Over.S_D.html

Overview: Supply and Demand
"Buy low, sell high"
"Price is a social fact"
"Prices are relationships among people, expressed as relationships among things."

Many of you will admit you know little about Economics, but you do understand the logic behind the quotes. You know how everyone loves a 'deal' and you have probably watched others using this strategy in their attempt to make money buying real estate and stocks.

There is no question prices play a key role in our society.  As Maital says, "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." Price movements also can have significant impact on people's financial condition. If you own something that increases in value, your house or your computer skills, then you benefit by an increase in the price of homes or wages of computer-trained workers.  Similarly, if you own stock in American Widgets and the price of the stock falls, then you've lost money.  It therefore seems reasonable to spend some time attempting to understand prices, how prices are determined, and how we can forecast price changes.

Before we move to the analysis of prices and price changes, 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 cost. We saw a similar situation in the earlier unit when we discussed the distinction between accounting and economic cost. 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 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 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 decision makers should be responding to. 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.

In this section we will talk about prices.  We will spend time developing a model of how prices are determined in a market economy. You will be asked to invest some time in mastering this model, the supply-demand model, that economists have found quite useful when explaining price movements. 

Fortunately, the model is rather simple - no more difficult than preparing a good meal by following directions in a cookbook.  In fact, I would suggest that you adopt the Cookbook Approach when trying to explain prices.  The 6 steps in the approach are:

Cookbook Approach

  1. Identify the market (what is it)
  2. Identify the participants (who are they?)
  3. Identify the determinants of behavior (why do they do what they do?)
  4. Identify the appropriate curves (why do they look like this?
  5. Identify the type of problem
    • disequilibrium - wrong price
    • comparative static - price change
  6. Identify any special situation (what's different here?)

First, you must identify the market which is not always easy.  For example, we could be interested in the impact of raising the state tax on booze on the price and consumption of booze in RI.  As we will see later, the answer will depend very heavily upon whether you use the market for booze, or the market for RI booze in your analysis.  Another example would be the impact of the Asian financial crisis of 1998 on the market for automobiles in the US.  You will find out the answer depends upon whether you are looking at the market for cars imported from Asia, cars produced in the US, or the total car market.

Second, you must identify the participants in the market.  You must identify who are the buyers and who are the sellers and experience has shown this too is not always an easy question to answer.  If we are talking about the market for cars, then the sellers are the car companies and the buyers are people like you and me.  But what about the labor market?   Who are the buyers and sellers?  In the labor market the buyers are the firms / businesses who hire workers and the sellers are individuals like you and me looking for work.  When you go looking for a job you are supplying labor to the labor market.  When IBM runs an ad announcing a new position, it is demanding labor in the labor market. 

Third, you must identify the factors that influence the behavior of the buyers and sellers - the determinants of their behavior.  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. On your list of factors would probably be the price of the car and your income.  If we were talking about the market for Hondas, then you would also be influenced by the prices of other cars.  To help you out with specifying the factors that would influence demand,  you should check out the list of determinants of demand. When it comes to the supply you can check out our list of determinants of supply. 

Fourth, you must turn your analysis into a picture - a graph.  Once you have followed the first three steps, it is time to turn your analysis of the market into a picture - into the infamous supply and demand graphs.  Experience has shown this to be the most difficult part of the analysis, but it is rather straightforward.  For a real simple example you should look at the RIU example.

Having set the stage, it is then time to represent visually the two participants in the market - the buyers and the sellers.  The supply curve (S) is the visual representation of the behavior of suppliers while the demand curve (D) is the visual representation of the behavior of buyers.  To make the curves work for you, you will need to be able to translate different aspects of the behavior into features of the curves.  If you are talking about the demand for automobiles, make sure the demand graph describes your behavior, while if you are talking about the labor market, be sure the supply curve corresponds to your behavior. [For those who want a little more practice with the construction of supply and demand curves you should turn to the examples where the demand schedule is transformed into the demand curve and the supply schedule is transformed into the supply curve]

You will find out the slope (steepness) and the position of the curves each tell us something different about behavior, and for this reason we will look at the slopes and shifts in the two curves.  Before you are done with this unit you should realize the downward sloping demand curve would be a way to "present" graphically the belief that a decrease in price would bring out more customers for the cars.  A change in income, meanwhile, has an impact on buyers which will show up in this analysis as a shift in the demand curve.  Similarly, if you were attempting to demonstrate the fact demand was very responsive to price changes - that a small increase in price would generate a substantial decrease in demand - this would show up in a flatter slope of the demand curve.

Supply - Demand Graph

Now you are ready for the fifth step - the determination of what type of problem we are dealing with - an equilibrium problem where we are concerned with a market clearing price, a disequilibrium situation where we are dealing with non market clearing prices, or a movement of the equilibrium due to some shock to the market.  

It is obvious to even the untrained eye that in the Supply - Demand graph there is one point that seems different from all of the others.  At one price (P*) we find there is an intersection of the supply and demand curves, and as you would expect, this point has great significance.  This is called the equilibrium point and it represents the price at which the amount the buyers demand is precisely equal to what the sellers want to supply.  If and when we get to this price, there will be no tendency for price to change, which is why we call it an equilibrium price. 

If the price is not at P*, however, we would have a disequilibrium situation and there will be pressure for changes in the price.  When prices are above the equilibrium price we will find surpluses where the buyers demand less than the sellers supply.  If the price of a ticket to a Madonna concert at Meade stadium was $10,000, you can expect there might be a few empty seats. When prices are below the equilibrium price we will have shortages as buyers demand more than sellers supply.  You are likely to find a shortage of seats and students camping out for days for tickets if they were priced at $10.  In this unit we will look at two disequilibrium situations resulting from government intervention - the imposition of minimum wages and rent control. 

In addition to using the supply and demand analysis to answer equilibrium and disequilibrium questions, you will also use it to answer comparative static questions. This is where you use the analysis to answer questions such as:  What will happen to the price of orange juice if there is a freeze in Florida? What will happen to the price of oil if Iraq's oil production increases?  What will happen to the price of homes in northern RI when Fidelity's large new facility opens?  What will happen to the price of automobiles when the value of the dollar rises?  What will happen to summer rental rates in Newport if the America's Cup returns to Newport?  What will happen to interest rates if the Fed increases the supply of money?  What will happen to the use of marijuana if it is legalized?

The common denominator in these questions is they all involve the impact of some event on the equilibrium in a market.  What you will need to do here is master how an event translates into shifts in the supply and / or demand curves.  For example, if the America's Cup returns to Newport you can expect there will be a large increase in the number of people looking for apartments in Newport.  This we would describe as an increase in demand and we would show it as an outward shift in the demand curve.  Once you have done this you will see the equilibrium point has shifted.  In this case, it will have shifted to the right and up.  The move to the right means quantity (the number of apartments) will increase.  The movement upward means the price will rise (apartments will be more expensive).  In this situation you can safely predict rents will rise for Newport apartments.

In some instances, however, predictions may be a bit more difficult.  This would be true when there is reason to believe both curves will shift, which is likely to be the situation when we look at the legalization of marijuana.  Based on the comments of students in the past, the legalization can be expected to increase both supply and demand.  The supply will increase since it will be cheaper to produce and sell marijuana because you will no longer need to pay for risk associated with the transportation and sale of the material. This will shift the supply curve out and put downward pressure on price and upward pressure on consumption (quantity).  But this is not the end of the story. The consensus seems to be that demand will increase once the legal deterrent is eliminated.  This would translate into an outward shift in the demand curve which will put upward pressure on price and consumption.  When we add the two effects we find there will definitely be an increase in consumption since each individual effect suggested this outcome.  We cannot, however, predict price with any certainty since there are two different tendencies - the supply effect tending to push price down while the demand effect tends to push price up.  The bottom line is we cannot predict the price effect without some additional information on the magnitude of the effects.  

And now we have arrived at the final step in the analysis.   Are there any special situations of which we should take account?  How would you reflect in your analysis the fact that demand for booze was not much affected by price changes?  How would you show a situation where supply was such that a price was set and supply would satisfy whatever demand was at that price? As you will see, in each of these cases we are talking about something that will show up in the slope of the curves. 

Once you have mastered the basics of the analysis you will be ready to move on.  In microeconomics we will look more closely at the behavior of the buyers and sellers in individual markets and discuss the concept of elasticity.  In macroeconomics we will use this analysis as our introduction into an analysis of inflation and unemployment which involves discussions of behavior in the aggregate labor, output, and capital markets.

In this unit there are also some examples of the supply and demand model in action. For those who want some extra help with a simple example, you should look at the URI Example .  There are also two additional examples of where supply - demand analysis can be very helpful. The first is in understanding Exchange Rates and the second is Stock Prices in  Investing for the 21st Century.

To get you ready for the type of work you will be doing in this section, you should begin by reading a brief article on world food production published by the foreign agricultural service.   In this unit of the course you will be repeatedly asked to look at real world headlines or stories and translate them into simple supply-demand graphs, and this production report offers an opportunity to see how this works. The second article on wheat production in Canada points out that "favorable summer weather aided crop development"  so total output was up from last year.  This is a story about supply and the story is one of an increase in supply.  We would demonstrate this with the outward shift in the supply curve in the diagram below which provides us with the basis for our forecast of the market - prices will fall and output will rise. 

The outward shift in the supply curve would also be the appropriate graph to demonstrate the situation in Argentina where additional lands are brought under cultivation which increased supply of wheat.  It also helps us visualize the situation in Mexico where favorable weather increased corn output.  The situation in Europe, however, was quite different with wheat production fell sharply.  This would be reflected in a shift inward in the supply curve - what you see in the diagram below.

Before we leave, you should look at one additional article - a forecast of the future aircraft market by Airbus, one of the BIG players in the commercial airline business.  In the forecast summary section in the article  you will read that "tremendous potential still exists for an increase in demand for air travel as the world's economy continues to grow and the most populous, but less developed, nations climb up the economic development curve."  This demand growth would be represented in the supply-demand model with the diagram below.  The increase in demand translates into an outward shift in the curve.

As you work through the supply-demand section you might want to look at a few more of the articles and see if you can make the translation to supply-demand graphs.