A Frequent Confusion and the Yo-Yo Economic Model By Pierre Lemieux

by Pierre Lemieux

“…without clear concepts, the theory is muddled and confusion reigns. There is no way to think clearly about how different factors will influence price and quantity because “demand” (or “supply”) means two different things. “

It is a bit frustrating that even the financial press often confuses demand and quantity demanded, or supply and quantity supplied. Consider a recent example from the Wall Street Journal (“Five Potential Risks to the Oil Rally,” January 16, 2018):

Strong demand for crude … has also fueled the recent rally… But the rising cost of oil could temper demand growth.

Demand is the whole schedule of the different quantities demanded at different prices. Quantity demanded is a specific price-quantity combination on the demand schedule. Demand is like a list; quantity demanded, an item on the list. When demand changes–say, it increases as in the first part of the Wall Street Journal sentence–the whole schedule changes. When quantity demanded changes, we move to another combination on a demand schedule. So what the rising price (that’s obviously what they mean by “cost”) could temper is quantity demanded, not demand. The confused statement quoted implies that an increase in demand has pushed up the price (“Strong demand for crude … has also fueled the recent rally”), which is correct, and that the price increase could reduce demand (“the rising cost of oil could temper demand growth”), which is at best muddled.

The same confusion affects the difference between supply and quantity supplied. If the sort of reasoning implied by these confusions were correct, prices and quantities would never change. An increase in demand would increase prices, which would reduce demand. Similarly, an increase in supply would push prices down, which would decrease supply.

We would live in a world similar to the one imagined by pre-Socratic philosopher Zeno, where everything is immobile, and change merely an illusion. Remember Zeno’s paradox. Achilles can never catch the tortoise he is chasing: before reaching it, he would have to run half the distance between them, which requires as a prerequisite to run half of that distance, that is, a fourth of the distance that separates him from the tortoise, and one-half of this fourth, and so on ad infinitum.

As it often happens, it is easier to see the distinction in mathematical or graphical form. Consider the chart below, which provides a stylized picture of the market for a given good. Prices (P) are given on the vertical axis, and quantities (Q) on the horizontal axis. The demand schedule is represented by demand curve D1, on which any point is the quantity demanded corresponding to a particular price. Quantity demanded (nearly always) varies inversely with price, as demonstrated in demand theory: it’s called the “law of demand.” The supply schedule is represented by supply curve S1, any point of which is the quantity supplied at a particular price. Quantity supplied typically varies directly with price, as demonstrated in cost theory (under certain assumptions).

Given demand D1 and supply S1, the equilibrium price will be P1, and both the quantity supplied and demanded equal to Q1. (Note that it is only when the equilibrium price obtains that quantity demanded equals quantity supplied.) Now suppose that demand increases so that the demand curve shifts to D2. Ceteris paribus, the price will increase to P2, and quantity supplied (and demanded) to Q2. Similarly, with demand as D1, if supply increases so that the supply curve shifts to S2, ceteris paribus, price will decrease to P3 and quantity demanded (and supplied) will increase to Q3.

Why does this matter? Because without clear concepts, the theory is muddled and confusion reigns. There is no way to think clearly about how different factors will influence price and quantity because “demand” (or “supply”) means two different things. Consider the following case from the Financial Times (“The Five Main Drivers of Oil Prices,” April 5, 2016):

Low prices helped propel global demand growth in 2015, but the picture for this year is more mixed. Concerns about a slowing economy in China have weighed on the outlook; a warm winter reduced demand for heating oil.

The first “demand” refers to quantity demanded (to a move along the demand curve because supply has increased from S1 to S2), while the second “demand” properly means demand (that is, the whole curve shifts down from D2 to D1). The author does not seem to clearly understand that, in order to predict the quantity demanded and supplied next year, he first has to predict the evolution of demand and the evolution of supply which, as whole schedules, do not respond to prices but to other factors such as population and income growth, or weather on the side of demand and cost of production on the side of supply. Prediction is already difficult without muddling the causal factors involved.

With hindsight, we know that, in 2016, world demand (“consumption” in the BP Statistical Review of World Energy 2017) of crude oil continued to increase despite a drop in prices. This is of course because supply increased more than demand; otherwise, oil prices would have increased.

Consider a more glaring example of the sort of absurdity that follows from the demand-supply-quantity confusion. A Financial Times journalist writes (“The Price Supply Disconnect,” January 21, 2015):

To put it very simply, as prices rise companies invest and supply increases. Prices then fall, which leads to production cuts, and eventually demand increases, pushing up the market and the cycle starts all over again. That is, at least, the theory.

False, of course. The theory says instead: As prices rise companies invest and quantity supplied increases. Prices don’t fall since we have just seen that they rise. And if prices did fall (because, say, supply has increased), quantity demanded not demand will increase. So the cycle does not start all over again, for the market has reached a new equilibrium. The price does not just go down because it has gone up, and then up because it has gone down. Economic theory is not based on a yo-yo model. The journalist may regret to have skipped ECON 101!

The real world is admittedly more complicated than the economist’s neat supply-demand model suggests. Producers plan quantity supplied as a function of expected, not current, prices; and forecasting errors mean that prices can temporarily overshoot their equilibrium levels. In the long run, higher prices can generate abnormal profits, which do push down the short-run supply curve. Everything is always more complicated than any explanation can convey; otherwise the explanation would only be an exhaustive description of a particular event. To understand complicated things, we must first understand simple ones.

The world would be a better place if more people understood it better, and people would understand it better with more economic literacy.