Economists Are a Joke?

A smarty-pants old story says that if you want a "learned economist," all you have to do is get a parrot and train the bird to squawk "supply and demand" in response to every question.

Not fair, but ...

It's true that the "theory of supply and demand" is a central part of economics. It is widely applicable, and also is a model of the way economists try to think most problems through, even when the theory of supply and demand is not applicable.

A Theory of Price

The theory of supply and demand is a theory of price and output in "highly competitive" markets.

Adam Smith had argued that each good or service has a "natural price." If the price (of beer, for example), were above the natural price, then more resources would be attracted into the trade (brewing, in the example), and the price would return to its "natural" level. Conversely if the price began below its "natural" level.

Evolution of A Theory of Price

To make a long story short, before about the 1850's most economists accepted the Labor Theory of Value as the theory of the "natural price." But there were some cases it did not apply to: international trade, for example. John Stuart Mill suggested a "supply and demand" solution for prices in international trade. Other economists extended it to apply to prices in general.

Unlike the "natural price," a long-run theory only, the theory of supply and demand applies in the short run as well as the long.

Two Sides

Like a good controversy, every market has two sides. In this case, the two sides are (obviously?) buyers and sellers.

The buyers are the "demand side" of the market.

Sellers are the "supply side" of the market.

Alfred Marshall compared the supply and demand sides to the two blades of scissors -- one won't cut. You have to have both.

Two Sides, Continued

To keep it simple, we may think of the buyers as consumers. (Later we will look at markets for inputs to production, in which the buyers are producers of other goods and services). Clearly, the buyers are the people who want or need the product or service -- but there is more to it than that. Demand is want or need backed by, and expressed in terms of, purchasing power. To put it a little differently still, demand is willingness to pay.

Similarly, it is not enough that the suppliers possess the good or (the capacity to perform) the service. Supply also means willingness to sell.

Analysis of Markets

Our approach to market theory will be first analytic and then synthetic. To "analyze" something is to take it apart into its components. Common sense tells us that competitive markets work through an interaction of "supply and demand." Accordingly, we will first "analyze" competitive markets, by discussing demand and supply separately. Then we will try to put them back together (synthesize them) in order to understand the working of competitive markets.

Thus, in these lectures, we will look at

  • demand
  • supply
  • equilibrium of demand and supply

The Demand Relation

Economics assumes that there is a systematic relationship between the price in the marketplace and the quantity that people are willing and able to buy. This relationship is called "the demand relationship" or, simply "demand."

The convention in economics is to use the word "demand" to mean the demand relationship and "quantity demanded" for the specific quantity that people are willing to purchase, when there could be confusion.

Example of The Demand Relation

Several years ago, I estimated the demand relationship for beer. Here is an example based on that estimate. The prices quoted are wholesale prices, in cents of 1972 purchasing power. Quantity demanded is measured in millions of gallons, for the United States as a whole.

Demand Schedule
Beer, 1960

price,
cents/gal. 		Quantity
demanded,
millions
of gals.


50 4899.27
60 4355.67
70 3812.07
80 3268.47
90 2724.87
100 2181.27
110 1637.67
120 1094.07

Demand Diagram for Beer

Here is a "demand curve" of the demand for beer in 1960, based on the estimated numbers from the previous page.

Figure 1

The Demand Relationship, Again

Remember: when we speak of "demand" we usually mean the entire demand relationship, that is, the entire demand curve or table. By contrast, the "quantity demanded" is the particular point on the demand curve, as in Figure 2 below, or the quantity in a particular line of the table.

Figure 2

The "Law of Demand"

Notice that, in this example, the demand curve is downward sloping. That's a common-sense point: the higher the price, the less people will want to buy. In this case, common-sense has it 100% right.

Economists call this the Law of Demand:

At a higher price, the quantity demanded will be less, ceteris paribus.

(Ceteris paribus means: if nothing else changes to offset the change in price).

The Demand Relationship: 3 More Points

1. The price must always be adjusted for inflation. We use the "real" (adjusted) price, not the nominal price.

2. The demand relationship can be represented, and approximated, by

  • numerical
  • graphical, or
  • mathematical and statistical methods

3. Mathematically, the demand schedule and diagram we have just seen can also be expressed as

Q = 7617.27 - 54.36*P

The Demand Relationship: Another Example

Here, in Figure 3, is another example, two estimates of the demand for cigarettes. Quantity is in pounds of cigarettes, and price in inflation-adjusted dollars per pound. The estimate is for 1974-1988.

The actual prices and quantities demanded for the different years are also shown, so you can see about how good an approximation it is.

Figure 3

(Thanks to Lester Craig, a Drexel Student, for the use of his term project).

Supply of Beer

Economists treat supply symmetrically as demand. That is, we treat supply (also) as a relationship between price and the quantity supplied. Usually, the relation is direct (upward sloping), rather than inverse.

Here is the supply schedule corresponding to the beer demand given before.

Supply of Beer, 1960

price,
cents/gal. 		Quantity
supplied,
millions
of gals.


50 0
60 0
70 0
80 1304.4
90 2894
100 4483.6
110 6073
120 7662.8

Supply of Beer

Economists treat supply symmetrically as demand. That is, we treat supply (also) as a relationship between price and the quantity supplied. Usually, the relation is direct (upward sloping), rather than inverse.

Here is the supply schedule corresponding to the beer demand given before.

Supply of Beer, 1960

price,
cents/gal. 		Quantity
supplied,
millions
of gals.


50 0
60 0
70 0
80 1304.4
90 2894
100 4483.6
110 6073
120 7662.8

Supply of Beer

Here is a diagram of the estimated supply for beer. As before, we put the price on the vertical axis, and the quantity supplied on the horizontal axis.

Figure 4

The Long and Short Run


Here's a complication: The supply relationship will depend on how long the suppliers have to adjust to a change in the price.

  • In the short run the plant and equipment (productive capacity) of the industry are fixed
  • In the long run sellers can change the productive capacity, in response to the price

In the short run, output can be increased only by using the fixed plant and equipment more intensively. Thus, we would expect the adjustment of supply to a change in price to be more complete in the long run than in the short run.

The long-run, short-run distinction is less important for demand, and we will not go into that in this introductory course.

Equilibrium of Supply and Demand

In economic theory, the interaction of supply and demand is understood as equilibrium.

Market "equilibrium" exists when the price is high enough so that the quantity supplied just equals the quantity demanded. In a diagram, the "equilibrium" price is the price at which the demand and supply curves cross. The corresponding quantity is the quantity that would be traded in a market equilibrium.

Let's see what that looks like in the market for beer.

Equilibrium of Estimated Supply and Demand for Beer

Figure 5 approximates the equilibrium of supply and demand for beer in 1960, on the basis of the estimates given before.

Figure 5

Excess Demand

Why do we call this an "equilibrium?" Let's see what happens when price is not high enough to bring supply into equality with demand:

Figure 6

What we see here is that the quantity demanded exceeds the quantity supplied -- we have excess demand. Thus, demanders will compete against one another, offering higher prices for the limited supply, and the price will rise.

Excess Supply

What if the price is too high?

Figure 7

Here we have excess supply -- the quantity supplied exceeds the quantity demanded. Thus, suppliers will compete to sell what they can by cutting the price.

Competition and Equilibrium

What we have seen is that the price will be in constant motion, up or down, except when quantity demanded is equal to quantity supplied. That is the position of rest.

Put another way, it is the price toward which competition pushes the price. At equilibrium, there is no competition either to buy or to sell, because everyone can buy or sell however much they may wish, at the going price. But whenever the market is away from equilibrium, competition will arise and tend to force it back.

Competition eliminates itself, by forcing the market into an equilibrium in which there is no need to compete. (This is a very different concept of competition than the biological "struggle for survival!)

Forces Opposing Competition

We have seen that competition forces the market into equilibrium. However, this might fail if:

  • There is only one seller or buyer, hence no competition
  • Sellers or buyers agree ("conspire") not to compete in this way
  • It is illegal to compete by offering a higher or lower price
  • People are unable to compete by price offer -- for example, they do not know who else buys or sells the item, or are unsure of the quality of the good or dervice offered by other traders.

Changing Demand and Supply

In order to use these concepts for practical purposes, we need to think about the ways in which demand and supply can change, and what happens when they do change.

Remember that economists think of "a change in demand" as a shift of an entire demand curve. Likewise supply.

By the way, always think of a shift in supply as "leftward" or "rightward," not "up" or "down." Thinking in terms of "up" and "down" will cause confusion!

Increase in Demand

Here is a figure to illustrate an increase in demand. The demand curve shifts from D1 to D2. With the new demand curve, there is a greater quantity demanded at every price. That is what we mean by an increase in demand.

Figure 6a

Decrease in Demand

Here is a figure to illustrate a decrease in demand. The demand curve shifts from D1 to D2. With the new demand curve, there is a smaller quantity demanded at every price. That is what we mean by a decrease in demand.

Figure 6b

Shifting Demand

Here are some things that would cause the demand curve to shift:

1. A change in income for the average consumer.
  • If an increase in income causes an increase in the demand for a particular good, that good is called a "normal" good. Example: steak.
  • If an increase in income causes a decrease in the demand for a particular good, that good is called an "inferior" good. Example: red beans.

2. A change in the population.

3. Changes in the prices of other goods.

  • Complements.
  • Substitutes.

4. Changes in consumer tastes.

Increase in Supply

Here is a figure to illustrate an increase in supply. The supply curve shifts to the right, from S1 to S2, so that the new supply curve shows a greater quantity supplied at every price. That is what we mean by an increase in supply.

Figure 7a

Decrease in Supply

This figure illustrates a decrease in supply. The supply curve shifts to the left, from S1 to S2. The new supply curve shows a smaller quantity supplied at every price, and that is what we mean by a decrease in supply.

Figure 7b

Shifting Supply

Here are some things that would cause the supply curve to shift:

1. Changes in the prices of input goods.
  • Labor
  • Raw materials

2. A change in technology.

3. Changes in natural conditions.

  • Rainfall
  • Environmental Conditions

A Change in Demand

We will analyze an increase in the demand for food:

Figure 8: Changing Equilibrium with an Increase in Demand


Before the increase in income, demand was D1 and supply was S, so that the equilibrium quantity of food sold was Q1 and the price per unit of food sold was p1. However, the increase in income resulted in a shift of the demand curve rightward, as shown by D2, and a new equilibrium quantity at Q2 and a price of p2.

A Change in Supply

This example shows a decrease in the supply of food.

Figure 9: Changing Equilibrium with a Reduction in Supply


With normal weather, supply would be S1 and demand is D, so that the equilibrium quantity of food sold was Q1 and the price per unit of food sold was p1. However, bad weather shifts the supply curve leftward, as shown by S2, and a new equilibrium quantity at Q2 and a price of p2.

Excise Tax


Here's an application: There is an "excise tax" on beer. What happens to price and sales when such a tax is imposed?
(The term "excise tax" is a bit redundant, since "excise" is an old word for "tax." Conventionally, though, an excise tax means a tax per physical unit; for example, per gallon).

You really need to load this figure.

The figure shows the impact of an excise tax. From the point of view of sellers, the tax decreases demand from D to D'; the vertical distance between the two curves is the tax. The price paid to the seller falls, but not as much as the tax, because the cutback in production moves downward along the supply curve.

Subsidy
A subsidy is a payment from the government to a firm or individual in the private sector, usually on the condition that the person or firm that receives the subsidy produce or do something, or to increase the income of a poor person.
In this example, we will look at the subsidy from the point of view of the buyers. From their point of view, the subsidy is an increase in supply.

You really need to load this figure.

Figure 11. A Subsidy

The figure shows the subsidy shifting the supply curve to the right, from S1 to S2. The vertical distance is the amount of the subsidy: one dollar per bushel. Demand is D, as usual. With supply S1 -- before the subsidy is given -- the market equilibrium price is p1 and the equilibrium production is Q1. With supply S2 -- when the subsidy is given -- the market equilibrium price is p2 and the equilibrium production is Q2.