VIII. THE INTERACTION OF DEMAND AND SUPPLY

Now that we know about quantity demanded, demand, quantity supplied and supply, we are ready to put supply and demand together and see how they interact. In FIGURE V, we see that at a price of $1 per gallon of gasoline, the quantity demanded is 500 million gallons a day, while the quantity supplied is only 450 million gallons per day, a shortage of 50 million gallons per day. With this shortage, the service station owners see cars begin to line up at their pumps and notice that they can sell all that they have at $1 per gallon and they could sell more if they could only get more gas. In these conditions, merchants find that they can raise prices and still sell all that they can get their hands on. So prices at the stations begin to rise.

If the prices rise to $1.25 per gallon, we see that the plans of the buyers to get gas and the plans of the sellers to sell gas just coordinate. At that price, consumers plan to buy 480 million gallons of gas per day and producers are willing to supply 480 gallons per day. The higher price of gas did two things, it got the consumers to reduce the amount of gas they planned to use, while at the same time encouraging producers to offer more gas on the market for sell.

If the market had started out at a price of $1.50, instead, consumers would have planned to buy 460 million gallons of gas per day, while producers would have planned to sell 510 million gallons of gas per day. Producers would have found themselves with gasoline that they could not sell, and would begin to run out of storage facilities. In an attempt to sell off some of their excess gasoline, some producer would begin to sell at a price below $1.50 and the price would fall and keep falling until it reached a stable price of $1.25 per gallon, and output and consumption rates matched at 480 million gallons per day.

We call this an equilibrium in the market, as the buyers' upward pressure on price is matched by the sellers' downward pressure on price, and the plans of the buyers and sellers are coordinated. The equilibrium price and quantity is where the supply curve intersects the demand curve, where the quantity demanded equals the quantity supplied at the going price. At prices above this equilibrium, quantity supplied will exceed quantity demanded and so a surplus appears on the market. At prices below this equilibrium, quantity demanded will exceed the quantity supplied and so a shortage appears on the market. Mathematically, this can be thought of as the solution to the system of simultaneous equations, demand and supply, with two unknowns, price and quantity.

FIG V

Supply and Demand

H. Resource allocation and communication between buyers and sellers

Case: Cigarette production after the 1964 Surgeon General's Report on the Health Effects of Smoking

Notice that if there is some change in people's tastes or information about health effects of certain goods, producers will respond in the direction of the change in tastes or health concerns. In 1964, the Surgeon General of the U.S. issued a report to the American people on the higher risks of heart disease and lung cancer associated with cigarette smoking. The demand for cigarettes fell and cigarette producers reduced their production. If producers had not dropped production, a surplus of unsold cigarettes would have begun to accumulate, production with associated costs that would not be matched with sales revenues.

Case: Hussein, the price of oil, and U.S. energy policy

Now let us examine how a change in one external factor will affect the price and quantity on a market. Let us begin with a market that is currently in equilibrium, such as the gasoline market depicted in FIGURE V, at a price of $1.25 per gallon and buyers and sellers trading 480 gallons per day, with no shortages and no surpluses. Now suppose a Madman invades a major oil producing country and there is a much higher chance that war will break out in a region of the world that produces most of the world's oil, which could send oil prices in the future soaring. Selling gas in the future is a close substitute in production with selling it now. The price of future gas is expected to be higher than it was once expected to be. The opportunity cost of selling gas now is much higher than it once was, because now, by holding on to it until the price goes up, one can expect to make a profit. Buyers respond to the higher prices by conserving gasoline. Producers respond by searching for alternative means of production and by finding new products that will not need gasoline that will achieve the same objectives for consumers, such as compressed natural gas.

Notice that gasoline use is shifted from the present when it is relatively plentiful and relatively cheap to the future when it is expected to be harder to obtain and relatively expensive compared to today's prices. No "National Energy Policy" is needed, no central direction of production or consumption was needed to assure adequate supplies of gasoline. We did not have adequate supplies of gasoline in 1973­4 and 1978 because this price mechanism was not allowed to work. Those who clamor for a "National Energy Policy" either have no understanding of how markets work, or have some ulterior motive that I shudder to think about.

Case: Joseph and Pharoe's Dream

The same sort of reallocation from present use to future use occurred when Joseph told Pharoe the meaning of Pharoe's dreams of seven fat calvesfollowed by seven emaciated calves. Joseph told Pharoe that it meant that there would be seven years of abundant harvest followed by seven years of famine. Pharoe followed Joseph's forecast of harvests and grain prices and bought up grain during the low prices of the seven years of plentiful harvest, stored the grain until the years of famine, and sold the grain at a huge profit. Grain prices would have been lower in the seven years of bountiful harvest, had it not been for Pharoe's increased buying of grain. Grain prices would have been higher during the seven years of famine had it not been for Pharoe's increased selling in those years. People cut back on their consumption during the seven years of bountiful harvest because of the higher prices, and they were able to consume more grain during the famine. Speculators are very helpful.

The remarkable thing with markets is that consumers and producers, each acting in their own interests, without any central authority, without a central plan, coordinate their plans. The former Soviets with their central plans cannot produce the goods that their people want. They produce too much of one good, not enough of some other essential good, such as food or toilet paper. Production is coordinated by committee, not directed by consumers' desires. The decentralized planning, the no­central­plan plan, seems to coordinate individual plans the best. The problem with the central plan is that without the profit incentive, there is no impetus for producers to seek to discover what consumers want.

Case: Hurricane Hugo and the price of ice

In 1989 a terrible hurricane struck the coast of South Carolina. People were without electricity for a long time in some areas. This meant that people had great difficulty in refrigerating their food. Some people who had ice for sale were chastised for "profiteering," charging very high prices for their ice. The high prices did two things, though. First, it made people cut back on their use of ice, using it only for the most important uses. Second, it gave other profit seekers an incentive to rush into South Carolina with loaded down ice trucks. If price were not allowed to "seek its own level," people would not conserve as much, nor would people be as quick to "export" ice to South Carolina.

I. Repealing the laws of supply and demand

Case: The Pharmaceuticals Shortage in Germany

Reunited Germany passed a law that went into effect January 1, 1991. To ease the transition that the East Germans make to a free market society, pharmaceuticals sold in East Germany must be sold at 50% of the West German price. The drug companies now refuse to sell in East Germany, as they can sell what they make for more in other countries. Now Germany has made the East Germans feel right at home­­they are used to not being able to buy essential goods.

Case: Diocletian's Edict in Ancient Rome

In the year 302 A.D. the Roman emperor Diocletian "commanded that there should be cheapness." His edict declared:

Unprincipled greed appears wherever our armies, following the commands of the public weal, march, not only in villages and cities but also upon all highways, with the result that prices of foodstuffs mount not only fourfold and eightfold, but transcend all measure. Our law shall fix a measure and a limit to this greed.

Why do you think Diocletian found food prices higher wherever he marched with his armies? What result would you anticipate from the command that "there should be cheapness"?