3: The classical marketplace – demand and supply

Other things equal – ceteris paribus

The demand and supply schedules rest on the assumption that all other influences on supply and demand remain the same as we move up and down the possible price values. The expression other things being equal, or its Latin counterpart ceteris paribus, describes this constancy of other influences. For example, we assume on the demand side that the prices of other goods remain constant, and that tastes and incomes are unchanging. On the supply side we assume, for example, that there is no technological change in production methods. If any of these elements change then the market supply or demand schedules will reflect such changes. For example, if coal or oil prices increase (decline) then some buyers may switch to (away from) gas or solar power. This will be reflected in the data: At any given price more (or less) will be demanded. We will illustrate this in graphic form presently.

Market equilibrium

Let us now bring the demand and supply schedules together in an attempt to analyze what the marketplace will produce – will a single price emerge that will equate supply and demand? We will keep other things constant for the moment, and explore what materializes at different prices. At low prices, the data in Table 3.1 indicate that the quantity demanded exceeds the quantity supplied – for example, verify what happens when the price is $3 per unit. The opposite occurs when the price is high – what would happen if the price were $8? Evidently, there exists an intermediate price, where the quantity demanded equals the quantity supplied. At this point we say that the market is in equilibrium. The equilibrium price equates demand and supply – it clears the market.

In Table 3.1 the equilibrium price is $4, and the equilibrium quantity is 6 thousand cubic feet of gas (we use the notation 'k' to denote thousands). At higher prices there is an excess supply—suppliers wish to sell more than buyers wish to buy. Conversely, at lower prices there is an excess demand. Only at the equilibrium price is the quantity supplied equal to the quantity demanded.

Does the market automatically reach equilibrium? To answer this question, suppose initially that the sellers choose a price of $10. Here suppliers would like to supply 18k cubic feet, but there are no buyers—a situation of extreme excess supply. At the price of $7 the excess supply is reduced to 9k, because both the quantity demanded is now higher at 3k units, and the quantity supplied is lower at 12k. But excess supply means that there are suppliers willing to supply at a lower price, and this willingness exerts continual downward pressure on any price above the price that equates demand and supply.

At prices below the equilibrium there is, conversely, an excess demand. In this situation, suppliers could force the price upward, knowing that buyers will continue to buy at a price at which the suppliers are willing to sell. Such upward pressure would continue until the excess demand is eliminated.

In general then, above the equilibrium price excess supply exerts downward pressure on price, and below the equilibrium excess demand exerts upward pressure on price. This process implies that the buyers and sellers have information on the various elements that make up the marketplace.

We will explore later in this chapter some specific circumstances in which trading could take place at prices above or below the equilibrium price. In such situations the quantity actually traded always corresponds to the short side of the market: this means that at high prices the quantity demanded is less than the quantity supplied, and it is the quantity demanded that is traded because buyers will not buy the amount suppliers would like to supply. Correspondingly, at low prices the quantity demanded exceeds quantity supplied, and it is the amount that suppliers are willing to sell that is traded. In sum, when trading takes place at prices other than the equilibrium price it is always the lesser of the quantity demanded or supplied that is traded. Hence we say that at non-equilibrium prices the short side dominates. We will return to this in a series of examples later in this chapter.

Supply and the nature of costs

Before progressing to a graphical analysis, we should add a word about costs. The supply schedules are based primarily on the cost of producing the product in question, and we frequently assume that all of the costs associated with supply are incorporated in the supply schedules. In Chapter 6 we will explore cases where costs additional to those incurred by producers may be relevant. For example, coal burning power plants emit pollutants into the atmosphere; but the individual supplier may not take account of these pollutants, which are costs to society at large, in deciding how much to supply at different prices. Stated another way, the private costs of production would not reflect the total, or full social costs of production. Conversely, if some individuals immunize themselves against a rampant virus, other individuals gain from that action because they become less likely to contract the virus - the social value thus exceeds the private value. For the moment the assumption is that no such additional costs are associated with the markets we analyze.

The prices of related goods – oil and gas, Kindle and paperbacks

We expect that the price of other forms of energy would impact the price of natural gas. For example, if hydro-electricity, oil or solar becomes less expensive we would expect some buyers to switch to these other products. Alternatively, if gas-burning furnaces experience a technological breakthrough that makes them more efficient and cheaper we would expect some users of other fuels to move to gas. Among these examples, oil and electricity are substitute fuels for gas; in contrast a more fuel-efficient new gas furnace complements the use of gas. We use these terms, substitutes and complements, to describe products that influence the demand for the primary good.

Clearly electricity is a substitute for gas in the power market, whereas a gas furnace is a complement for gas as a fuel. The words substitutes and complements immediately suggest the nature of the relationships. Every product has complements and substitutes. As another example: Electronic readers and tablets are substitutes for paper-form books; a rise in the price of paper books should increase the demand for electronic readers at any given price for electronic readers. In graphical terms, the demand curve shifts in response to changes in the prices of other goods – an increase in the price of paper-form books shifts the demand for electronic readers outward, because more electronic readers will be demanded at any price.

Buyer incomes – which goods to buy

The demand for most goods increases in response to income growth. Given this, the demand curve for gas will shift outward if household incomes in the economy increase. Household incomes may increase either because there are more households in the economy or because the incomes of the existing households grow.

Most goods are demanded in greater quantity in response to higher incomes at any given price. But there are exceptions. For example, public transit demand may decline at any price when household incomes rise, because some individuals move to cars. Or the demand for laundromats may decline in response to higher incomes, as households purchase more of their own consumer durables – washers and driers. We use the term inferior good to define these cases: An inferior good is one whose demand declines in response to increasing incomes, whereas a normal good experiences an increase in demand in response to rising incomes.

There is a further sense in which consumer incomes influence demand, and this relates to how the incomes are distributed in the economy. In the discussion above we stated that higher total incomes shift demand curves outwards when goods are normal. But think of the difference in the demand for electronic readers between Portugal and Saudi Arabia. These economies have roughly the same average per-person income, but incomes are distributed more unequally in Saudi Arabia. It does not have a large middle class that can afford electronic readers or iPads, despite the huge wealth held by the elite. In contrast, Portugal has a relatively larger middle class that can afford such goods. Consequently, the distribution of income can be an important determinant of the demand for many commodities and services.

Tastes and networks – hemlines, lapels and homogeneity

While demand functions are drawn on the assumption that tastes are constant, in an evolving world they are not. We are all subject to peer pressure, the fashion industry, marketing, and a desire to maintain our image. If the fashion industry dictates that lapels on men's suits or long skirts are de rigueur for the coming season, some fashion-conscious individuals will discard a large segment of their wardrobe, even though the clothes may be in perfectly good condition: Their demand is influenced by the dictates of current fashion.

Correspondingly, the items that other individuals buy or use frequently determine our own purchases. Businesses frequently decide that all of their employees will have the same type of computer and software on account of network economies: It is easier to communicate if equipment is compatible, and it is less costly to maintain infrastructure where the variety is less.

Expectations – betting on the future

In our natural gas example, if households expected that the price of natural gas was going to stay relatively low for many years – perhaps on account of the discovery of large deposits – then they would be tempted to purchase a gas burning furnace rather than one based upon an alternative fuel. In this example, it is more than the current price that determines choices; the prices that are expected to prevail in the future also determine current demand.

Expectations are particularly important in stock markets. When investors anticipate that corporations will earn high rewards in the future they will buy a stock today. If enough people believe this, the price of the stock will be driven upward on the market, even before profitable earnings are registered.

Shifts in demand

The demand curve in Figure 3.2 is drawn for a given level of other prices, incomes, tastes, and expectations. Movements along the demand curve reflect solely the impact of different prices for the good in question, holding other influences constant. But changes in any of these other factors will change the position of the demand curve. Figure 3.3 illustrates a shift in the demand curve. This shift could result from a rise in household incomes that increase the quantity demanded at every price. This is illustrated by an outward shift in the demand curve. With supply conditions unchanged, there is a new equilibrium at , indicating a greater quantity of purchases accompanied by a higher price. The new equilibrium reflects a change in quantity supplied and a change in demand.

Figure 3.3 Demand shift and new equilibrium

The outward shift in demand leads to a new equilibrium E₁.

We may well ask why so much emphasis in our diagrams and analysis is placed on the relationship between price and quantity, rather than on the relationship between quantity and its other determinants. The answer is that we could indeed draw diagrams with quantity on the horizontal axis and a measure of one of these other influences on the vertical axis. But the price mechanism plays a very important role. Variations in price are what equilibrate the market. By focusing primarily upon the price, we see the self-correcting mechanism by which the market reacts to excess supply or excess demand.

In addition, this analysis illustrates the method of comparative statics—examining the impact of changing one of the other things that are assumed constant in the supply and demand diagrams.

'Comparative' obviously denotes the idea of a comparison, and static means that we are not in a state of motion. Hence we use these words in conjunction to indicate that we compare one outcome with another, without being concerned too much about the transition from an initial equilibrium to a new equilibrium. The transition would be concerned with dynamics rather than statics. In Figure 3.3 we explain the difference between the points E₀ and E₁ by indicating that there has been a change in incomes or in the price of a substitute good. We do not attempt to analyze the details of this move or the exact path from E₀ to E₁.

Technology – computers and fracking

A technological advance may involve an idea that allows more output to be produced with the same inputs, or an equal output with fewer inputs. A good example is just-in-time technology. Before the modern era, virtually all manufacturers kept large stocks of components in their production facilities, but developments in communications and computers at that time made it possible for manufacturers to link directly with their input suppliers. Nowadays auto assembly plants place their order for, say, seat delivery to their local seat supplier well ahead of assembly time. The seats swing into the assembly area hours or minutes before assembly—just in time. The result is that the assembler reduces her seat inventory (an input) and thereby reduces production cost.

Such a technology-induced cost saving is represented by moving the supply curve downward or outward: The supplier is now able and willing to supply the same quantity at a lower price because of the technological innovation. Or, saying the same thing slightly differently, suppliers will supply more at a given price than before.

A second example relates to the extraction of natural gas. The development of 'fracking' means that companies involved in gas recovery can now do so at a lower cost. Hence they are willing to supply any given quantity at a lower price. A third example concerns aluminum cans. Today they weigh a fraction of what they weighed 20 years ago. This is a technology-based cost saving.

Input costs

Input costs can vary independently of technology. For example, a wage negotiation that grants workers a substantial pay raise will increase the cost of production. This is reflected in a leftward, or upward, supply shift: Any quantity supplied is now priced higher; alternatively, suppliers are willing to supply less at the going price.

Production costs may increase as a result of higher required standards in production. As governments implement new safety or product-stress standards, costs may increase. In this instance the increase in costs is not a 'bad' outcome for the buyer. She may be purchasing a higher quality good as a result.

Competing products – Airbnb versus hotels

If competing products improve in quality or fall in price, a supplier may be forced to follow suit. For example, Asus and Dell are constantly watching each other's pricing policies. If Dell brings out a new generation of computers at a lower price, Asus may lower its prices in turn—which is to say that Asus' supply curve will shift downward. Likewise, Samsung and Apple each responds to the other's pricing and technology behaviours. The arrival of new products in the marketplace also impacts the willingness of suppliers to supply goods at a given price. New intermediaries such as Airbnb and Vacation Rentals by Owner have shifted the supply curves of hotel rooms downward.

These are some of the many factors that influence the position of the supply curve in a given market.

Shifts in supply

Whenever technology changes, or the costs of production change, or the prices of competing products adjust, then one of our ceteris paribus assumptions is violated. Such changes are generally reflected by shifting the supply curve. Figure 3.4 illustrates the impact of the arrival of just-in-time technology. The supply curve shifts, reflecting the ability of suppliers to supply the same output at a reduced price. The resulting new equilibrium price is lower, since production costs have fallen. At this reduced price more gas is traded at a lower price.

Figure 3.4 Supply shift and new equilibrium

The supply curve shifts due to lower production costs. A new equilibrium E₁ is attained in the market at a lower price.

Price ceilings – rental boards

Ceilings mean that suppliers cannot legally charge more than a specific price. Limits on apartment rents are one form of ceiling. In times of emergency – such as flooding or famine, price controls are frequently imposed on foodstuffs, in conjunction with rationing, to ensure that access is not determined by who has the most income. The problem with price ceilings, however, is that they leave demand unsatisfied, and therefore they must be accompanied by some other allocation mechanism.

Consider an environment where, for some reason – perhaps a sudden and unanticipated growth in population – rents increase. Let the resulting equilibrium be defined by the point E₀ in Figure 3.6. If the government were to decide that this is an unfair price because it places hardships on low- and middle-income households, it might impose a price limit, or ceiling, of P_c. The problem with such a limit is that excess demand results: Individuals want to rent more apartments than are available in the city. In a free market the price would adjust upward to eliminate the excess demand, but in this controlled environment it cannot. So some other way of allocating the available supply between demanders must evolve.

In reality, most apartments are allocated to those households already occupying them. But what happens when such a resident household decides to purchase a home or move to another city? In a free market, the landlord could increase the rent in accordance with market pressures. But in a controlled market a city's rental tribunal may restrict the annual rent increase to just a couple of percent and the demand may continue to outstrip supply. So how does the stock of apartments get allocated between the potential renters? One allocation method is well known: The existing tenant informs her friends of her plan to move, and the friends are the first to apply to the landlord to occupy the apartment. But that still leaves much unmet demand. If this is a student rental market, students whose parents live nearby may simply return 'home'. Others may chose to move to a part of the city where rents are more affordable.

Figure 3.6 The effect of a price ceiling

The free market equilibrium occurs at E₀. A price ceiling at P_c holds down the price but leads to excess demand E_cB, because Q_c is the quantity traded. A price ceiling above P₀ is irrelevant since the free market equilibrium E₀ can still be attained.

However, rent controls sometimes yield undesirable outcomes. Rent controls are widely studied in economics, and the consequences are well understood: Landlords tend not to repair or maintain their rental units in good condition if they cannot obtain the rent they believe they are entitled to. Accordingly, the residential rental stock deteriorates. In addition, builders realize that more money is to be made in building condominium units than rental units, or in converting rental units to condominiums. The frequent consequence is thus a reduction in supply and a reduced quality. Market forces are hard to circumvent because, as we emphasized in Chapter 1, economic players react to the incentives they face. These outcomes are examples of what we call the law of unintended consequences.

Price floors – minimum wages

An effective price floor sets the price above the market-clearing price. A minimum wage is the most widespread example in the Canadian economy. Provinces each set their own minimum, and it is seen as a way of protecting the well-being of low-skill workers. Such a floor is illustrated in Figure 3.7. The free-market equilibrium is again E₀, but the effective market outcome is the combination of price and quantity corresponding to the point E_f at the price floor, P_f. In this instance, there is excess supply equal to the amount E_fC.

Figure 3.7 Price floor – minimum wage

In a free market the equilibrium is E₀. A minimum wage of P_f raises the hourly wage, but reduces the hours demanded to Q_f. Thus E_fC is the excess supply.

Note that there is a similarity between the outcomes defined in the floor and ceiling cases: The quantity actually traded is the lesser of the supply quantity and demand quantity at the going price: The short side dominates.

If price floors, in the form of minimum wages, result in some workers going unemployed, why do governments choose to put them in place? The excess supply in this case corresponds to unemployment – more individuals are willing to work for the going wage than buyers (employers) wish to employ. The answer really depends upon the magnitude of the excess supply. In particular, suppose, in Figure 3.7 that the supply and demand curves going through the equilibrium E₀ were more 'vertical'. This would result in a smaller excess supply than is represented with the existing supply and demand curves. This would mean in practice that a higher wage could go to workers, making them better off, without causing substantial unemployment. This is the trade off that governments face: With a view to increasing the purchasing power of generally lower-skill individuals, a minimum wage is set, hoping that the negative impact on employment will be small. We will return to this in the next chapter, where we examine the responsiveness of supply and demand curves to different prices.

Quotas – agricultural supply

A quota represents the right to supply a specified quantity of a good to the market. It is a means of keeping prices higher than the free-market equilibrium price. As an alternative to imposing a price floor, the government can generate a high price by restricting supply.

Agricultural markets abound with examples. In these markets, farmers can supply only what they are permitted by the quota they hold, and there is usually a market for these quotas. For example, in several Canadian provinces it currently costs in the region of $30,000 to purchase a quota granting the right to sell the milk of one cow. The cost of purchasing quotas can thus easily outstrip the cost of a farm and herd. Canadian cheese importers must pay for the right to import cheese from abroad. Restrictions also apply to poultry. The impact of all of these restrictions is to raise the domestic price above the free market price.

In Figure 3.8, the free-market equilibrium is at E₀. In order to raise the price above P₀, the government restricts supply to Q_q by granting quotas, which permit producers to supply a limited amount of the good in question. This supply is purchased at the price equal to P_q. From the standpoint of farmers, a higher price might be beneficial, even if they get to supply a smaller quantity, provided the amount of revenue they get as a result is as great as the revenue in the free market.

Figure 3.8 The effect of a quota

The government decides that the equilibrium price P₀ is too low. It decides to boost price by reducing supply from Q₀ to Q_q. It achieves this by requiring producers to have a production quota. This is equivalent to fixing supply at S_q.

Marketing boards – milk and maple syrup

A marketing board is a means of insuring that a quota or price floor can be maintained. Quotas are frequent in the agriculture sector of the economy. One example is maple syrup in Quebec. The Federation of Maple Syrup Producers of Quebec has the sole right to market maple syrup. All producers must sell their syrup through this marketing board. The board thus has a particular type of power in the market: it has control of the market at the wholesale end, because it is a sole buyer. The Federation increases the total revenue going to producers by artificially restricting the supply to the market. The Federation calculates that by reducing supply and selling it at a higher price, more revenue will accrue to the producers. This is illustrated in Figure 3.8. The market equilibrium is given by E₀, but the Federation restricts supply to the quantity Q_q, which is sold to buyers at price P_q. To make this possible the total supply must be restricted; otherwise producers would supply the amount given by the point C on the supply curve, and this would result in excess supply in the amount E_qC. In order to restrict supply to Q_q in total, individual producers are limited in what they can sell to the Federation; they have a quota, which gives them the right to produce and sell no more than a specified amount. This system of quotas is necessary to eliminate the excess supply that would emerge at the above-equilibrium price P_q.

We will return to this topic in Chapter 4. For the moment, to see that this type of revenue-increasing outcome is possible, examine Table 3.1 again. At this equilibrium price of $4 the quantity traded is 6 units, yielding a total expenditure by buyers (revenue to suppliers) of $24. However, if the supply were restricted and a price of $5 were set, the expenditure by buyers (revenue to suppliers) would rise to $25.

Modelling market interventions using equations

To illustrate the impact of market interventions examined in Section 3.7 on our numerical market model for natural gas, suppose that the government imposes a minimum price of $6 – above the equilibrium price obviously. We can easily determine the quantity supplied and demanded at such a price. Given the supply equation

it follows that at P=6 the quantity supplied is 10. This follows by solving the relationship 6=1+(1/2)Q for the value of Q. Accordingly, suppliers would like to supply 10 units at this price.

Correspondingly on the demand side, given the demand curve

with a price given by , it must be the case that Q=4. So buyers would like to buy 4 units at that price: There is excess supply. But we know that the short side of the market will win out, and so the actual amount traded at this restricted price will be 4 units.