It's the demand, stupid: theory and practice

Econ 101: The Basics of Supply and Demand

When I teach principles of economics, I start the class by asking two questions:

1. Do you believe people buy more at lower prices and less at higher prices?
2. Do you believe that sellers want to sell more at higher prices and less at lower prices?

After I get almost universal agreement--and I do because I tell them their grade hinges on agreeing with me--I tell them:  Then you believe that markets work. 

So let's take a quick look the basics and then use it to explain why the current high gas prices are your fault.

Believing that people buy less at higher prices and that sellers want to sell more at higher prices means that you believe that price and quantity demanded are inversely related and that price and quantity supplied are directly related.  If we put this onto a standard graph with prices on the vertical axis and quantity on the horizontal axis then believing those two statements means we can draw an downward sloping demand curve and an upward sloping supply curve.  Bear with me...the good stuff's coming.

OK, so we now know that demand and supply can be drawn as an X on an L shaped graph.  Just like the picture on the right.  After the buyers and sellers bargain with each other until everyone is happy the market price and quantity stabilize.  This is called the equilibrium--the point (Q0, P0) on the graph--and it means that those willing and able to buy the good are the ones who get it, and those willing and able to sell the good are the ones who sell.  Just so you know I'm not using sleight of hand, remember, all of this hinges on you agreeing that people buy more at low prices and sellers want to sell more at high prices, that's all.

Now that the market is stable, we can start to figure out why prices and quantities change.  There are only 4 things that can change a price:  Demand increases, Demand decreases, Supply increases or Supply decreases.  If you understand these 4 cases, you can identify the cause of almost any price or quantity change in any market--that's a pretty powerful statement, but supply and demand is a pretty powerful tool.

Increases and decreases in supply and demand are represented by shifts to the left (decreases) or right (increases) of the demand or supply curve.  After the demand or supply changes, buyers and sellers renegotiate the deals they had previously made and the price and quantity are adjusted according to these deals.  When everyone is happy again, we can compare the new price and quantity to the old and see what happened.  Again, all of this depends only on you agreeing that people buy more at low prices and sellers want to sell more at high prices.   

The picture on the right lays out all four of the possible market changes.  You'll notice that each of the inset pictures has one of the four possible market changes.  You'll also notice that each market change causes a uniquely identifiable change in the price, quantity combination:

1. Demand Increase: price increases, quantity increases.
2. Demand Decrease: price decreases, quantity decreases.
3. Supply Increase: price decreases, quantity increases.
4. Supply Decrease: price increases, quantity decreases.

So if you observe a price and quantity changing, you know have a powerful tool for understanding the underlying cause. 

Take the case of high gas prices. From Reuters:

Millions of Americans will drive their cars to visit family and friends over the Thanksgiving holiday even though gasoline is above $3.00 per gallon, travel and leisure group AAA said Thursday.

About 38.7 million Americans, 1.5 percent more than last year, will travel 50 miles or more from home this holiday, AAA estimated, based on a national Web survey of 2,200 adults.

The price per mile of travel is increasing (gas prices are increasing) and miles traveled are increasing relative to last year. The only thing consistent with higher prices and higher quantity is an increase in demand.  If high gas prices were supply driven we would see consumption decreasing, not increasing. 

And all you have to believe is people buy less at higher prices and that seller want to sell more at higher prices.  That's all.

Comments

[John Whitehead]

Remind me to add this to our 101 page.

[Tim Haab]

Hey John,

Don't forget to add this to the 101 page (you didn't say when to remind you).

[another john whitehead]

now, I'm sure the word "inelastic" is running around in all the economists' heads right now, but what I would like to propose is that the enjoyment of driving has increased in value at exactly the same rate as the price of gasoline.

[aaron schiff]

the underlying cause may be 'demand driven', but the size of the price change depends on the slope of the supply curve too, no? i get your point though.

[.]

You are asssuming that people put a bit of thought into the purchase of gasoline. I think it is done out of habit, and perceived demand (my boss demands that I go to work today, and if I don't buy gas, I won't be able to drive that far.)

Decisions about buying a more efficient car don't occur daily. Decisions about finding a bus route from suburb X to downtown to switch to a bus to suburb Y don't occur daily. Decisions about setting up a carpool don't occur daily. I am in the habit of buying gas for my 25 MPG car, and I will keep thinking about buying a more efficient car soon, but that won't happen for a while, even if gas goes to $5.00 per gallon.

[mgroves]

Just because you don't make a conscious decision about consumption every day, doesn't mean you aren't making a decision every day. It sounds like you are trying to shift the blame, but I'm not sure to who...

[another john whitehead]

the decision may be conscious or unconscious, but certainly inertia and infrastructure have a lot to do with it. If gas doubled in price today I'd still have to travel the same distance to work, there'd still be no bus line on that route, and I would still own the same car. Making those changes takes time.

Tim, John, how do economists address market inertia and long-term effects vs. short-term inelasticity?

[Ironman]

Just a heads-up - I've used this post as inspiration and distilled its key lessons into a simple tool - exchanging gas for turkeys for the example, which I figure is appropriate given the time of year.

Also, don't forget to add this post to your 101 page (you also didn't say how many times you wanted to be reminded....)

[Morgan]

Aren't we getting a little ahead of ourselves here? You say its all very simple. But aren't there assumptions you are making? This is why people get out of economics 101 knowing much less about economics than when they went in. The Economist had an article exactly about this subject a couple of years ago.

You spend no time at all attending to the extremely important assumptions that go into your perfectly competitive market. Is this why econ 101 students walk out the door assuming that every market in which something is bought and sold is a competitive free market?

Someone already mentioned elasticity. Is it possible that both curves are shifting? Is gasoline indeed a perfectly competitive market? What effect does speculation have on prices? Can the market be manipulated? Painfully obvious answer is yes, but you seem to dismiss that out of hand.

Economics is suppose to teach us to think and to analyze, not to jump to immediate conclusions based on superficial information.