LESSON 11

Supply and Demand

In this lesson you will learn:

Supply and Demand: The Purpose

An old joke says that if you taught a parrot to say “Supply and demand,” it could answer any economics question. This is almost right—to be truly a good economist, the parrot would also need to be trained to disagree with half of the other parrots.

The lessons contained in this book are designed to give you a solid foundation in economic thinking. Its pages are not covered with the graphs you will find in a typical economics textbook. The one exception to this rule is the famous supply and demand graph. In addition to the concepts underlying the graph, we provide diagrams because it makes some of the points easier to grasp. However, you should never ascribe too much importance to the particular supply and demand curves we will draw in this (and subsequent) lessons. They are simply convenient ways to give a concrete example of a particular point, just as the specific numbers used in some of our stories in previous lessons were not crucial to the general economic principles that we were illustrating.

Keep in mind that economists don’t rely on a theory of supply and demand; they rather use them as tools. The concepts of supply and demand are ways of viewing the world. They allow economists to group different forces or causes into two different categories, in order to think clearly and systematically about changes in the world and how they will impact market prices.

Because supply and demand are conceptual tools, not an empirical theory, there will never be evidence that demonstrates that “supply and demand” is somehow false. What might happen is that future economists decide that “supply and demand” is no longer the most useful approach to thinking about prices. For now, virtually all practicing economists use supply and demand to explain market prices, because superior tools have yet to be discovered.

Demand: Its Definition and Its Law

Demand is the relationship between various hypothetical market prices for a good or service, and the total number of units that consumers want to purchase at each hypothetical price. To remind us that demand is not a specific number, but rather a relationship among many numbers, economists often use the term demand schedule. A demand schedule can be constructed for one person or for many people. The following table illustrates Jennifer’s demand schedule for gasoline.

The demand schedule that follows lists the amount of gasoline that Jennifer would buy at various hypothetical prices. We have stressed that this is a snapshot in time, namely, on a particular Tuesday afternoon. It is important to remember that someone’s demand for a good or service can change from moment to moment, depending on the person’s subjective preferences as well as other factors.

The situation we had in mind for the numbers that follow is that Jennifer’s car is almost out of gas, and she plans on stopping at a station on her way home from work. At a price of $4 or higher per gallon, Jennifer would not buy any gasoline, because that would strike her as an unusually high price and she would hope to fill up at a different station the following day. To motivate the other numbers, we have further assumed that Jennifer only has $16 in her purse, and that her car has a 15-gallon tank (which is almost empty). At the prices of $3.50 and $3.00 per gallon, Jennifer would only buy a small amount of gas, enough to get her back and forth to work the next day (though she gives herself a bigger cushion at the lower price). At $2.50 she would buy more gasoline because of the better deal, while at $2.00 and $1.50 she would spend all of her cash. Finally, at $1.00 and $0.50, she would fill up her car completely

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The only “rule” that the schedule above obeys is the Law of Demand, which states that holding other influences constant, a lower price will lead a consumer to buy either the same or a greater amount of the good or service.1

In the table below, we retain Jennifer’s demand but add in the demand schedules for several other people:

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Again, the only specific rule that the above table obeys is the Law of Demand. Since it is true in each individual’s case, it is also true for the market demand for gasoline, because “the market” is simply the combination of the individuals. The only explanatory comments for the numbers in the table are that Hank is on a road trip for his company, and his travel expenses will be reimbursed, so he fills up his tank regardless of the price. Jill doesn’t own a car, so she buys no gasoline regardless of the price.

Once we have the market demand schedule, it’s a simple matter of plotting points to graph the market’s demand curve:

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The above graph doesn’t look very pretty. That’s why economists cheat when they are using generic demand curves, and draw something like this:

Generic Demand Curve

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or

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Supply: Its Definition and Its Law

Once you understand demand, supply is easy to explain: Supply is the relationship between various hypothetical market prices for a good or service, and the total number of units that producers want to sell at each hypothetical price. As with demand, we can construct a supply schedule and a supply curve to illustrate this relationship for an individual or group, at a particular snapshot in time. The following table shows the supply schedule for our hypothetical community (on the same Tuesday afternoon), followed by the corresponding supply curve.

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The story behind the above figures is that there are two single-pump gasoline stations in town, the Quik Mart and Fill ‘Er Up. The owners arrange for the periodic replenishing of their underground fuel tanks—one of which has a capacity of 50 gallons, the other of 200 gallons—assuming a market price between $2.50 and $3.00 per gallon. If the price should fall too low, they simply shut their stores and hope they can fetch a better deal in the near future. As the price rises, they use various techniques to sell larger quantities—such as working through their lunch breaks, keeping the store open longer, and rushing outside whenever a customer pulls up in order to pump the gas at no additional charge (and thus clear out the pump for the next potential customer). At a price of $6.00 per gallon or higher, Farmer Jim finds it worthwhile to enter the market. He has backup gasoline on hand to run his equipment, and at a high enough price he leaves his farm work to set up a roadside stand and sell some of the gasoline back to other motorists.

Our hypothetical numbers obey the Law of Supply, which states that as the market price of a good or service rises, producers offer the same or greater number of units. Here is what a generic supply curve looks like:

Generic Supply Curve

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or

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Using Supply and Demand to Explain the Market Price

The whole purpose of using the concepts of supply and demand is to organize our thinking around different changes and how they will affect market prices. When something changes—such as consumer tastes, or the availability of a certain resource—we methodically walk through the impacts on supply and demand for a particular good or service, and then we can gauge the ultimate impact on the market price. But before we give some examples (in the next section), you first need to see the standard demonstration of how stable supply and demand curves provide a target or an anchor for the market price.

Let’s finish up with our gasoline market example from above. In the table below, we’ve combined the information from the demand and supply schedules for the whole market, and we’ve also added two new calculations for each hypothetical price:

Market for Gasoline (Tuesday Afternoon)

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A surplus (or a “glut”) occurs when producers are trying to sell more units of a good or service than consumers want to purchase (at a particular price). A shortage occurs when consumers want to buy more units than producers want to sell (at a particular price). In this context, the equilibrium price (or the market-clearing price) is the one at which the amount supplied exactly equals the amount demanded. If the market is in equilibrium, there is no surplus and no shortage.

In our example, the equilibrium market price is $2.50 per gallon of gasoline. This price is in equilibrium because it balances the pressures of the consumers and the producers. (In physics, a ball at rest on a table is in equilibrium because the downward force of gravity is exactly counterbalanced by the upward force of the table pushing against the ball.) The idea is that if the price for some reason happened to be more than $2.50 per gallon, market forces would push it down.

For example, if producers thought the market price on this Tuesday afternoon would be $3.50, they would plan on selling a total of 130 gallons of gasoline. But at this posted price, consumers would only start buying at a pace to purchase a total of 21.5 gallons during the course of the day. If the owners of the Quik Mart and Fill ‘Er Up stubbornly clung to the price of $3.50, they would end up with a surplus of 108.5 gallons that they had planned on selling but couldn’t. The definition of supply (at various prices) is how many units producers would sell if they actually received that hypothetical price for every supplied unit. Because the owners of our gas stations would soon realize that they had misjudged the market—meaning that they would not be able to sell a combined 130 gallons for $3.50 each—they would reduce the posted gasoline price and revise their ambitious sales projections.2

On the other hand, if the market price should happen to be below $2.50 on this Tuesday afternoon, market forces would tend to push it up. Specifically, the owners would realize that customers were buying gasoline in larger quantities than the owners had planned on selling at the low price. Consequently the owners would raise the posted price, so that they could earn more profits and avoid the awkward situation of having to shut down the store early and send customers away with no gas.

Our intuitive arguments show that the only “stable” or equilibrium price for gasoline is $2.50 per gallon. Especially if we assume that the supply and demand schedules remained fairly stable in our hypothetical community we would expect that in practice the actual market price would be $2.50 (or very close to it). At this price, producers want to sell exactly as many gallons as consumers want to buy—36 gallons with our specific numbers. This is the equilibrium quantity.

In a generic supply and demand graph, the equilibrium price and quantity line up with the intersection of the curves, as we show below. In many textbooks, these items are denoted P* and Q*.

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We can also use the generic graph to denote a surplus (from a price PH that is too high) and a shortage (from a price PL that is too low). The sizes of the surplus and shortage are also indicated by the respective brackets.

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Using Supply and Demand to Understand Price Changes

People who are untrained in economic thinking often tie themselves in knots when they try to analyze some world event and its impact on prices. For example, if OPEC countries announce that they are reducing their output of oil, many people—sometimes even newspaper reporters!—will say nonsense like this:

“The OPEC announcement means a reduction in the supply of oil, which will raise prices. However, at the higher prices there will be less demand for oil, which will lower prices.”

Thus we apparently conclude that the OPEC announcement will both raise and lower oil prices! Now that you are armed with the tools of supply and demand analysis, you can avoid such silliness. We’ll first deal with two examples of changes on the supply side, and then we’ll deal with two examples of changes on the demand side. Our fifth example will involve simultaneous changes to supply and demand.

Example 1: Supply Reduction

For this first example, let’s deal with the oil example we just discussed. Suppose that the OPEC countries announce that they are cutting their production of oil by several hundred thousand barrels per day What effect will this have on the oil market?

If all we want to figure out is the direction of the (equilibrium) price and quantity change, we can use generic supply and demand curves. (This will be our strategy for all of the examples in the remainder of this lesson.) We’ll first draw two arbitrary curves and come up with P* and Q* for the situation just before the OPEC announcement:

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Oil Market

Now we want to examine the impact of the OPEC announcement. Does their decision affect the supply curve, the demand curve, or both?

The OPEC ministers are clearly reducing the supply of oil. We can translate their statement like this: “Before we had various quantities of barrels of oil that we would sell, depending on the price of oil. Now we have changed our minds, and for each hypothetical price, we will sell fewer barrels than we would have yesterday.” Economists refer to this as a reduction in supply or a leftward shift in the supply curve. The reason for the latter phrase is simple enough: Graphically a reduction in supply appears as a leftward movement in the supply curve. Really what’s happening is that we’re drawing a new curve altogether, but visually the new curve looks like the old curve “shifted to the left.”

Before drawing our new graph, we should ask: Will the OPEC announcement affect the demand for oil? Here we need to be careful. When you think of “demand,” remember that it is the entire relationship between hypothetical prices and quantities—demand is not simply one number. (Think of the demand schedule—i.e., the whole table—to keep this straight.) As we’ll see, the OPEC announcement will definitely affect the equilibrium quantity of oil purchased, but that by itself doesn’t mean that demand has shifted. No, the vast majority of buyers of oil don’t directly care about how many barrels OPEC is producing. This information is only relevant to them because they know (from basic economics) that the OPEC decision will affect the price of oil. But as far as their willingness to buy more or fewer barrels at various hypothetical prices—i.e., their demand schedule—the OPEC announcement probably won’t have much of an effect.3 So in our graph below, we’ll keep the demand curve the same.

As the following chart indicates, the leftward shift in supply leads to a higher (equilibrium) price of oil and a lower (equilibrium) quantity of oil produced and purchased. To be precise, economists would say that the demand for oil remained constant, but the quantity demanded declined. Another way of making this crucial distinction is to say that we moved the supply curve itself, while we merely moved along the same demand curve. Our hypothetical journalist above—who ended up concluding that the OPEC announcement would lead to both higher and lower oil prices—got confused on this essential point; he mixed up a shift in demand, with a movement along the demand curve.

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Oil Market

We already see the tremendous benefit of carefully defining supply and demand. What economists have basically done is first take everything that could possibly affect producers’ decisions to sell various quantities of a good. This list of causes could be huge, including the weather, the producers’ forecasts of future customer behavior, and even the possibility of civil war. Then, after they have come up with a list of all the different factors that could influence producers’ decisions on how much to sell, the economists hold every single one of those influences constant, except they allow the price of the good to change. The supply schedule (and curve) is then the tracing out of the thought experiment where only the price of the good is allowed to change, while all the other influences are held constant. So to repeat, economists are not saying that the price of a good is the only thing that affects the quantity that producers want to sell. But when economists construct a supply schedule or draw a supply curve, they are holding all the other influences constant in order to isolate the effects of the change in price.

Similarly, the demand schedule (and curve) traces out the thought experiment where economists hold constant all factors that could possibly affect consumers’ desires to purchase quantities of a good, except the price of the good. By varying that one element, and holding everything else constant, economists can map out the demand for the good.

When we’re trying to analyze the impact of some change, then, what we’re doing is trying to figure out which list the factor belongs in. Is it something that will influence producers and how much they would be willing to sell the good in question? Is it a factor that will influence how much consumers would be willing to purchase of the good in question? Or both? Let’s move on to another example.

Example 2: Supply Increase

Suppose the weather is very accommodating and the orange crop is unusually large. What effect will this have on the price of oranges?

The unusually good weather means that farmers will have more oranges than they normally have after their harvest. Consequently they will probably be willing to sell more oranges at various hypothetical prices than they would have in the case of normal weather. In other words, supply has increased, meaning the supply curve shifts to the right.

At the same time, the weather per se probably doesn’t have a very big effect on consumers’ willingness to buy oranges at various prices. For all practical purposes, we can say that the unusual weather won’t influence the demand for oranges.

As the graph shows, a rightward shift in supply, coupled with a stable demand, leads to a lower (equilibrium) price and a higher (equilibrium) quantity:

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Orange Market

Example 3: Demand Decrease

Let’s continue with the example above, and assume that great weather in Florida has yielded a bumper crop of oranges. What effect, if any, will this have on the market price of apples, if we assume that the apple orchards experience a normal year?

The perfect combination of sunshine and rainfall in Florida, by assumption, doesn’t translate into a bigger apple crop among the major orchards. It’s hard to see how the bumper orange crop would directly affect the supply schedule of apples, so we’ll assume it stays the same.

However, it does make sense to think that the Florida weather will affect consumers and their demand for apples. For many consumers, apples and oranges are substitutes, meaning that one or the other can satisfy the consumers’ ultimate objectives (in this case, the desire for fruit).4 When the price of a good goes down, the demand for its substitutes goes down as well. In our case, the flow of cause-and-effect runs like this: The unusual weather leads to a bumper crop of oranges in Florida, which increases the supply of oranges and doesn’t affect the demand for oranges. This means the price of oranges falls. The lower price of oranges doesn’t affect the supply of apples, but it does affect the demand for apples, by shifting it to the left.

This is a subtle point that sometimes confuses people who are new to the economic way of thinking. Remember that supply and demand curves vary the price of the good in question while keeping everything else the same. So one of the elements of “everything else” is the price of other goods. To put it in other words: When the price of apples changes, this doesn’t affect the demand for apples; all that happens is we move along the demand curve for apples. However, when the price of oranges changes, this can indeed shift the entire demand curve for apples (to the left).

In the following chart we show the effect of a generic reduction in demand while supply is held constant:

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Market for Apples

Example 4: Demand Increase

Suppose the actor Robert Pattinson moves into an apartment complex. What will be the likely effect on the rental price of the apartments in the building?

In this example the analysis is straightforward. The supply of apartments in the building is unchanged; the owner of the building can’t sell more units than physically exist, and Pattinson’s decision to rent one of the units presumably won’t make the landlord decide to rent out fewer units. On the other hand, there are plenty of consumers (mostly female) who would love to live in the same building as the Twilight star. The fact that he now lives in the building would increase the market demand for apartments in that complex:

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Market for Apartment Units

The only complication in our diagram above is the odd-shaped supply curve. We are taking the opportunity in this example not merely to show the effects of a demand increase, but also to show the possibility of a fixed (unchanging) supply With a more typical supply curve, an increase in demand moves price and quantity up, but in our example, only the price has increased, since the quantity of apartments cannot increase, at least not anytime soon.5

The graph above also shows that if the price falls low enough, the owner of the building doesn’t bother renting any units out to tenants. Instead, he prefers to keep the building empty and avoid the headaches of dealing with customers who complain of no hot water, loud parties, and so on. But since the whole point of owning the building is to make money, even at a relatively low price the landlord is willing to rent out all the units.

Example 5: A Simultaneous Change in Supply and Demand

In the previous examples we have analyzed situations where a change clearly had a large effect on either supply or demand, but a minor impact on the other. What happens when a change has significant impacts on both supply and demand at the same time?

For example, suppose that a new medical report shows that leather shoes pose serious health risks to those who come in frequent contact with them. What will happen to the equilibrium price and quantity of leather shoes?

The new report will (eventually) cause the supply curve of leather shoes to shift to the left.6 If the entrepreneurs are directly involved with handling the shoes, they won’t be as eager to handle as many pairs per day. But even if they merely hire others to sell the shoes, they will still have to pay higher wages as workers prefer to take other, safer jobs. The higher wages of workers will raise the expenses of selling shoes, making the supply curve shift left.

But for obvious reasons, the medical report will also significantly affect the demand for shoes, shifting it to the left as well. In this case, we can confidently say that the equilibrium quantity will decline, but we don’t know what will happen to the equilibrium price of leather shoes. The leftward supply shift would tend to raise the price, but the leftward demand shift would tend to lower it. Only if we had exact numbers could we say which effect would be larger. Generically speaking, a reduction in supply and demand at the same time can make the equilibrium price go up or down:

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Market for Shoes

or

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Market for Shoes

In the exercises accompanying this lesson you will work through other combinations of changes in supply and demand that occur at the same time. In each case, either price or quantity will move in a certain direction without a doubt, but then the other item’s movement will be uncertain.7