Among the most useful approaches of economic analysis is the market supply and demand model. The market model is also the topic of economics most familiar to the lay person who has not studied economics. Individuals often attribute price changes, shortages and other economic phenomenon to supply and demand, without much more of an understanding that if more people want a good than is available, the price is apt to rise, and if the opposite is true the price will fall. And in fact, as you shall see, that is one conclusion of the supply and demand model of markets. But there is more to the analysis than just price changes. In this chapter we will review the concepts and conclusions of the market model of supply and demand, and take our first move into understanding policy from an economic viewpoint.
Our economic system is organized around the ideas of markets. We have goods markets, like those for food, automobiles and diamonds. There are also markets for inputs into the production process, for labor and capital, as well as money markets where one set of agents supply money (loan it out at a price) and another set demand the money, paying interest and dividends in return for using it as investment capital. All markets share some characteristics. They all have some sort of supply side and demand side. All markets use prices to carry information. And, perhaps most important, behind every supply and demand curve, somewhere back in the analysis, lies an individual trying to make him- or herself better off. There is trade in markets because both sides perceive it to be to their advantage.
Markets and the Role of Prices
Markets are just a collection of individuals who perceive a common good to negotiate about trades. In the ancient past most markets were barter, with different individual's bringing diverse goods together, and trying through several trades to arrive at a mutually beneficial exchange. Unfortunately, since most goods were not particularly malleable, barter exchange was a cumbersome process. But the invention of money made things all that much easier. Now there was a common unit in which to express the value that individuals placed on each good, trade was facilitated, and markets began to thrive as a means for trading goods and services. And with money came the formal idea of prices, much like we think of them today. With barter, each good had to have its value expressed in terms of all other goods for which it could potentially be traded. One pig was worth two goats but only half a cow. Money and prices made this much easier. Now each good was expressed in the units of the currency, and comparing the value of two goods just meant comparing their prices.
So one role of prices is the conveyor of information. The level of the price asked by the seller represents the value its holder places on the good. Usually there is some strong connection between such a price and the cost of providing the good. But not always. If an individual has a strong attachment, the price at which the individual is willing to sell may far exceed the money opportunity cost of the good. Thing like art, pets and homes come to mind. At this point utility rather than cost can affect supply as well as demand. On the demand side, the price is an indicator of how much utility the purchaser expects to get from the good. An individual processes information about what additional happiness the good will provide her, and is willing to pay at most that price, which is called the reservation price of demand.
While the level of prices tells us some important information, such as the relative value people place on the consumption of different goods, economists are most interested in what prices are doing. How they move, and how much they move tells a lot about the market, especially how the market is working, what constraints exist, and if any person or institution is interfering with the smooth market mechanism in any way. Understanding these things is what makes policy analysis interesting. But first, a look at each side.
Market Demand
The market demand for a good is not a specific quantity. Instead it indicates a relationship between the price of a good and how much of a good would be bought. As a relationship, market demand enables us to see the specific quantity demanded at various prices. The demand, which will normally be denoted D, is the entire relationship between price and quantity. This relationship shows what happens to the quantity demanded as price changes. The quantity demanded on the other hand, usually denoted Qd, is the specific amount that would be bought at a specific price, and is a contingent amount depending on price. In both cases everything else (e.g., income) is considered fixed. The relationship between price and quantity is the demand or demand schedule, and for a given price that schedule determines a specific quantity demanded.
An alternative and useful way to express demand (the relationship, not the quantity) is graphically (figure 2.1). Although in theory the causal relationship of the demand schedule goes from price to quantity (that is, the demand schedule shows how much would be the quantity demanded at each price) graphically the convention is to put quantity on the horizontal axis and price on the vertical axis. Mathematicians would view the causality as quantity determining price. Economists have been drawing demand curves this way since the nineteenth century English economist Alfred Marshall. Backward graphing has been a source of confusion for students ever since. A point on the demand curve indicates a specific quantity demanded. A change in the quantity demanded is shown as a movement along the curve (say from point a to point b) due to a change in price.
We have shown a negative relationship between price and quantity demanded. That is, the demand curve slopes downward. This is known as the Law of Demand. While not actually a law, the Law of Demand is a theory based on much observed evidence. Quite simply, it means that as the price of a good falls, the quantity demanded of that good increases, all else not changing. There are two causes for this in the market demand. First, as the price of a good falls, more people will find that the price is below their reservation price for the good, thus these people will enter the market and purchase. The price of the good is now below the value they would place on the good. Additionally, people who have already would have purchased the good may buy more of it. While the additional units probably would yield less additional utility to the individuals than the earlier units, since they cost less too, the additional utility exceeds the price. What this means is that, in most cases, the reservation price for later units of a good is lower than for earlier units of a good. As the price of a good falls, individuals see it in their interests to buy more.
Many factors influence the market demand curve's shape and location. Four of the most important are
1. Tastes and Preferences
2. Income Level and Distribution
3. Population Demographics
4. Prices of Substitutes and Complements
Tastes and preferences rely on how the good factors into making individuals happy. Essentially, we are talking about what characteristics of the product people like.
For example, there is strong demand for oranges because people like oranges. As tastes change, demand adjusts. In 1989 scientists and physicians claimed that oat bran lowered the cholesterol level in blood. Suddenly, all sorts of companies began adding oat bran to their recipes. People believed that consuming oat bran improved their utility, and the demand increased. Moreover, an individual often was willing to pay a price premium to get a product that contained oat bran over a similar one without it. In fact, that oat bran became more important in people's conception of what constituted a healthy diet shifted the demand curve for oats out, and likely made the curve steeper. This is a clear example of how tastes and preferences affect the location and shape of the demand curve.
Income levels and distribution are also important. Pullman, Washington, the location of Washington State University, has a population of about 25,000 people, of which 16,000 or so are students and student related individuals. Since students generally have low incomes, the average income in the town is not particularly high. But there is really a bimodal distribution, with the students having a low average income, and the faculty and staff personnel having a relatively high (middle-class) average income. Based on the overall average, any restaurant with a moderate or expensive menu might be thought out of place. But since they often catered to the non-student population, several good restaurants could be supported. So while the average income is important, how it is distributed also matters.
Related to income are other demographic characteristics of the population being served. Pullman has an abnormally high number of pizza restaurants for a town of its size. Obviously, the relatively young student population supported them. But there was little (really no) demand for Gefilte fish in Pullman, as there is almost no Jewish population. On the other hand, in Boro Park in Brooklyn, there are relatively few pizza places for the population size (and many of those are Kosher), and probably a reasonable demand for Gefilte fish, because here most of the population is Jewish.
Finally, the prices and availability of substitutes and complements have a large impact on the shape and location of demand curves. If there are few substitutes available for a good perceived to be necessary for happiness, or those available are very expensive, then we would expect that lots of people will demand the good. Moreover, the demand curve might be steep. With few substitutes, people will want to buy the good even if its per unit cost is high.
It is easy to understand the role of these other factors on demand in a graphical analysis. Figure 2.3 shows a hypothetical demand curve for oats before their perceived beneficial health effects were known. Not being a particularly savory or special grain, there was relatively low demand, illustrated here by the curve D, with the quantity demanded somewhat low even at low prices. As the price increased, people were willing to find other substitutes, so the quantity demanded dropped off rather severely as price per unit increased.
Then the purported health aspects of oat bran consumption became known. Suddenly, everyone wanted oats in their food stuff. At each price the quantity demanded increased to D'. So at a representative price, P1, the quantity demanded increased from Q1 to Q1'. Moreover, the curve became more steep. People viewed oats as becoming relatively more important in achieving happiness (through health) and thus reservation prices increased.
But the next year further research revealed that it wasn't the oats in oat bran that mattered. Other grains, including barley, kidney and other dried beans, and some fruits and vegetables, also had cholesterol lowering powers. While oats were still in favor, there were suddenly numerous substitutes for the purpose of a healthy diet. Demand shifted back to D''.
An Application of Demand
Sometimes, just knowing that in general demand curves have a negative slope, so that as prices increase the quantity that people will use decreases, can be very useful. In 1985 an editorial in the Wall Street Journal lambasted New York City for its policy on providing water based solely on demand analysis. The editorial dealt with the water shortage facing the city, and shows that there is an economics lesson to be learned from the water crisis in New York.
The problem facing New York City, according to the Journal, is that administrators ignore the fact that the quantity demanded is responsive to price:
If New York were the kind of city that believed in markets, even its neglect of a vital resource need not have generated the political hysteria that currently grips the town. But, operating on the assumption that water is above the law of supply and demand, it hasn't bothered much with water meters. Roughly 75% of the city's water flow goes to its 630,000 unmetered residential accounts. The millions of apartment and home-dwellers tied in to these accounts pay flat fees no matter how much water they use. Only the city's 110,000 commercial accounts, plus some 30,000 residential accounts, are metered.
This illustrates that the metered price really measures the value of the marginal or last unit. Once linked to the system, a consumer of water in New York (one without metering) sees the cost of another gallon as zero. In figure 2.4,such an individual consumes at point a, where price is zero and the demand curve crosses the horizontal axis. In fact, water is consumed until the point where the value of the last gallon consumed is zero. The last gallon adds nothing to the consumer's happiness. If instead water was metered at a price of P per gallon, the quantity consumed would drop to point b.
The Journal goes on to bemoan the plethora of laws and regulations that were imposed by the city to conserve water;
So in the absence of a useful pricing mechanism, City Hall in recent weeks has poured forth a flood of regulations, forbidding residents to sprinkle lawns, wash cars or fill private pools, and requiring water-saving devices in all shower heads. Instead of raising water rates for those accounts that are metered, the city has ruled that all businesses must reduce water consumption 25% below the amount they used last year. ... Violations of any of these rules carry fines of $200 to $500.
Moreover, there are costs to enforcement that must be considered. But most interesting is the failure of the attempt at non-price rationing. While per-capital water consumption in New York City was reduced from 207 gallons to 188 gallons a day, this level of consumption was still well in excess of the amount used in Detroit, a metered city where per capita consumption was 172 gallons per day. The Journal did note that the city had recently called for meters in all new and renovated buildings, but questioned even then whether the city would learn how to use prices to ration water use.
Market Supply
Just as market demand is derived from people trying to make themselves happy by purchasing goods, there is optimizing behavior behind market supply. In a less direct fashion market supply is also utility based. Supply consists of individuals, or institutions and firms backed by individuals, who sell goods to make a profit. The profits that are made, explored in chapter 9, are used to increase the utility of the recipients. Market supply is made up of the supply from the smaller entities, and again can be divided up into identifiable subsets.
The market supply indicates how much suppliers as a group are willing to sell at various prices. When we refer to supply we are talking about this relationship. The quantity supplied, generally denoted Qs refers to how much suppliers are willing to sell at a particular price. The difference is explained in Table 2.2, which shows a hypothetical relationship between the price per pizza and how many pizzas would be available for purchase at that price. The entire schedule of paired prices and quantities given in Table 2.2 is the supply or market supply. The quantity supplied, however, is contingent on price, and varies from 1000 if the price is 6 to 2500 if the price is 12.
Table 2.2: Hypothetical Market Supply Schedule
Price per Pizza |
Quantity Supplied |
12 |
2500 |
10 |
2000 |
8 |
1600 |
6 |
1000 |
Usually we will work with graphical or algebraic representations of supply. Figure
2.5 graphs the supply schedule given in Table 2.2. To conform with the demand curve,
again price goes on the vertical axis. A point on the supply curve indicates a specific
quantity supplied (contingent on the price indicated by the line), while the entire line
is the supply curve. A change in the quantity supplied is shown as a movement along the
curve (say from point c to d), while a shift or change in supply is shown by a movement of
the curve. In figure 2.6, supply is shown to increase, so at each price, the quantity
supplied that is contingent on that price has increased. For example, at a price of P1,
on supply schedule S1, the quantity supplied is Q1. If supply
shifted (increased) to S2, at P1 the quantity supplied is Q2.
As in demand, there are many things that are behind the shape and location of the supply curve. The two most important, which control to a large extent the costs associated with providing the good, are the state of technology and the price of inputs used to produce the good. Technology and the price of inputs are not unrelated. Typing services provides a good example of how these two elements affect the supply curve. The technological innovation of computer word processing greatly increased the speed at which a corrected final document can be finished. But when personal computers were very expensive, the fact that the technology was available really did not affect the supply of typing services appreciably. Only when personal computers became relatively affordable, thus the price of one input dropped, did the supply of typing (word processing) services increase.
Related to these two factors are the number of firms in the market, and the size of each firm. The size of the firms is important because it can affect the cost structure of providing the good or service. Generally, the greater the number of firms, the larger we would expect to find quantity supplied at each price. Quantity supplied increases with the number of firms because each firm would look only at its own ability to cover costs at that price, not the industry's, and total supply would be the sum of individual supplies.
Technology and the costs of inputs are primary factors behind the shape of the supply curve. If provision of the good depends on an input which is relatively expensive, and for which there are no substitutes, then supply will likely be steep. As technology provides more substitute inputs, supply may flatten out. The growth of the computer clone market, for example, has likely flattened the supply curve for typing services. Yet because it is expensive to train good neurosurgeons, and you really cannot replace them for brain surgery, the supply of brain surgery is rather steep.
Prices of inputs move, in general, in the opposite direction of the supply of a good or service. If the cost of pizza sauce goes up, we expect that the supply of pizza will decrease. At any given price for pizzas, the firms that supply pizzas will not make as much money, and some will either cut back or go out of business. But if the price of sauce goes down, the pizza sellers can afford to sell more at the same price. And the more firms in the market, the greater is the expected supply at each price.
Equilibrium in the Market
By using the market supply curve and the market demand curve on a single graph it is possible to determine the quantity at which market equilibrium occurs. Notice that the emphasis is on market, and not quantity, and at this point price has not even been mentioned. Market equilibrium is a situation when there exist no pressures for change within that market. In the market model we have been discussing there are three variables; price, quantity supplied and quantity demanded. The shape and position of the supply and demand curves gives a picture of the market. If the variables underlying these two curves change, then the picture of the market also changes.
Market equilibrium, then, describes a situation where there are no pressures for price or either quantity demanded or quantity supplied to change. Most economic analysis focuses on the price being charged, and we can use that focus for a clearer view of equilibrium. If there are no pressures for price to change within a market, then that market is in equilibrium. Again, notice that I have not used the quantity supplied or the quantity demanded in this definition. For now at least, we have been viewing participants in the market as price takers, that is, behaving as if their individual actions will not affect the market price. Thus, the variables of interest are quantity demanded and quantity supplied, and together they determine if the market is in equilibrium.
A market is in equilibrium if the quantity supplied is equal to the quantity demanded. In the situation we are dealing with now, that will result in a single market price at the intersection of the demand and supply curves. Figure 2.8 shows a market in equilibrium. As before, Qs is the supply curve and Qd is the demand curve. At a market price of P*, the quantity demanded equals Q*, as does the quantity supplied.
We can get a better grasp of the concept of equilibrium by looking at a situation where the market is not in equilibrium (see figure 2.9). Suppose the market price is P1. Then the quantity supplied, reading off the supply curve, is Qs1, which is well in excess of the quantity demanded at that price, Qd1. The amount that sellers want to sell at P1 far exceeds the amount that buyers want to buy at that price. After sitting on their stocks for awhile, sellers need to do something to sell their goods. A natural response, sellers not being ignorant about the law of demand, is to lower the price. Consumers want to buy more. But at the lower price sellers do not want to sell as much. The downward pressure on price continues until the quantity demanded equals the quantity supplied.
Similarly, if price is at P2, the quantity demanded exceeds the quantity supplied. Sellers find that they run out of goods long before the potential sales are exhausted. In response, as a rationing device, sellers will find that they can sell at a price higher than before. As the price increases, the individual sellers will want to provide more of the good. The quantity supplied increases. Meanwhile, as the price being charged increases, the quantity demanded decreases. Equilibrium is reached when the price is such that quantity supplied equals quantity demanded.
When the quantity supplied exceeds the quantity demanded the situation is called an excess supply or surplus, and there is downward pressure on price. In general, the market equilibrium will occur at a quantity of the good lower than the initial quantity supplied, but higher than the initial quantity demanded. If the quantity demanded exceeds the quantity supplied, that is an excess demand, and the expectation is that market price will increase.
Changes in Supply and Demand
Market equilibrium, when the quantity demanded equals the quantity supplied, is only a temporary concept, kind of a moving target that causes adjustments. The reason is simply that the things that underlie the supply curve (prices of inputs, technology, and such) and the things that underlie the demand curve (tastes, prices of other goods, income) change, thus causing shifts in the shape and positions of the curves. Most of these things are in constant flux. So while graphically it is easy to understand the idea of market equilibrium, in reality market equilibrium should be thought of as a target towards which disequilibria pressures in the market push price, quantity supplied, and quantity demanded. Markets are often out of equilibrium because the target has moved.
Comparative statics is the analysis of what happens to the equilibrium quantities and prices as things shift the supply or demand curves. By shifting the supply curve or the demand curve we can see what happens to this target equilibrium that the market moves toward.
Suppose, for example, one of the underlying factors for the demand curve changes, causing it to shift outward. Remember that an increase in demand is a horizontal movement (as in figure 2.10), so at every price a greater quantity is demanded. The old equilibrium price was P1, but after the shift, a new equilibrium occurs if price is P2, and quantity demanded (supplied) increases from Q1 to Q2.
What can cause the demand curve to shift? As we saw earlier, for consumer goods tastes, demographic considerations, and the prices of other goods all affect the location of the demand curve. Economic growth, which raises incomes, changes in the age distribution and fads are just some things that shift demand. Sometimes, news helps shift demand. In 1989 it was reported that oat bran helped lower blood cholesterol levels. Suddenly, everyone wanted to consume oats, and the demand increased. There was an excess demand, prices rose, and the equilibrium quantity increased as well. In 1990, after the oat fad had quieted down, and new research showed oat bran was no more valuable than many other forms of bran, the demand shifted to the left, lowering the price and quantity associated with equilibrium.
Supply curves can, of course, also shift. During the summers of 1988 and 1989 severe drought hit the grain producing areas of the Midwest and north central states. The supply curves for grain shifted inward, as shown in figure 2.11, from S1 to S2. Equilibrium price increased to P2, while equilibrium quantity fell to Q2. Again, notice that the shift in supply is horizontal.
Comparative statics can deal with shifts in both the demand and supply curve simultaneously as well. Depending on the type of shifts, what happens to equilibrium price and equilibrium quantity can be clear or ambiguous. Play with different shifts, and try to figure out what shifts cause price changes, what shifts cause quantity changes, and what shifts give ambiguous outcomes.
Some changes are ambiguous because they depend on the relative magnitudes of the shifts. For example, look at figure 2.12. Initially, the supply and demand curves are S and D respectively, giving equilibrium price of P and quantity of Q. If demand increases to D*, and supply decreases to S*, the new equilibrium price would be P*, with an equilibrium quantity of Q*. But if instead, supply shifted to S', with demand still shifting to D*, the new equilibrium would quantities would be P' and Q'. In both cases price goes up, but the change in equilibrium quantity is in determinant. If for example, you combine the drought, which lowered the supply of oats, with the news about oat bran health benefits, which increased its demand, you have the situation pictured in figure 2.12.