Reading: Lesson 2 - Using the Supply-and-Demand Framework

1. A Shift in Demand

1. Recall the second story from the chapter introduction about Detroit Tiger merchandise. In that story, we learned that “most shops have marked down jerseys and T-shirts branded with ex-Tigers between 25 and 50 percent.” The Figure below "Shifts in Household Demand" shows the demand of a typical Detroit household’s demand for Granderson shirts. Now that Granderson has left the Tigers for the New York Yankees, the household’s marginal valuation for these shirts is lower. At any given price, a household wants to purchase fewer shirts, so the household’s demand curve shifts to the left. 
   

   
   
   

   Note: A decrease in the marginal valuation of Granderson T-shirts leads a household to demand a smaller quantity at any given price. This means that a household’s demand curve shifts to the left.

2. We would expect that this shift in demand would apply to most households that contain Detroit Tigers fans. If we now add all the demand curves together, we get the market demand curve. The market demand curve shifts to the left (the Figure below "Shifts in Market Demand"). The end result is that we expect to see a decrease in the price of T-shirts—that is, the retailers put them in the discount bins—and also a decrease in demand. 
   

   
   
   

   Note: The decrease in demand causes both the equilibrium price and the equilibrium quantity of T-shirts to decrease.

2. Shifts in a Curve versus Movements Along a Curve

1. Understanding the distinction between moving along a curve (either supply or demand) and shifting a curve is the hardest part about learning to use the supply-and-demand framework. Journalists and others frequently are confused about this—and no wonder. It requires practice to learn how to use supply and demand properly.

   Let’s look at another example. An article in the British newspaper the Guardian reported about sales of beef when the news came out that eating beef might carry a risk of bovine spongiform encephalopathy (BSE), better known as mad cow disease. On November 1, 2000, the newspaper wrote, “Beef sales did drop after the link between BSE and deaths in humans was circumstantially established in 1996, but they have recovered as prices have fallen.”“First Beef—Now Lamb to the Slaughter?” Analysis, Guardian, November 1, 2000, accessed February 4, 2011, http://www.guardian.co.uk/uk/2000/nov/01/bse?INTCMP=SRCH.

   
   

2. The exogenous event here is the medical news about beef and mad cow disease. Presumably, this primarily affects the demand for beef: consumers decide to eat less beef and more of other products—such as chicken and pork. The demand curve for beef shifts to the left. As we saw in the T-shirt example, a leftward shift of the demand curve has two consequences: price decreases, and the quantity demanded and supplied also decreases. Thus the conclusion that the news should lead to a decrease in beef sales is perfectly consistent with our supply-and-demand analysis, as well as with common sense.
   

3. But what about the second part of the sentence? The article claims that beef sales “have recovered as prices have fallen.” This is not consistent with our supply-and-demand analysis. The decrease in prices is intimately connected with the decrease in quantity: both were caused by the health news. They are two sides of the same coin, so it does not make sense to use the decrease in prices to explain a recovery in beef sales.
   

4. In fact, you should be able to convince yourself that an increase in beef sales together with a decrease in prices (as asserted by the article) would require a rightward shift of the supply curve. (Draw a diagram to make sure you understand this.) It seems unlikely that health concerns about beef led cattle farmers to increase their production of beef. It is hard to escape the conclusion that the journalist became confused about shifts in the demand curve and movements along the curve.
   

3. Estimating Demand and Supply Curves

1. Comparative statics allows us to make qualitative predictions about prices and quantities. Given an exogenous shock in a market, we can determine whether (1) the price is likely to increase or decrease and (2) the quantity bought and sold is likely to increase or decrease. Often, though, we would like to be able to do more. We would like to be able to make some predictions about the magnitudes of the changes.
   
   
2. Figuring out what will happen to equilibrium prices and quantities requires economists to know the shapes of supply and demand. When the supply curve shifts, we need to know about the slope of the demand curve to predict the impact on price and quantity. When the demand curve shifts, we need to know about the slope of the supply curve to predict the impact on price and quantity. More precisely, we need measures of the elasticity of demand and of supply.
   
   
3. How do economists learn about these elasticities? The answer, perhaps surprisingly, is through the logic of comparative statics. For example, suppose the supply curve does not move, but the demand curve shifts around a lot. As the demand curve shifts, we observe different combinations of prices and quantities. Part (a) of the Figure below "Finding the Elasticities of the Supply and Demand Curves" shows this in a supply-and-demand diagram. The different points that we observe are points on the supply curve. If the demand curve shifts but the supply curve does not, we eventually gather data on the supply curve. We can use these data to come up with estimates of the price elasticity of supply. 
   

   
   
   

   Note: Economists estimate the elasticities of supply and demand curves by looking for situations in which one curve is relatively stable while the other one is moving. What we actually observe are the equilibrium points. Movements in the demand curve (a) mean that the equilibrium points trace out the supply curve; movements in the supply curve (b) allow us to observe the demand curve. In most real-life cases, both curves move, and economists use sophisticated statistical techniques to tease apart shifts in supply from shifts in demand.

4. Part (b) of the Figure above "Finding the Elasticities of the Supply and Demand Curves" shows the opposite case, where demand is stable and the supply curve is shifting. In this case, the data that we observe are different points on the demand curve. We can use this information to estimate the price elasticity of demand, which is the percentage change in the quantity demanded divided by the percentage change in price. It is important to note that we are speaking here about the elasticity of the market demand curve, not the elasticity of the demand curve facing an individual firm.
   

5. This sounds straightforward in theory, but it is difficult in practice. Economic data are messy. Typically, both the demand curve and the supply curve are shifting simultaneously. If economists had access to controlled environments, perhaps like a biochemist does, we could “shift the demand curve” and see what happens in the laboratory. Occasionally, we get lucky. Sometimes we can isolate a particular event that we know is likely to shift only one of the curves. This is sometimes called a natural experiment. Most of the time, however, we are not so lucky. Economists and statisticians have come up with sophisticated statistical techniques to disentangle shifts in demand and supply in these circumstances.
   

Checking Your Understanding

1. Suppose coffee crops in Brazil are destroyed by inclement weather. What happens to the supply curve for coffee? What happens to the price of coffee and the equilibrium quantity of coffee?
2. The discussion of the Detroit Tigers states that “it’s too soon to tell which Tigers will prove popular at the checkout line.” Suppose that Miguel Cabrera has an excellent season and breaks the home run record. What do you expect will happen to the price and quantity of T-shirts with his name on the back?
3. In our discussion of the demand for beef and mad cow disease, we said that an increase in quantity and a decrease in price require a rightward shift of the supply curve. Draw a diagram to illustrate this case.