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Fig. II

Demand Increase

Demand Decrease

i : °



Assume that, at one and the same dme and for unrelated reasons, a new epidemic of Mediterranean fruit flies strikes just as the wages of chemical workers producing insecdcides rise. We are therefore dealing vviih two effects: the first, the new epidemic, will increase the demand for the fruit fly insecdcide malathion, while the second, higher wages in the chemical industry, will decrease the malathion supply. Figure V models the situadon. Inidally equilibrium malathion price and quandty, P and Q, are given by the intersecdon of the original supply and demand curves S and D. But the new situadon decreases the supply to Sj and increases demand to Di. (You can ignore D2 for now.) In the new equilibrium, price vvill rise to Pj and quantity demanded will fall to Qj Given that the curves have normal slopes, price must unambiguously rise because both shifts work together to pull price upward. However, the effect upon equilibrium quantity is unpredicuble from the information given. Here the demand increase pulls quantit) upward, while die supply decrease pulls it downward. Because the shifts pull quandtv- in opposite direcuons, the final re.sult depends upon the size of the two effects. In Figure V the supply decrease overpowers the demand increase to D). causing the quandty sold to fall to Qj On the other hand, should the demand increase be strong enough to shift the curve to D2 instead of Dj, the equilibrium quantity would have risen to Q2 rather dian decreased to Qi.

Although we shall not graph these cases, in other instances the change in quantity can be predicted but not the change in price. If for example, demand had increased at the same time that an advance in malathion producdon had increased the

supply, we could predict die effect upon quandt) but] not the effect upon price. Again, because bothj changes pull quandty upward, die equilibrium quanti-J t) must unambiguously increase. Because the two! shifts pull price in opposite direcdons, the effect onj the equilibrium price will be uncertain. The gene rule can be summarized as follows:

(1) If supply and demand change in oppositi directions, we can predict the impact upon price bu not upon quandty sold.

(2) If, however, supply and demand change i the same direcdon, we can predict the impact ] quandty sold, but not upon price.


At the start of Section I we noted that die; cauon of a capitalist economys scarce resources made via die price system. That is to say, that pric are highly compact bits of information which fil through the economy giving those most affected informadon they should know. The formal appar weve constructed so far allows us to trace some of t effects. Suppose there is an increase, in the dema for bicycles. At first bicycle shops will see their inv tories of bicycles being driven down. To repleiiij these depleted inventories, shops will place grea orders with bicycle manufacturers. In response j these increased orders biqcle makers will likewise 1 tially draw down their own inventories. But if] suaded that the increase in orders is relatively peri] nent rather than just a temporary flucuiation, they want to place more orders for rubber, metals, pla fitungs, labor, and other bicycle components, acquire more of these inputs, they will need to


Fig. IV

Supply Increase




1 ,

pii; them away from competing uses, that is to say, tliey yvill f need to bid up their prices.

Bicycle manufacturers therefore stand willing to produce more bicycles, but only if the}- get a higher price to cover dieir increased costs. Bike shops will likewise be delighted to sell more biqcles, but will truthfully report to the public that they first raise their retail prices purely in response to bicycle manufacturers increased prices. Uldmately bicycle buyers will be able to buy more bikes, something they signaled they wanted by their demand increase, but they will have to th pay higher prices for them. To the outside observer it looks as if die increase in retail price is due to an .increase in costs, when, in fact, the entire increase in costs is due to an increase in demand.

The fact that the actual cause of die price increase is inrisible is at once a strength and a weakness of the price system. It is a strengdi because the system transmits only the realh crucial information; namely, that someone is willing to pav more for the parts needed to manufacture bicycles. Just as organisms need not understand diffusion in order to breathe, neither do traders need to understand the mechanism of supply and demand in oider to respond appropriately. Indeed, both respiration and markets have functioned well for thousands of vears before anyone grasped the nature of either.

Sometimes economic transactions are incor-recdy understood, and this becomes the price systems essential yveakness. Because it falsely appears that bicycle prices risen due to cost increases to the middleman bicycle seller, it seems to follow thai holding down costs through price controls should lead to uced consumer prices. But not only is this line of

thought utterly false, the policy which somedmes follows from it is positively counterproducdve.

Think about this for a moment Are surgeons who need double the normal dme to perform an appendectomy paid twice as much due to their higher costs? Do rock stars fetch higher prices than surgeons due to their higher costs? Would you be willing to pay double for this book if it cost us double to produce it? The simple fact is that production costs are relevant to market price only insofar as they affect the quantity supplied: the equilibrium price of exacdy two million new Sony tape recorders offered for sale in the United States will be the same regardless of what they cost Sony to make. Whether Sony will in fact be willing to offer two million or some other amount does indeed depend upon its costs, as we shall see in Secdon V. But once two million machines are put up for sale, the

Fig. V Simultaneous Shifts

I ; D

market determines their price independently of the manufacturers cost.

Unfortunately, the government occasiouallv forgets this simple fact and attempts to lower consumer prices b} imposing price controls on input or wholesale prices. The result is ineritably disastrous. Suppose controls on the price of bic)cles sold to bike shops rather than to consumers are imposed. Then by the analysis in Section 111, a reduction in the number of bikes manufacturers will sell to retailers must thereby occur. Since every bike sold by a retailer must first be bought from a manufacturer, these price controls also mean a reduction in the number of bikes ultimately offered by retailers to the public. But the smaller the number offered to the public, the higher their ultimate retail price. Consequendy, the attempt to reduce consumer prices by reducing bike shops costs actually ends up raising, rather than lowering, retail prices.

A case in point is the Energ) Price Control Act of 1975, vvhich was a price control on the wellhead price of domestic crude oil. Reportedly Congress, the President, and the early Department of Energy, but not the Presidents Council of Economic Advasors, were su rised that it made refiners rich vvithout cut-Ung gas pump prices.

The transmittal of information also proceeds from the supply side. If, for example, world-wide depledon of aluminum ore should occur, we would want to use the ore more sparingly. The price system automatically provides appropriate incentives through the following mechanism: Clearly as depletion occurs, aluminum suppliers will be prepared to offer less aluminum at any given price, which is to say, the supply of

aluminum will decrease. But as we jiisi saw, \\\\ jjj raise the price of aluminum. Reacting to this priced increase, manufacturers of products made viili ;ili) niinuni will atiempi lo subsutuie other ores. ,\i same Ume, higher aluminum prices will induce people to recycle previoush used aluminum, to develop tecli- oologies for aluminum from waste, and to search for cheaper reco\cry methods from lo\\ grad, ore. Nonetheless, the prices of products made with alu- miniim will rise relaUNe to the prices of other piodtuis. Consumers reacting to the higher prices of such goods will switch out of expensive aluminum products and into cheaper goods. To respond appro, priately, consumers need not even know that ah minum exists. The higher price of aluminum good alone provides the cot rect signal.


We already noted in Section I diat competitio exists among bu\ers for the favor of .sellers and ii Secdon III that resources tend to flow to the highe: valued uses. Now that the supply/demand model hs been introduced we can paint these notions a bil moi brightly. Our topic will be the rental housing markl in Isla Vista.

Given the current water moratorium, it is effi dvely impossible to build more rental housing in Vista, no matter hoiv high rents may soar. Hence Isla Vsta supply of housing is essendally fixed at tW given stock, Q in Figure M. The market demand f( housing in Isla Vista is compo.sed of two different kin of demanders, students and non-students, denoted and D in the figure. .\s we saw in Section II, the m ket demand is the horizontal summation of the

Fig. VI The Coiripetitlon for Rental Housing

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