But the latest recession has caused some big changes. High unemployment meant that fewer people were driving to work, and a slump in consumer spending meant that less freight needed to be moved around the country. As gas prices soared in 2005, the number of miles driven – including commercial and personal – began to fall, and continued to drop after 2008 even as gasoline became cheaper.

From The New York Times

This image – click on it for a larger view – shows periods of what we would expect from a demand curve – downward sloping, showing more miles driven when gas prices are lower.  However there are periods where prices change and driving miles don’t, or when prices increase and miles driven increase.  What gives?

The key is found in the title of this post – ceteris paribus – which loosely translated means “all things remaining equal.” In a typical demand curve we look at changes in price and their impact of demand. We assume that everything else about the market is held constant – remain equal. For this chart, which shows annual data from 1956 to the present, ceteris paribus is not in play. There are many things changing, including driver incomes. So some segments of this historical trend look like a standard demand curve, sloping down and to the right. In other cases, what we are really seeing is a shift in demand, driven by factors other than price.

a quick excerpt…

Well, part of the reason is that economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. Too bad for the theory, things don’t seem to work that way.

There are exceptions to this and one class of them is called “inferior goods.” Demand for these goods declines as income rises. Keeping with the restaurant theme, demand for McDonald’s meals might go down as incomes rise and people substitute away from fast food to a more relaxed setting.

In the Freakonomics blog today there is another “tasty” example of inferior goods – the demand for rat meat in Cambodia. Now that you’re curious, read more here…

But, before going further down that road, let’s explore the idea of demand a bit more.

We know that our interest in, or demand for a product will be influenced by its price. For many, or most items, lower prices will mean we are willing to buy more, and higher prices mean we will buy less. This relationship – between the price of a product and the quantity demanded of the product – is what defines the demand curve. Mathematicians would say that price and quantity are inversely related – when one goes up the other goes down and vice versa.

If you wanted to draw a demand curve, you would label the vertical axis (y-axis) with price and the horizontal axis (x-axis) with quantity. The typical demand curve would start somewhere in the upper left and go to the lower right of the graph. Again, mathematically we say that the demand curve has a negative slope.

Price is a very important determinant of buyer’s demand for products, but it is not the only determinant. Let’s talk about several other, non-price determinants:

First is income. For many normal products an increase in the income of the buyers will cause an increase in their demand for a product. If we see an increase in income, the demand curve will shift to the right. That means at any price buyers will be willing to demand more of the product, since they have more income – more money to spend.

Notice that when income changes we see a shift in the demand curve – to the right or to the left.

Another determinant is taste or preferences. Buyers are fickle and sometimes a product will become more popular for reasons not having to do with price – it’s just more popular. At the other end, sometimes products just lose favor with buyers. In either case the demand curve can shift right or left.

Expectations can cause a shift in demand. Expectations mean the buyers change their buying behavior based on what they think is going to happen in the future. If there is a forecast for rain in the afternoon, the demand for umbrellas in the morning might go up.

Two other determinants have to do with with price of other products – products we call related goods.

If the price of a competing product changes, then demand for our product will change. Let’s say, for example, we are looking at the price of student housing, and trying to understand the demand for off-campus apartments. A competing product in this case would be on campus dorms. If rents in on campus dorms went down, we should expect to see the demand for off-campus apartments go down, too. Some number of students will take advantage of the change in dorm costs and switch their demand in that direction. These two competing products – off campus and on campus housing, are called substitutes for one another. If the price of a substitute goes down, the demand for the original product will go down as well.

Another kind of related product are those we buy with. Let’s return to our housing question. Let’s say that utilities are a separate purchase in off campus housing. You have to pay for gas and electricity in addition to the rent for the off campus apartment. Now let’s say that the cost of utilities goes up. That will make the whole package – the apartment rent and the utilities – more expensive, and we should expect to see a drop in demand for off campus housing. We call products that are bought together – complements. A change in the price of a complement will affect the demand for the original product.

And of course, if more buyers arrive on the scene, that would shift demand to the right, or if buyers were blocked for purchasing items that would shift demand to the left.

So – let’s review the determinants of demand – the forces that help describe our interest in a product.

• First and most important – price. A change in price causes movement along the demand curve
• Then the rest of the determinants will cause a shift in the demand curve. They include:
• A change in income
• A change in tastes or preferences
• A change in expectations
• A change in the price of a related good, like a change in the price of a substitute product, or a complementary product
• A change in the number of buyers

OK – take a brief mental break – then we will shift to supply.

When we look at the supply curve, we are assuming the perspective of the producer – the seller. Their objective is to maximize profit – or at least that’s what we assume in most cases.
The general rule for supply is that as price goes up the sellers are more likely to send their products to market. They are anxious to take advantage of the potential for higher profits. On the other hand as price falls, the sellers are more reluctant to send products to market. At a lower price the ability to make a profit is reduced.

Mathematically we say that supply is directly related to the price of the good. As the price goes up, the quantity supplied goes up and vice versa. The supply curve has a positive slope.

On a graph, with Price on the vertical axis and Quantity on the horizontal axis, the supply curve goes up and to the right.

So, price is a key determinant of supply, and a change in price will cause movement along or up and down the supply curve. There are other, non-price determinants, too.

First, supply decisions are affected by a change in the cost of inputs? Inputs mean things like raw materials and labor, and other production costs. If wages go up or the cost of raw materials goes up we would expect to see the supply curve shift to the left. How come? Because if production costs go up, the sellers will be less likely to bring products to market – at any price. So the supply curve shifts.

A change in technology – usually an increase in technology – is likely to improve costs and so would shift the supply curve to the right.

Sellers also make decisions based on expectations. We had the same factor when looking at the determinants of demand. Expectations means a seller might change their supply of product based on a forecast of events in the future. A seller who expects the market price to rise in the future might hold off selling products now and will wait until later. That expectation of a future event has affected seller behavior now.

Taxes – particularly taxes imposed on each item sold – will cause sellers to shift supply to the left.

Finally, if the number of sellers increases, we would expect the supply curve to shift to the right.

OK – let’s review…

Supply is most directly affected by a change in price. If price changes there will be movement along the supply curve.

There are other forces that can shift the supply curve to the right or to the left. They include:

• A change in the cost of inputs
• A change in technology
• A change in expectations
• A change in taxes
• A change in the number of sellers

Now what we want to do is put demand and supply together in a market.

Graphically the demand curve is going down and to the right, while supply is going up and to the right. They form an “X” in a typical graph of demand and supply.

Let’s imagine that the price in the market is somewhere above the cross over point between demand and supply. If that is the case, then
there will be fairly low demand and fairly high supply. As a result we will have a surplus – there is more product being offered for sale than there is demand for the product – at that price. So what would we expect to happen to the price? Right! We would expect the price to be bid down, until the surplus goes away. The surplus goes away when the quantity supplied is equal to the quantity demanded – where the two curves cross.

If the price started out less than the cross over point, there would be plenty of demand – after all the price is pretty low. There will be less supply, however, because at a low price the sellers will have a hard time making a profit. The result is that we have a shortage – more demand than supply. In this case we would expect the price to increase, until there is no more shortage.

In both of these cases the natural forces of the market will force the price to the place where the two curves cross – where quantity demanded is equal to quantity supplied.

We call this cross over point equilibrium. I think of equilibrium as a point where there are no more forces acting on price – it will likely stay right there – at least until something changes demand or supply.

The beauty of a simple market like this is that the buyers and the sellers, each acting in their own self-interest, will react to a surplus or a shortage and the market will correct itself. These actions will force the price to the equilibrium level – all without the help or intervention of an outside force, like the government.

As usual, we have just scratched the surface on the interesting and important dynamics of a free market place. In a later post we’ll talk more about the meaning of market equilibrium, price as a signaling mechanism, and the perils of intervening in a market.