PSST: About Supply and Demand, 1/21
Unfortunately, those terms are mis-used, especially by economists
I have two complaints about the way the terms supply and demand get mis-used.
First, it is wrong to talk about a “shortage,” as if supply and demand were fixed independently of price. Credentialed economists almost never make this mistake.
Second, and more important, it is misleading to talk about the economy as a whole in terms of supply and demand. That is a mistake that permeates economic analysis, with credentialed economists the primary offenders.
Concerning the first misconception, when prices are free to move, there are no shortages. You can create a shortage of gasoline by fixing the price at a penny a gallon. There will be more demand than supply at that price. But if you let the price go higher, demand will decrease and supply will increase. At the right price, they will be in balance. When I read stories of empty shelves in stores, that tells me that prices for those goods have further to rise.
The misconception in macroeconomics is different. Macro is the study of economy-wide phenomena, as measured by variables such as unemployment and inflation. Conventional macro courses also use the terms supply and demand—misleadingly, in my opinion.
Conventional macroeconomic analysis proceeds as if all economic activity takes place in a single firm. I call this the GDP factory. “Aggregate demand,” meaning the total demand for everything in the economy, can be thought of as demand for the output of this GDP factory. “Aggregate supply” can be thought of as the ability of the GDP factory to supply output.
When there is high unemployment, conventional macro attributes this to a lack of aggregate demand. The GDP factory does not need as many workers, so some workers are told to stay home.
When there is low unemployment and firms have unfilled positions, as has been the case in the United States recently, conventional macro attributes this to a lack of aggregate supply. The GDP factory wants more workers, but the only potential workers are people who prefer to stay home. Conventional economists term this a “supply shock” or a “supply constraint.”
In the macro story, the price mechanism has disappeared. There can be a shortage of jobs. Or there can be a shortage of workers. But nothing that happens to prices, including the price of labor, can change that. So the macroeconomic concept of “supply and demand” utterly disregards the way that supply and demand are supposed to operate.
The conventional view is that instead of prices adjusting to keep aggregate demand and aggregate supply in balance, the task falls on our central bank, the Federal Reserve. The Fed uses its tools to raise aggregate demand to fight unemployment or to lower aggregate demand to fight inflation. Larry Summers, who represents the conventional view, is all over the media these days saying that we have too much demand and the Fed needs to tighten policy in order to bring about balance.
I have a heterodox view that rejects all of this. I consider the GDP factory story misleading, because the actual economy consists of millions of different types of work. To coordinate all of this, markets develop what I call Patterns of Sustainable Specialization and Trade. Individual workers specialize in different productive activities, which means that we need to trade in the market. The patterns of trade that emerge are sustainable only as long as they are efficient relative to overall conditions, including available resources and the state of knowledge in society.
As resource availability shifts, and as we develop and test new inventions and business models, some patterns become unsustainable. This shows up as some businesses becoming unprofitable and having to cut back or shut down altogether. At the same time, but not necessarily at the same rate, new patterns of trade become sustainable, and new initiatives earn profits. Joseph Schumpeter famously called this “Creative Destruction.”
Every month, some businesses cut back or fail altogether, and other businesses expand or start up. In the United States, around 4 million workers lose jobs each month, and about 4 million new jobs are created.
The PSST story for a recession is that for several months the unsustainable enterprises that shed workers are not balanced by businesses creating new patterns of trade. Entrepreneurs have to figure out how to use the available labor. This process can take months, or even years.
For example, when the virus crisis hit, and consumer demand for restaurant meals and other in-person services declined, previous patterns of specialization and trade became unsustainable. Selling lunch to downtown office workers is not a sustainable business if the laptop class is working from home.
New opportunities presented themselves. Firms provided video conferencing. Home delivery expanded. The wealth that landed in Silicon Valley began to trickle down to non-profits and other enterprises, which then needed workers.
The conventional story of the GDP factory says that when the unemployment rate is low, inflation accelerates, and conversely. This has the advantage of being a specific, plausible-sounding theory of inflation. Unfortunately, more often than not it is wrong. In the 1970s, inflation was high even in years with high unemployment. On the other hand between 1990 and 2020, inflation remained within a narrow band while unemployment varied in a wide range, from a “full employment” rate below 4 percent just prior to the pandemic to a “Great Recession” high of 10 percent in the wake of the 2008 financial crisis.
My view of inflation is that there are two “regimes.” In one regime, inflation is low and steady. In another regime, inflation is high and variable. The transition from one regime to the other is like a phase change in chemistry. You can apply a lot of heat to water and yet it remains liquid until the heat is sufficient to bring the water to a boil. As the government engages in deficit spending, for a long time people will buy and sell their usual goods at their usual prices. But as the government prints more and more paper wealth without producing anything, eventually this moves the economy into the regime of high and variable inflation.
In my view, the central bank is not able to make much difference. The growth in paper wealth has to subside if inflation is going to be contained.
One could shove the PSST story into the GDP factory framework by saying that I think that paper wealth represents “demand” and PSST represents “supply.” But I would push back against thinking that for any given configuration of PSST there is a straightforward linear relationship between paper wealth and prices. When people are used to a stable pattern of prices, large changes in wealth do not affect inflation. Only when the level of wealth gets very out of line does the price pressure reach a boiling point.
Unlike the conventional view, the two-regimes view does not lend itself to exact predictions of changes in the inflation rate. It only allows for general indications about the likelihood of a transition from one regime to another. But it is better to be humble and inexact than confident and wrong.
You can find more about the PSST story in my book, Specialization and Trade. I don’t get any royalties from the book. You should buy it ($3 on Kindle) if you think you’ll get something out of it, not to support me.
Speaking on the topic of stock-outs on store shelves and elsewhere: this is often caused by the contractual arrangements between the retailer, its suppliers, and the brand. There are also issues in which the retailer may be trying to substitute for an out-of-stock brand but was unable to make the replacement in a reasonable time period.
Customers are not rational and will complain when retailers allow prices to rise to the equilibrium level. The complaints that customers have are different for out of stock and for high prices. A store manager may decide that they would prefer the OOS complaints to the insane price complaints. Some marketplaces like Amazon will actually deactivate your offers if you let the price rise to the equilibrium level to delay a stock-out, because their automated systems consider a price X% above the historic price to be a bad customer experience.
Additionally, customers are touchier the higher the price goes. It may be preferable to sell nothing and to cede ground to competitors than it is to suffer customer complaints and reputational damage related to price-driven quality complaints. For example, a customer will consider a $9 product a five star product because of the value perception. The same product at $24, priced so to prevent a stock-out, suddenly becomes a three star product in the eyes of the now pickier consumer. A three star product is not profitable to sell online: the drop-off in profitability is insane at every half-star rating below 4.5. It is better to never sell again something with a bad customer reputation. So, it can be better to stock-out until it can be replaced.
Also under officially declared emergency conditions, many states have price gouging laws. Retailers do get letters from stage AGs shaking them down for settlements, so these legal actions do not necessarily surface to the level at which the public sees them. For online retailers this means getting potentially shaken down by prosecutors from dozens of states. The C****D-1* emergency declarations are mostly done with, but you never know when minds will change on that front. So, with those, you have suppliers raising prices on retailers, but retailers having to either eat the loss or wait for the general price level to increase to restock. You cannot get a mean letter from an AG for an empty shelf, but you can if you raise your price 25% prematurely.
So, brands and retailers alike are sensitive to price perceptions which get in the way of efficiency. You watch what other people are doing and raise your prices in tandem with the others, using inflation sizing and other methods to smooth out the changes. Doing the economically efficient thing makes people and governments real mad about it, which has real consequences for managers. It is easier to be economically efficient further up the supply chain because people at the retail level have mob mentality and business people are more rational about such things.
If you view supply/demand systems as feedback control systems, where changes in demand induce changes in supply, the criticality of response times becomes obvious. If slight increases in demand result in rapid increases in supply as companies like Walmart send sales information directly to producers who then know they will see a reorder of x in the near future and plan for the production and it all happens smoothly.
If the demand varies on a business cycle time scale of a decade or so but the supply size takes 2 decades to respond demand (cycle times < supply response times), because of permission problems with building more capacity (visualize permission for a major housing development or refinery or chemical plant or mine), the system goes unstable as prices go way beyond any relationship with real costs. A good example of this phenomena was solar grade silicon that went to 10 time the production cost when Germany went subsidized solar years ago and Western suppliers couldn't get permission for new facilities (big chemical plants), but China allowed construction of a new solar grade silicon facility that was build in 15 months with a huge fraction of the world capacity. Now china owns solar grade silicon and solar technology markets.
Delay time are critical and drop out of using partial differential equations to describe any dynamic system including economics.