Unit 8 Supply and demand: Markets with many buyers and sellers
8.6 Changes in supply and demand
Quinoa is a cereal crop grown on the Altiplano, a high barren plateau in the Andes of South America. It is a traditional staple food in Peru and Bolivia. At the beginning of the twenty-first century, as its nutritional properties became known, there was a huge increase in demand from richer, health-conscious consumers in Europe and North America. Figures 8.13a and 8.13b show that the price of quinoa trebled and production almost doubled in 10 years. Figure 8.13c indicates the strength of the increase in demand: spending on imports of quinoa rose from just $2.4 million to $43.7 million.
Figure 8.13a The production of quinoa.
Jose Daniel Reyes and Julia Oliver. 2013. ‘Quinoa: The Little Cereal That Could’. The Trade Post. 19 March. Underlying data from Food and Agriculture Organization of the United Nations. FAOSTAT Database.
For the producer countries, these changes were a mixed blessing. While their staple food became expensive for poor consumers, farmers—who are among the poorest—benefited from the boom in export sales.
Figure 8.13b Quinoa producer prices.
Jose Daniel Reyes and Julia Oliver. 2013. ‘Quinoa: The Little Cereal That Could’. The Trade Post. 19 March. Underlying data from Food and Agriculture Organization of the United Nations. FAOSTAT Database.
How can we explain the rapid increase in the price of quinoa? In this section and the next, we analyse the effects of changes in demand and supply using simple examples. At the end of the next section, you can apply the analysis to the real-world case of quinoa.
Figure 8.13c Global import demand for quinoa.
Jose Daniel Reyes and Julia Oliver. 2013. ‘Quinoa: The Little Cereal That Could’. The Trade Post. 19 March.. Underlying data from Food and Agriculture Organization of the United Nations. FAOSTAT Database.
An increase in demand
Imagine a market in which hat sellers make and sell hats to consumers. Figure 8.14 shows the competitive equilibrium of this market. At point A, the equilibrium price equalizes the number of hats demanded by consumers and supplied by hat sellers. At this point, no one can benefit by offering or charging a different price, given the price everyone else is offering or charging—it is a Nash equilibrium.
Suppose that hat-wearing becomes more fashionable. More people want to buy hats. Follow the steps in Figure 8.14 to analyse the effects of this increase in the demand.
The increase in demand moves the equilibrium from A to C, where more hats are sold at a higher price. Since the price is higher, additional hats are produced at higher marginal cost. Although more people buy hats at point C compared to point A, those with WTP between $8 and $10 (between points C and D) no longer want to buy.
We have described the scenario in which hats become more fashionable as an ‘increase in demand’. It’s important to understand exactly what we mean:
- Demand is higher at each possible price, so the demand curve has shifted.
- In response to this shift, there is a change in the equilibrium price. At the current price, sellers find that they can sell more hats than before.
- Sellers respond to this price message by increasing the quantity supplied, along the supply curve.
- But the supply curve itself has not shifted (the marginal costs of hat sellers have not changed): instead the equilibrium quantity supplied has increased because of the price change.
Figure 8.14 shows that if the supply curve were steeper (more inelastic), price would rise more and quantity would increase less. Conversely, if the supply curve were quite flat (elastic), then the price rise would be smaller and the quantity increase larger.
- exogenous shock
- An exogenous shock (for example a demand shock or a supply shock) is a change in one or more of the exogenous variables in a model—that is, variables that are othewise held constant by the modeller.
- exogenous
- Exogenous means ‘generated outside the model’. In an economic model, a variable is exogenous if its value is set by the modeller, rather than being determined by the workings of the model itself. See also: endogenous.
Shifts in demand (or supply) are often referred to as exogenous shocks in economic analysis. We start by specifying an economic model and find the equilibrium. Then we analyse how the equilibrium changes when something changes—the model receives a shock. The shock is called exogenous because the model doesn’t explain why it happened: it shows the consequences, not the causes.
Market equilibration through rent-seeking
How does the hat market adjust from A to C? At the original competitive equilibrium, the price of a hat was $8, and all buyers and sellers were acting as price-takers. When demand increases, they do not immediately know that the equilibrium price has risen to $10. If everyone were to remain a price-taker, the price would not change. But when demand shifts, some of the buyers or sellers will realise that they can benefit by being a price-maker, and decide to offer or charge a different price from the others.
For example, when a hat seller notices that every day there are customers wishing to buy hats, but none left on the shelf, she realises that some of them would be happy to pay more than the going price. And that some who had bought hats at the going price would have been willing to pay more. So she will raise her price the next day—price-taking is no longer her best strategy, and she becomes a price-maker. She does not know exactly where the new demand curve is, but she realises that now there are people who want to buy hats, but go home disappointed.
By raising the price, she raises her profit rate. If she was making normal profit in the original equilibrium, she is now earning an economic rent (at least temporarily)—that is, higher profits than are necessary to keep her hat business going.
Moreover, because hats are now being sold at prices above the marginal cost in the hat industry, some sellers will produce and sell more hats. As a result of the rent-seeking behaviour of hat sellers, a new equilibrium is reached at point C in Figure 8.14. At this point, the market again clears and none of the sellers or buyers can benefit from charging a price different from $10. They all return to being price-takers, until the next shock comes along.
- disequilibrium rent
- The economic rent that arises when a market is not in equilibrium, for example when there is excess demand or excess supply in a market for some good or service. In contrast, rents that arise in equilibrium are called equilibrium rents.
When a market is not in equilibrium, both buyers and sellers can act as price-makers, transacting at prices different from the previous equilibrium price and earning disequilibrium rents. In the opposite case of a fall in demand for hats, there would be excess supply at the original equilibrium price of $8. A customer at the hat shop might say to the hat seller: ‘You have quite a few unsold hats piling up on your shelf. I’d be happy to buy one of those for $7.’ To the buyer this would be a bargain. But it may also be a good deal for the seller, if at the reduced level of sales $7 is still greater than the marginal cost of producing a hat.
An increase in supply due to improved productivity
As an example of an exogenous increase in supply (a supply shock), think again about the case of the bread market. The supply curve represents the marginal cost of producing bread. Suppose that bakeries discover a new technique that allows workers to make bread more quickly. This will reduce the marginal cost of a loaf at each level of output. The marginal cost curve of each bakery shifts down, and so does the market supply curve.
Figure 8.15 shows the original supply and demand curves for the bakeries, and what happens when marginal costs fall.
The improvement in the technology of breadmaking leads to:
- an increase in supply (the supply curve shifts)
- a fall in the price of bread
- a rise in the quantity sold.
The demand curve does not shift, but the quantity demanded rises along the demand curve in response to the price change.
The supply curve would also shift if the number of firms in the market and their capacity for producing bread were to change. In the next section, we consider why and how this might happen, and how the equilibrium would change.
Exercise 8.5 Prices, shocks, and revolutions
Historians usually attribute the wave of revolutions in Europe in 1848 to long-term socioeconomic factors and a surge of radical ideas. But a poor wheat harvest in 1845 lead to food shortages and sharp price rises, which may have contributed to these sudden changes.1
The table shows the average and peak prices of wheat from 1838 to 1845, relative to silver. There are three groups of countries: those where violent revolutions took place, those where constitutional change took place without widespread violence, and those where no revolution occurred.
- Explain, using supply and demand curves, how a poor wheat harvest could lead to price rises and food shortages.
- Find a way to present the data to show that the size of the price shock, rather than the price level, is associated with the likelihood of revolution. (An Excel file containing this data is available for download).
- Do you think this is a plausible explanation for the revolutions that occurred?
- A journalist suggests that similar factors played a part in the Arab Spring in 2010. Read the post. What do you think of this hypothesis?
Avg. price (1838–45) |
Max. price (1845–48) |
||
---|---|---|---|
Violent revolution (1848) | Austria | 52.9 | 104.0 |
Baden | 77.0 | 136.6 | |
Bavaria | 70.0 | 127.3 | |
Bohemia | 61.5 | 101.2 | |
France | 93.8 | 149.2 | |
Hamburg | 67.1 | 108.7 | |
Hessedarmstadt | 76.7 | 119.7 | |
Hungary | 39.0 | 92.3 | |
Lombardy | 88.3 | 119.9 | |
Mecklenburgschwerin | 72.9 | 110.9 | |
Papal states | 74.0 | 105.1 | |
Prussia | 71.2 | 110.7 | |
Saxony | 73.3 | 125.2 | |
Switzerland | 87.9 | 146.7 | |
Württemberg | 75.9 | 128.7 | |
Immediate constitutional change (1848) | Belgium | 93.8 | 140.1 |
Bremen | 76.1 | 109.5 | |
Brunswick | 62.3 | 100.3 | |
Denmark | 66.3 | 81.5 | |
Netherlands | 82.6 | 136.0 | |
Oldenburg | 52.1 | 79.3 | |
No revolution (1848) | England | 115.3 | 134.7 |
Finland | 73.6 | 73.7 | |
Norway | 89.3 | 119.7 | |
Russia | 50.7 | 44.1 | |
Spain | 105.3 | 141.3 | |
Sweden | 75.8 | 81.4 |
Helge Berger and Mark Spoerer. 2001. ‘Economic Crises and the European Revolutions of 1848.’ The Journal of Economic History 61 (2): pp. 293–326.
Exercise 8.6 Cotton prices and the American Civil War
Read Section 8.1 and the ‘Great economists’ box about Friedrich Hayek. Use the supply and demand model to represent the following events described in the reading. In each case, indicate which curve(s) shift and explain the result.
- The increase in the price of US raw cotton (show the market for US raw cotton, a market with many producers and buyers).
- The increase in the price of Indian cotton (show the market for Indian raw cotton, a market with many producers and buyers).
- The reduction in textile output in an English textile mill (show a single firm in a competitive product market).
Question 8.8 Choose the correct answer(s)
Figure 8.14, reproduced here, shows the hat market before and after a demand shift. Based on this information, read the following statements and choose the correct option(s).
- Sellers would not increase sales beyond A at $8, because their marginal cost would be higher than $8.
- Adjustment requires prices and quantities to be changed. Rent-seeking provides incentives for buyers and sellers to make these changes.
- Until the new equilibrium is reached, buyers and sellers may find opportunities to benefit from transactions at different prices.
- In the new equilibrium, supply must equal demand (at the new demand curve). The new equilibrium price will be $10.
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Helge Berger and Mark Spoerer. 2001. ‘Economic Crises and the European Revolutions of 1848.’ The Journal of Economic History 61 (2): pp. 293–326. ↩