In last Wednesday's lecture, we took a first look at demand, supply, and equilibrium price and quantity. At the end of the lecture I introduced the notion of the laws of supply and demand, indicating that they would be developed further in the recitation sections. Because of the importance of this topic, I want to reinforce what you covered in the recitations with a few examples of my own.
The laws of supply and demand trace out what happens to equilibrium price and quantity when either supply or demand changes. More specifically:
1. An increase in demand (shift to the right of the demand curve) causes an increase in both the equilibrium price and the equilibrium quantity exchanged.
2. A decline in demand (shift to the left) reduces the equilibrium price and the equilibrium quantity exchanged.
3. An increase in supply (shift to the right of the supply curve) results in a decrease in the equilibrium price and an increase in the equilibrium quantity exchanged.
4. A decrease in supply (shift to the left) causes an increase in the equilibrium price and a decrease in the equilibrium quantity.
We see these laws in action frequently. For example, last Wednesday there was a story in the NY Times entitled "Moves Against Iraq Send Oil Prices Surging." The story explained that in the wake of the U.S. military action in Iraq and the suspension by the United Nations of an agreement to allow Iraqi oil exports (which was expected to bring additional supplies onto the world oil market beginning later this month), oil prices had soared. Consider this in the context of the basic supply and demand model.
We begin with a simple diagram showing a demand curve, a supply curve, and the resulting equlibrium price and quantity.
We can imagine this diagram as representing the situation expected in the oil market later this month BEFORE the recent events in Iraq (i.e., when it was expected that Iraq would be bringing more oil onto the world market).
Now consider the consequences of not allowing Iraq to export oil onto the world oil market. With a major supplier removed from the scene, the quantity of oil that producers will bring to
the market at various prices will be reduced, as compared to the situation that would have prevailed if Iraq did not have its oil exports suspended. Hence, there will be a leftward shift in the supply curve (S --> S').
All other things being equal, a leftward shift in the supply curve will result in an increase in the equilibrium price and a decrease in the quantity of oil that is traded on world markets. But note that this refers to changes that will affect the oil market later this month.
Hence, as of today, we now expect the future price of oil to rise. But we saw last week that if future (relative) prices are
expected to rise, then that will contribute to an increase in demand today (D --> D'). Increased demand today, in turn, will raise the equilibrium price and the equilibrium quantity of oil.
Thus, the "supply shock" that will occur later this month as a result of the U.N. suspending its agreement to allow Iraq to export oil, by contributing to an increased future price of oil, also contributed via increased demand now to a higher price of oil right away.
Consider a second example. It's a fish story, but it illustrates both basic supply and demand analysis and how markets tend to be linked up to one another. Here's the story, again from the NY Times:
Those Peruvian anchovies are in trouble again. The warm South American wind, El Nino, is making the normally icy Humboldt current off the coast of Peru too warm for the silvery fish and they're moving out. [The last time this happened it] helped set the stage for a world-wide run-up in soybean prices, because the fish meal is used in poultry and cattle feed, and its shortage puts pressure on soybeans, a substitute.
Let's analyze what happened in the anchovy and soybean markets. As before, we begin with a simple supply and demand diagram, in this case showing the anchovy market. El Nino's influence essentially makes it more expensive to catch anchovies, because boats have to travel farther and anchovy fishermen have to work longer to catch any given quantity of anchovies. In terms of our diagram, this translates into a decrease in supply, a shortage at the old equilibrium price, and an increase in the equilibrium price.
In addition to these changes in the anchovy market, the fact that anchovies and soybeans are substitutes means that the price change in the anchovy market will have spillovers to the soybean market. More specifically, when two
goods are substitutes for one another an increase in the price of one will result in an increase in demand for the other. Hence, the anchovy price increase results in increased demand for soybeans (a second-order effect of El Nino), and hence in a higher equilibrium price for soybeans (cf., third-order effects back on the anchovy market).
Both of the preceding examples begin with a single change: a shift in demand in the oil case, and a shift in supply in the anchovy case. If we look at individual markets over a period of time, however, we are often confronted with changes in both demand and supply, and it's useful to know how to analyze such situations.
Consider, for example, the market for hand calculators over the course of the past 20 years. During this period both incomes and population have grown, resulting in an increase in demand. This should, by itself, increase price and quantity in the market.
At the same time, the technology used to produce calculators has improved dramatically, resulting in an increase in supply. By itself, this should result in a lower price and higher quantity.
If we put the two changes together (increases in both demand and supply), it should be clear that quantity will increase. However, theory cannot tell us what will happen to price, since
the two effects work in opposing directions (note importance of
looking at the real or constant-dollar price rather than nominal price). In fact, the price has dropped dramatically, indicating that the shift in supply has been distinctly larger than the shift in demand.
You need to know how to analyze these kinds of double shifts. In symbols, what we've just seen is that DD ==> P and Q, while SS ==> P and Q. Putting the two together, it's clear that DD and SS together must result in an increase in Q, but could yield either an increase, a decrease, or no change in P. By breaking down a double shift into its two component parts, you can easily see the consequences.
Consider the other three logical possibilities:
1. DD and SS ==> P and Q from the reduced DD, and P and Q from the increased SS. On both counts, then, P must decrease, while the presence of offsetting effects on Q means that we can't predict what will happen. If Q increases, it means that the increase in SS is greater than the decline in DD; and vice-versa if Q decreases.
2. DD and SS ==> P and Q from the increased DD, and P and Q from the decrease in SS. On both counts, then, P must increase, while the presence of offsetting effects on Q means that we can't predict what will happen. If Q increases, it means that the increase in DD is greater than the decrease in SS; and vice-versa if Q decreases.
3. DD and SS ==> P and Q from the reduced DD, and P and Q from the decreased SS. On both counts, then, Q must decrease, while the presence of offsetting effects on P means that we can't predict what will happen. If P increases, it means that the decrease in SS is greater than the decline in DD; and vice-versa if P decreases.
A final point worth noting is the impact of taxes. Often people suggest that, for example, an increase in the gasoline tax will be passed on to consumers. We can use our demand and supply framework to analyze such a policy change.
The key here is to recognize the dual interpretation of supply curves. That is, I noted last week that we can think of the supply curve as reflecting producers' plans to provide output to the market at different prices. However, as Parkin mentions, we can also think about the supply curve as showing the minimum price at which the last unit will be supplied -- i.e., the minimum price required by sellers to bring the output to the market.
From this perspective, imagine the consequences of imposition of a new tax on gasoline of $1 per gallon, to be collected by gas stations. As always, we start with a basic demand and supply diagram showing a market in equilibrium. Imposition of the new gas tax is equivalent to adding a new cost of bringing gasoline to the market. That is, producers (gas stations) will now have to pay an additional $1 per gallon (to the government), over and above their other costs.
The new tax, then, will effectively shift the supply curve upward by exactly one dollar at every quantity -- a parallel shift in the supply curve, or decrease in supply. The old equilibrium price will no longer be an equlibrium, and using our analytical tool it should be clear that the price of gasoline
will rise. Note, however, that since the demand curve is downward-sloped, the increase in the equilibrium price will be less than a dollar (cf., dynamic aspects vs. comparative statics). Hence, the full tax increase of $1 is not passed on to consumers; producers bear some of the brunt of the tax.
© 1996 David Shapiro
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