Supply and Demand

Supply and Demand "Prices are to the market economy what red cells are to the human body - they both direct vital life-giving resources to the right place at the right time, with little interference or direction." Overview Prices are a central feature of our lives, and sharp changes in prices can have a direct bearing on our well-being as well as the economic health of industries and entire nations. In fact we can summarize the secret to financial success very succinctly: "buy low, sell high." If the price of something rises significantly, you benefit if you own it. Think about the wealth created for investors by dramatic increases in the price of stock in the late 1990s, or the wealth created for homeowners by the meteoric rise home prices in the early 2000s. There was also the rise in gas prices that dominated news in 2007-2008 and greatly concerned my students as they filled up at $4+ a gallon. It was painful, most so for those with those gas guzzling SUVs. While we suffered, money flowed into the oil producing countries such as Saudi Arabia, Venezuela, and Russia. They got rich, and some would say these new riches helped finance terrorism and rebuild the Russian military that marched into Georgia in 2008.i Rising food prices in 2008, meanwhile, had a devastating impact of many of the world's poorest, triggering riots in some countries and prompting others to restrict exports of grains. Prices also have an enormous impact on the choices we make in our lives. Many of you are enrolled in college because the "price" of college-educated labor has been rising, and chose URI because it is a public university and its price is lower than that at private universities. Those who major in Pharmacy or Business overwhelmingly do so because of they believe it brings higher earnings, while those gas-guzzling car owners will trade them in for more energy efficient cars when the price of gas rises. To understand prices economists rely on the Supply-Demand model. For example, look at the following headlines of stories on prices for a minute. All of them are essentially variations on the same theme – prices are affected by the behavior of market participants –buyers and sellers – and when the behavior of either changes then prices change. The good news is that you are already probably “wired” to understand prices. Experience has shown that students generally are good at reconstructing the story based on the headlines. "Natural Gas Prices Rise on Nuclear Outages." "Biofuels causing food price rises" "NY power prices rise on plant outages." "Ivory Coast unrest causes cocoa's price to climb." “Nursing shortage eases with higher pay and a weak labor market” “Marines miss January goal for recruits” Natural gas and food prices are rising because of increases in demand: demand for natural gas rises as firms seek to replace nuclear power with gas powered plants, while an increase in demand for biofuels has increased demand for corn. NY power and cocoa price increases, meanwhile, are the result of decreases in supply: the closure of power plants in NY has reduced production of electricity, while unrest in the Ivory Coast, a large supplier of cocoa, has lowered world supply of cocoa. The shortage of nurses and Marine recruits also reflect changes in supply and demand when prices are not free to move. A nursing shortage is simple another way of saying that the price of nurses is too low, and this shortage will be reduced by allowing the price to rise. Similarly, in 2005 as things were going badly in the Iraq war, the supply of new recruits dropped, which resulted in a shortage of recruits prompting the services to offer “perks” and lower standards. The bad news is that once the supply and demand curves economists use to explain prices, students tend to lose their intuitive understanding of prices. It does not have to be this way, however, since it is not that difficult to master supply & demand curves. In fact it can be no more difficult then making dinner - you just need to follow 1 the directions. In a later section you will find the “Cookbook Approach” – a set of guidelines you should follow if you are to find your experiences with supply & demand as successful as my experiences with cooking. First, however, we will look at a few instances where the prices generated by markets are wrong. When prices are not quite right The market system is one of the wonders of the world, solving society's scarcity problem with markets sending signals to decision makers. Some times markets fail to send out the correct signals, and when the signals are wrong, the results can be quite bad.ii A wonderful, yet painful example, of where markets got it wrong was the housing boom-bust in the first decade of the 21st century that you can see in the graph below. This is a picture of a classic price bubble - a situation where markets clearly send the wrong signals, and where those wrong signals lead to real hardships in the Great Recession of 2008-2009. What makes it worse is we should have recognized this as a price bubble earlier, before much of the damage was done. We certainly have seen speculative real estate bubbles before, so you would think we would have seen it coming. There were "substantial property crashes with widespread major repercussions in Athens (333 B.C.); Britain (1773); Chicago (1837); France (1838), Germany (1870); Vienna (1873); Southern California (1880s); Britain (1890s); Florida (1925); Japan (1990)."[Dick Pidcock, "The A-Z of Crashes"] And those in Rhode Island had their own bubble in the late 1980s and early 1990s that was big enough for the governor to shutdown the state’s credit unions. And there is nothing unique about real estate. It was a dramatic collapse in stock prices in 1929-1930 that ushered in the Great Depression in the US, a stock market bust in the late 1980s in Japan that ushered in a decades long recession, and the collapse of the .com bubble in the early 2000s that ended the roaring 1990s in the US. There was also the bubble in gold prices in the late 1980s and the collapse of exchange rates in a number of Asian countries in 1997 that triggered the Asian Crisis.iii The "pictures" of four price bubbles appear below - the boom-bust cycles in the price of gold and the price of cotton, the price of stock in Japan, and the price of the baht, Thailand's currency. Speculative Bubbles 2 It turns out price bubbles are not all that rare, especially in asset market such as real estate, stocks, and currencies where purchases are based on expected changes in price. Niall Ferguson, in The Ascent of Money, sees these cycles as a reflection of the human psyche that is prone to bouts of greed and fear, and there is nothing to suggest that we will overcome either greed or fear. So when you find yourself in the middle of the next speculative bubble, and you will, you can expect to hear "this time it is different," and when you do, think seriously about getting out of that market.iv Bubbles and large price swings are not, however, the only potential problem with market prices. On a number of occasions politicians and economists have acknowledged that market prices may be inappropriate for equity reasons. In the US we have imposed rent control and minimum wages to “correct” market prices by raising wages and lowering rents. We also raise the price on some goods such as cigarettes to reduce demand, while in numerous poor countries governments have established ceilings on food and oil below market rates. In each case the market interventions occurred because of a belief that market prices did not adequately take into account social considerations, and in the last section of this unit we will examine government market interventions. Another potential problem with market prices would be the fact they may not reflect all costs, an issue we look at in detail in the externalities unit of ECN201. Later in this unit we will also look at some instances When markets are wrong In addition to the ideological debate over the adequacy of markets in “solving” society’s scarcity problems and generating acceptable prices, there is also a debate about the limits of markets. It may be perfectly OK to let my wage as a university professor or the price you pay for a watch to be set in a market, but what about a price for a pound of horsemeat, a kidney or a sexual encounter being set in a market? It turns out there are a number of goods and services for which markets are thought to be entirely inappropriate, although the list varies across time and space. There are some things like charging interest on loans and buying life insurance that were at one time thought to be immoral and now perfectly acceptable, although even today not everyone accepts interest payments. Some things like slavery that were once accepted, meanwhile, are now thought to be immoral There are also some jurisdictions where markets for sex are accepted, while in others it is banned. One of the factors that has been identified as affecting the acceptability of markets is “repugnance” – people are simply turned off by the concept and want it banned.v One example is the ban in California on horsemeat in restaurants. Neither safety nor health considerations noted in the ban; it is simply banned because some people find it repulsive, even though it is entirely acceptable to have it in dog food and to serve it in restaurants in Europe.

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