With the start of the fall semester, I’m back to teaching my favorite topic: supply and demand. I teach intro to macro and it’s still topic #1.
My students, no doubt, get sick of hearing that dreaded phrase, supply and demand.
They probably relate to Irving Fisher who (quoting an unnamed critic of economics) said “Catch a parrot and teach him to say ‘supply and demand,’ and you have an excellent economist.”
What does that even tell us, “supply and demand?” Fisher goes on to express his dissatisfaction with this supposed answer: “Prices, wages, rent, interest, and profits were thought to be fully “explained” by this glib phrase.” Yet, I keep harping on supply and demand; it’s really our brand here at Economic Forces.
So what do I think that tells us? When I say “supply and demand”, I don’t mean it as a conclusion but as an invitation to asking more questions. It’s “here is how we can unravel the mysteries of the universe”, not the mysteries themselves.
In this week’s newsletter, I will argue that using supply and demand is helpful because it forces us to specify
what we’re comparing
identify what is different between the two comparisons, and
trace out the implication to other markets.
Usually, we use supply and demand to teach us something about the world. Here I will use the recent car market to teach how we can use supply and demand.
It’s not about the X
Steven Landsburg starts off the best pop econ book by confessing how he used to just explain puzzles by saying “‘supply and demand’ as if that meant something.” He’s right. Saying “supply and demand” doesn’t tell us much of anything.
Any time you put two lines on a graph you may be tempted to focus on where the cross is and say ta-da! Look at it! That’s the special spot.
This may come as a surprise but that’s really not the important part. I can draw any two curves I want and have them cross at any point. That doesn’t tell me anything. I could say that the price of a new car is $40,000 and 1,000 were sold last month. Therefore, that must be where the curves cross. That may be a valid statement but it really doesn’t help us in any way.
Compared to what?
Supply and demand is really about making comparisons. It’s not just about where supply and demand cross each other; it is a tool for thinking through comparisons. After all, economics tells us to always ask “compared to what?”
Sometimes the comparison is obvious. In the case of cars, we see that the price is higher this summer than it was last winter. We naturally seek to compare the supply and demand of cars today vs. last winter.
It’s easiest to compare physically identical goods across time, but we could also make other comparisons. We could also compare the car market across different states (say Minnesota vs. Wisconsin) for the same time period. Then we draw supply and demand for Minnesota and Wisconsin and compare them somehow.
Once we realize that we are interested in comparing two different “supplies and demands”, we need to focus on what is the important difference. This is often an art but sometimes we can a good idea. In the car example, what changed between winter and summer? Suppose we decide it’s likely the computer chip shortage. Then supply and demand forces us to ask, which side of the market does that change?
Now we are no longer in “anything goes” territory, drawing arbitrary curves that cross wherever we want. Instead, we can say that the shortage directly affects the supply side of the car market and that it reduces supply. When the supply is reduced, prices must go up. That’s basic, and in some sense, we knew the answer, but it’s only the first step.
Markets are interconnected
When we think about supply and demand, we are forced to think about markets and price, not just technological problems of production.
The next key insight is that markets are connected. It's not just the supply and demand of new cars that matters but how that market interacts with related markets. As the Chicago Price Theory textbook puts it, “The market-equilibrium approach says that the most important effects of policy, technical change, and other events are not necessarily found in the immediate proximity of the event.” Or as Alex Salter put it, “price theory is general equilibrium reasoning using partial equilibrium models.”
Back to the car example, why did the price of used cars go up too? A chip shortage does not directly affect used cars, which presumably already have their chips.
Because some people are debating between buying a used car or a new car, the two prices are linked. If the price of new cars goes up, people on the fence will switch to buying a used car, which drives up the price of used cars. The used car market responds, even though used cars didn’t have a chip shortage.
In fact, used car prices rose even more than new car prices! How is possible that the aftershock is stronger than the initial shock?
Again, our trusty hammer can help us. It wasn’t just the demand for used cars that shifted. The supply also shifted. Some of the people on the margin of buying a new car will decide to hold on to their current car longer. This is a shift of the supply curve. The used market is hit from both sides, driving the price up even higher.
While there are details that I have missed (I'm no expert on car markets), the tools of economics gave me (and every student) the ability to start making sense of the world.
The model of supply and demand allows us not to glibly respond to Irving Fisher, but to systematically trace out our line of reasoning, including showing the three points above. Without the tool to aid us, even well-credentialed economists can spin themselves into circles. Personally, I’ll keep the tool by my side instead of relying on my own intuition.
Laibson and List once wrote about behavioral economics that
if you want to get from Chicago to the bleachers of Fenway Park to watch the Boston Red Sox, standard economics will get you to Cambridge, or even Boston University (which is adjacent to Fenway), but you may need behavioral economics to take the final steps and find your seat in the bleachers.
I’d say (a proper use of) just supply and demand will get you to Boston University! The rest of economics (monopoly or behavioral models) can maybe help on those final steps.
Thanks to everyone who downloaded/listened to/streamed/shared our first podcast episode with Larry White. We received over 2400 downloads in the first week. Not bad for a niche talk about UCLA economics.
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I don't think S/D models are worth saving. Supply curves can only be made in the case of perfect competition, which is almost never the case and any business in such a state doesn't have the extra cash to hire an economist. Businesses frequently don't know and don't care to know their demand curves either, instead they just use a discounting model. If you want more information about how prices are set, just look at market power. The only use of supply and demand models is as a complicated proof to show that customers generally prefer lower prices and business generally prefer higher prices. This isn't very informative and it's just as easily taught as the assumption of self-interest. We could save students a lot of time by skipping perfect competition and equilibrium and moving on to discounting formulas. Discounting also sets students up for learning about money and banking, which is oddly absent in all these models as well.