2. Supply and Demand, often it works in reverse.
After we have understood the nature of money, perhaps the second most fundamental thing to understand in economics is the concept of supply and demand.
The relationship between the demand for some particular good and the amount of that good that will get supplied can be very complex. For example, short-term reactions to changes in either supply or demand can be very different to, or even the opposite of, long-term reactions. Economists typically use the mathematical tool supply and demand curves to model real-world economic behaviours. These curves are often required to slide up and down or left and right over time in order to accommodate awkward economic phenomena. Some economists have questioned the validity of using these curves as the basis of any economic analysis at all. In this chapter we will look at the idea of supply and demand without the use of those curves. This chapter is not intended to be comprehensive. It will only consider the types of market which will be useful to understand when developing arguments used later.
The whole idea of supply and demand is that there are forces which drive them to be in equilibrium with each other. That is to say that if demand is greater than supply or supply is greater than demand then incentives will be created for actions to be taken which will tend to redress the balance. The table below shows the approximate nature of those actions.
Current state
What this means
What will happen in the short term?
What will happen in the long term (perhaps several years)?
Demand greater than supply
The manufacturers can sell everything they make despite setting a price so high that they are more profitable than other comparable industries.
Manufacturers make large profits.
The company may be tempted to expand production. Potential rivals will observe the high profits to be made in this sector and be tempted to join in. Either action will eventually lead to increased supply.
Supply greater than demand
The only way that manufacturers can sell all that they make is to lower their prices to such a level that they are less profitable than other comparable industries.
Poor or even negative profits to be made.
Depending on the severity of the lack of demand, the companies may eventually start laying off staff, or go bust. Either of these actions will eventually lead to reduced supply.
Supply equals demand
Manufacturers are making profits on a par with comparable industries.
No change.
No change.
Looking at this table, you may wonder why the actions described in the far right column are labelled as “long term”. This is actually a bit of a generalisation and there are exceptions, but the gist is that the rate of production of a great many goods is rather awkward to change at short notice. In order to increase production, new machinery may need to be purchased, new factories built, new staff hired and trained. Depending on the industry this could take months or years. All of these things are very risky and companies may be reluctant to do them at all unless they are thoroughly convinced that the increase in demand is going to be sustained. They may well wish to monitor the demand for a while in order to build up the confidence to risk the money required for the new investment. Equally, decisions about reducing production may happen rather slowly. Business managers will usually be reluctant to make staff redundant for personal reasons. They may simply not give them any annual pay rise, or they may cut their pay. They may also be rather slow to make people redundant just in case the downturn in demand turns out to be temporary or the next marketing campaign saves the day.
Balancing supply and demand for Product X can be restated as the combination of the following two phenomena, one that acts quickly and one that in general acts more slowly:
Fast acting: The selling price of X is adjusted up or down such that the selling rate matches what producers can comfortably keep up with using existing factories, mines or workers. As markets change and evolve. I.e. in the short term, prices are tuned such that the selling rate will tend toward the current comfortable rate of production.
On a longer timescale: If producers are making excess profits then consider increasing capacity. If producers are making insufficient profits then consider decreasing capacity.
The model presented so far describes the supply and demand mechanism for a great deal, perhaps the majority, of normal goods and services. But there are a variety of special cases where things act a little differently. One such case is where the rate of supply of a good is not under the direct control of the people who sell it.
The special case of the supply not being in direct control of the producers
Imagine a company that sells bottled water from one particular spring. If the demand was to rise, there would be no way of creating any more supply. In this case the price would simply be adjusted upwards until the rate of sales again matched the rate of flow of the spring.
In the special case of the supply not being in direct control of the producers, balancing supply and demand can be restated as simply:
Adjust the price such that you sell at a rate that matches what you can comfortably keep up with.
We shall be relying on this formulation later in the book in relation to bank lending.
Supply and demand for investment products
So far the discussions of supply and demand have all concerned goods which have a fairly straightforward and short path from production to sale and consumption. There are, however, some items of value that tend to change hands many times and are not so obviously “consumed”; for example, shares, bonds and houses.
The classical model of supply and demand now runs into a big problem which has not been fully appreciated by sections of the economics profession. For normal “consumed” goods it is usually obvious that higher prices deter buyers and lower prices encourage buyers. Unfortunately too many economists believe that this principle applies equally to items purchased as an investment or partially as an investment.
To illustrate what is wrong with this idea, consider a hypothetical price history of Product X shown in the figure below. Imagine that this is happening in a country with very low inflation, so the price rise is real. If Product X is a consumer good, perhaps a type of food, it is clear that the rising price will discourage purchases; people will increasingly consume some alternative foodstuff instead. But now imagine that X is an “investment product”, something that people purchase in the hope that they can sell it on at a higher price at some later time. The classical laws of supply and demand would suggest that the current high price will deter purchases, but is it so clear that people will ignore the history of the price? How would you feel about purchasing this product as an investment? Would you ignore the history of the development of the price?
How about a falling price history shown in the following figure. How would you feel about purchasing Product X with an eye to selling it on a few years later?
The free market fundamentalists implicitly believe that virtually all investors completely ignore the history of the development of the price of investment products and base their purchasing decisions purely on the basis of the current price. In this book we take the view that many investors do indeed take the history of the current price into consideration as part of their decision to purchase or not. It is human nature to assume that almost anything that has been steadily behaving in a certain way for a long time will continue to behave in that way. This principle is built into the way our brains operate and learn. Mankind was confident that the sun would rise each morning simply because it always had in the past. This confidence came about long before any knowledge of gravity or the laws of motion. Everyone knows people who would insist that house prices would always go up, not because of any technical analysis of demographics and building regulations, but simply “because they always have”. Keynes appeared to be well aware of this phenomenon when in 1937 he wrote:
We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.
The act of taking the history of a price into consideration vandalises the simple law of supply and demand for that product. A rising price can sometimes entice purchasing rather than discourage it, especially if the history of the price rise is seen to be steady and reliable in recent history rather than chaotic. In finance, the process of assuming that future price changes will carry on in the same direction as previous price changes is known as 'trend following'. Trend following is kryptonite to most economists because it destroys so many theories and principles on which they rely.
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