
find jobs, although there are widely varying opinions as to the extent of the level of unemployment. In 2014 the
Congressional budget Office released a report estimating the impact of a $10.10 minimum wage on employment
to be between zero and one million jobs.
In the case of agricultural supports, the government would end up buying the surplus, which increases
government spending and creates a problem of what to do with the surplus. Destroying it is not a defensible
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position so the surplus tends to show as foreign aid to poor countries and school lunches in this country. The
foreign aid dimension has been very expensive for the world's richest countries, and one that has been quite
controversial in international trade negotiations between the world's rich and poor countries. Poor countries want
price supports eliminated so they can sell agricultural products to the rich countries, but farmers in the rich
countries have resisted this move that would lower the price they receive. Another concern is the potential for
corruption with price supports as those who receive the supports have a strong incentive to ensure that politicians
in favor of the supports are elected.
Price Ceilings (rent control)
There are also times when the government wishes to keep prices below market rates. An example would be rent
control where the government specifies the maximum rent as Po, which is below the equilibrium price (P*).
Because Po is below the equilibrium rent, there will be a shortage (excess demand) equal to D*-S*. Normally the
shortage would drive up prices, but if the price cannot adjust, then the shortage would show up in long waiting
lists for apartments. Over time the two of the problems with price controls is that suppliers have less incentive to
build new units and to maintain existing units.
The graph above also provides insight into those very long gas lines of the early 1970s. In 1973 OPEC countries
agreed to stop selling oil to the US, which shows up as a decrease in supply. If you look at the graph above, think
about the curve So being the curve after OPEC had shut off the supply of oil. Once the shut off took place, at the
existing price Po we had a shortage since demand (D*) was more than supply (S*). Normally what would have
happened would be that the price would have risen to P*, but the government had imposed a price ceiling on gas
so with a price of Po the shortage did not disappear. In fact it was very visible as cars waited hours in line at gas
stations to get gas. In the mid 1970s, the reduced amount of gas was allocated not by a rising price but by long
gas lines.
Quantity Restrictions
There are also times when governments wish to control the supply, and
a perfect example is the taxicab market in NYC. Beginning in the
1930s during the Great Depression, the city of New York instituted a
policy where each cab needed a city issued medallion in an attempt to
improve the quality of cabs and reduce the supply of cabs that had
multiplied substantially during the tough times. The equilibrium price
would be about $4 and there would be about 14,000 cabs on the street,
until the government passed a law requiring a cab to have a medallion
and restricting the number of medallions to about 11,000. At that time
there are 11,000 cabs willing to drive for about $2.50 a fare and there
are 11,000 riders willing to pay a fare of about $5.50. The difference
between the two prices is a measure of economic rent – the profit that
the owner of a medallion can make for each ride. Because of this profit,
a market for medallions emerged where the value of the medallions would depend upon the gap between the
sellers and buyers’ prices. To see how this works, look at the graph above and think about what would happen if
the population of NYC increased. The demand would increase increasing the gap between the two prices and this
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would increase demand for the medallions. If potential drivers had fewer alternative sources of income, the
supply of drives would increase and this would also drive up price of the medallions by increasing the gap in the
diagram above.
Imposition of taxes (ECN201 only)
There are many instances when the government decides to alter market outcomes by imposing taxes, and here
we will look at the case of government taxes on seats at the university. In fact we will look at two separate taxes
– one imposed on the sellers of seats and one imposed on the buyers – and we will see that it really does not
matter since the outcome is the same. The only real difference is who pays the tax.
Tax on sellers
Let’s look at the market for gas with the traditional S&D curves. In this example the no-tax equilibrium price is
$4 a gallon and the equilibrium consumption (quantity) is 10,000, and what we want to see the incidence of the
tax – how much of the tax is passed on to consumers and how much is paid by sellers.
Now let’s assume the government imposes a tax of $1 on every seat. Without the tax about 14,000 seats would
be supplied at the price of $3.5 ($3,500) a seat, but now the schools will add on the $1 tax so the price with the
tax, which we show this by shifting the S curve up by $1. The initial red line represents what the seller will
receive and the S+tax line represents what the buyer will pay, with the difference is simply the tax of $1. As you
would expect, the equilibrium changes – with the equilibrium seats reduced to about 12,000, while the price paid
by consumers is $4.00, while the price received by the suppliers is $3.00. The effect of the $1 tax on the seller is
that the price paid by consumers has risen by $.50, the price received by the sellers has dropped by $.5, and the
revenue generated by the government is $12,000 (12,000*$1).
Tax on buyers
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Now let’s assume the government imposes the $1 tax on each student, which we show by shifting the D curve
down by $1 to D+tax in the right-side graph. The initial blue demand curve (D) represents the full cost of the gas
plus the tax, while the new line (D+tax) represents what the supplier will receive. The difference is simply the
tax of $1. As you would expect, the equilibrium changes – with equilibrium consumption reduced to 12,000,
while the price paid by consumers is $4.00, while the price received by the suppliers is $3.00. The effect of the
$1 tax on the seller is that the price paid by consumers has risen by $.50, the price received by the sellers has
dropped by $.5, and the revenue generated by the government is $12,000 (12,000*$1) – exactly what we saw if
we taxed the supplier.
So, it does not really matter who pays the tax – the seller or buyer. The incidence of the tax is the same, so when
you impose a tax you will reduce consumption, lower the price received by the seller, and increase the price paid
by the consumer. In the elasticity unit we will look to see what determines the split between consumers and
sellers.
Peak-Load Pricing
Demand for many things has a predictable pattern to it. For example, demand for roadways and subways changes
dramatically during the day, with very high demand during peak commuting hours and very low at night.
Demand for electricity also has a definite daily pattern with demand higher during the working hours and lower
at night. Demand for seats on flights to Europe, hotel rooms in Disney World, and gas for automobiles, or
jewelry for gifts, also all have a well-defined seasonal pattern. In some of these markets, we see prices vary with
demand - those hotel rooms, flights and gas are generally higher during the peak months - which we can see in
the left-side diagram below. During peak period when demand is D(peak) the price charged is Pp, substantially
higher than the price charged in off peak periods (Po). In other situation we see no variations in price - the costs
of commuting or electricity - that we can see in the right-side diagram below. The price at all times remains at Po
so during peak period when demand is D(peak) the consumption (quantity) is Qp, substantially higher than the
price charged in off peak periods (Po).
Peak Load Variations in Price
Peak Load Variations in Quantity
So far no big surprises, but technology now provides more knowledge of demand and enables sellers to change
prices as demand changes. Consider the problems of pricing electricity or parking spaces. Demand varies
substantially during the day, but the price does not. You could have meter maids patrolling the streets and
changing the price of parking on signs and meters, but this makes no financial sense so meters have a single
price for certain hours of the day. With electricity you simply pay for electricity used during the month. As a
result, to satisfy demand during peak times the supply must be Qp, and during the off peak periods there will
simply be unused capacity.
But technology now exists to change this situation, and we can expect to see more of what we call peak-load
pricing - charging more during peak hours. If you charged differential prices - Po in off-peak periods and Pp in
peak-periods, needed capacity would be reduced from Qp to Qo. In Chicago the wholesale price of electricity
changes daily and these prices are passed on to consumers who never know about it and just pay their bill at the
end of the month. Some residents, however, belong to a program that notifies them a day in advance of high
prices so they can reduce energy consumption during those periods.ix A similar situation is emerging with
parking spaces where meters can now be programmed to charge different prices at different times of the day and
week.8 And for sports fans, you can see the same thing in the pricing of seats. Prior to 2001 all seats at Mets
games were sold for the same price regardless of the day, which resulted in shortages on games with good teams
18
and surpluses (empty seats) on days with bad teams. The team “corrected” this with variable prices that allowed
for higher prices for games on more popular days and with better teams.x
We have now examined how markets work and it is time to move on. The moral of this story is that markets and
prices are extremely powerful and it is not easy to intervene in markets to establish nonequilibrium prices.
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20
21
Supply & Demand
i
In 2008 it might be hard to believe that one of the concerns among US policy makers in the late 1990s was falling oil prices
[T]he backfire of low oil prices could undermine US policy assumptions and imperil US interests"... The
political reverberations of a sustained oil glut should not be underestimated ... Without the salve of rising
oil revenues, many of these nations can expect to see heightened political instability, social unrest, or
even civil wars ... The high probability of oil prices in the $12-$20 range over most of the next two
decades will condemn to a perilous future the arc of instability along the southern rim of Eurasia...
Leonardo Maugeri's "Two cheers for expensive oil," Foreign Affairs M/A 2006
ii
When talking about prices it is important to make a distinction between what could be called full and money prices. Money
prices are the actual prices you pay when shopping, but they are often not reflective of the full price. As an example of the
difference between the two price concepts, let's examine the cost of a burger for lunch. Two options would be the University
dining facility where the price of a burger is $3.25, and an off-campus burger joint where the price is $2.25. The burgers are
essentially the same except that buying the burger off campus means an extra fifteen minutes (1/4 of an hour) for the walk
and the wait. If you think of this as lost time, then you would want to add this to the price of the burger. For someone capable
of earning $6.00 an hour in a part-time job, the extra price would be $1.50 (1/4*$6.00) and the full price of the off-campus
burger would be $3.75.
As we saw in this example, the differences between full price and money prices can be substantial and it is the full price to
which decision makers should respond. This helps explain why consumers would pay more per pound of chicken if the
chicken has been precooked since this will save the preparation time. It is also where to look for the explanation of the higher
prices at highway restaurants and gas stations and convenience stores.
iii
There are a number of examples past speculative bubbles and online sources of information on them. Pidcock's article,
"The A-Z of Crashes," is available on-line at Applied Derivative Trading journal (March, 1997). Another source is
Investment Manias and Speculative Bubbles by Jonathan Myers where you will find information on two of the most widely
known bubbles - Tulipmania, the name given to the boom-bust movement of tulip prices in Holland in the 1630s and the
South Sea Bubble of a century later in England where the stock price of the South Sea Company imploded. For another
perspective on bubbles, you should check out Eric Janszen's "The Next Bubble" in the February 2008 Harpers.
iv
Large price swings can also result from timing problems, and commercial real estate offers a good example. Put yourself in
the position of someone thinking of constructing a high-rise office building. You consider building because rents are high and
vacancy rates low, but you are not the only person with the same idea. You begin the long process of approvals and
construction, and eventually the building is completed. That's the good news. The bad news is that it comes on the market at
the same time as those built by other investors with the same idea, which pushes rents down and vacancy rates up. Builders
see this and stop building until the empty space eventually gets filled - pushing rents higher and vacancy rates lower - and
investors decide it is time to build again. You can see an example of this cycle in the chart below.
John Krainer, "Natural Vacancy Rates in Commercial Real Estate Markets," Economic Letter, October 5, 2001
Roth, “Repugnance as a constraint on markets,” JEP 2007
vi
Bill Keller, “How to legalize pot,” NYT May 19, 2013
vii
Roth, “Repugnance as a constraint on markets,” JEP 2007
viii
In the Iowa Electronic Markets there are a number of futures markets we will be interested in, one of which was a market
for the 2004 presidential election. In this futures market speculators vote on the outcome of elections where the price reflects
the confidence in a particular Democratic candidate, and below are the graphs tracking the "prices" of Howard Dean and John
Kerry. The changing fortunes of the two candidates is obvious in the graphs where you can see the devastating effect of the
Iowa Caucus and Dean's 'scream" in the sharp fall in Dean's price and rise in Kerry's price after January 20th.
v
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For those looking for a little 'relaxation" with supply and demand you might what to check out where you can bet on some
entertainment events or Tradesport where you can bet on everything from politics to sports to entertainment. At the time I am
writing this you could bet on the upcoming winners of Dancing with the Stars at Tradesport or the winner of American Idol
on the Hollywood Stock Exchange. You can also 'bet' on the winners a the box office on the upcoming weekend, but now its
time to turn our attention to the supply-demand model of price that allows us to better understand the movements in prices.
ix
David Clay Johnston, "Taking Control of Electric Bill, Hour by Hour," New York Times January 7, 2007
x
Robert Frank, “Pricing the ballgame,” NYT 12/2/2002
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