Market Disruption
- Why Should I Care?
Markets are supposed to be stable and self-regulating. But social and natural events can disrupt markets and wreak havoc on regular peoples’ lives. Predicting how markets will react to outside factors can make you rich, or at least avoid becoming poor.
- This Lecture Has 2 Parts
- Shifts in Demand and Supply
- New Equilibrium
- What is a Market Disruption?
Markets are stable and self-regulating. Under an assumption of perfect competition, buyers and sellers react to changes in price, that’s obvious. That is the Free Market Mechanism, which sets equilibrium prices and output. Even in a monopoly, the market is in a stable of equilibrium.
But changes in nature like an earthquake, or social events like a labour strike, can disrupt an otherwise stable market. There will be a “new normal”, a new equilibrium. The supply and demand model enables us to predict the market outcome of such disruptions. The trick is to analyze changes to the demand and supply curves independently.
- Shifts in Demand and Supply
The Marshallian model allows us to sort out the effects of a multitude of factors that can change the quantities of product on a market.
Essentially, the variables are sorted out where Qs, and Qd, are a function of several factors. Quantity is thus considered a Dependent variable. All other variables explain quantity, so they are considered Independent variables. In essence, its a clever model, because you actually have two dependent variables, which are very similar (Qd and Qs).
Qd = f ( Price, Population, Income, Expectations, Tastes and Preferences, Prices of related goods )
Qs = f ( Price, Number of producers, Prices of related goods, Technology, Expectations, Price of Inputs )
Notice that the Price of a good influences both Qd, and Qs. This is basically the reason why Price is a variable that was chosen to be on the graph at all times (vertical axis). Qd and Qs are also on the graph, simultaneously on the same axis (horizontal). Price and Quantity are therefore considered ENDOGENOUS variables. Any change in price is always included on the Supply curve, and the Demand curve. The market graph has already taken this into account.
All other variables are EXOGENOUS. Their effect is not already factored into the Demand and Supply curves. Their effect will SHIFT either curve. An exogenous shift will bring about an unbalance in the market forces, a market condition of shortage, or surplus. This will generate a change in price, which will move the Qs and Qd along the new curves.
An example: new robots will increase production without increasing costs. More robots will increase the supply of automobiles.
|
Variable |
Moves Curve |
Function |
Role in model |
|
Qs |
No |
Dependent |
Endogenous |
|
Qd |
No |
Dependent |
Endogenous |
|
Price |
No |
Independent |
Endogenous |
|
Population |
Demand |
Independent |
Exogenous |
|
Income |
Demand |
Independent |
Exogenous |
|
Expectations |
Demand |
Independent |
Exogenous |
|
Tastes and Preferences |
Demand |
Independent |
Exogenous |
|
Prices of related goods |
Demand |
Independent |
Exogenous |
|
Number of producers |
Supply |
Independent |
Exogenous |
|
Prices of related goods |
Supply |
Independent |
Exogenous |
|
Technology |
Supply |
Independent |
Exogenous |
|
Expectations |
Supply |
Independent |
Exogenous |
|
Price of Inputs |
Supply |
Independent |
Exogenous |
Economists can predict how the market will react to these shifts because they suppose certain behaviours and relationships ahead of time. The factors mentioned will shift the whole curve, whether demand or supply.
The curve will shift left if demand (or supply) decreases, or right if it increases. (The curve does not shift up or down, it shifts horizontally along the quantity axis keeping prices constant.)
Why does the curve shift?
These outside factors are exogenous variables. They are “game-changers” that were not taken in consideration when building the theory, which focuses on prices and quantities. Price is an endogenous variable, which means it is included on the graph. This is why changes in price are already accounted for in the shape of the demand curve. In plain English, for the same price, people’s demand has completely changed for the product. You could say they love the product more, or less, for the same price. Because the “love” has changed, there has to be a new curve to depict the new level of demand.
Market Changes and the Reaction of Buyers
|
Market Change |
Buyer’s Reaction |
On graph |
|
A - Price increases |
Love it the same, but buy less |
Qd slides to the left |
|
B - Price decreases |
Love it the same, but buy more |
Qd slides to the right |
|
C - External factor increases Demand |
Love it more, Buy more at same price |
Qd jumps right |
|
D - External factor decreases Demand |
Love it less, Buy less at same price |
Qd jumps left |
Scenario
Here are some market values for different products. Qe represents an equilibrium market production level where Qd = Qs. For each market, a demand-side shock triggers a disruption.
|
Product |
Price ($) |
Qe / mth |
Shock |
New Qd |
Price change |
New Qe |
|
Shoes |
600 |
100 |
Out of fashion |
50 |
Down |
50-100 |
|
Ice cream |
5 |
250 |
New immigrants |
300 |
Up |
250-300 |
|
Internet Access |
45 |
3,000 |
New movies on Netflix |
4,000 |
Up |
3,000-4,000 |
|
iPhone 11 |
700 |
400 |
iPhone 12 released |
350 |
Down |
350-400 |
The supply and demand framework allows us to identify where the market will be going. But it's not possible, at this level of analysis, to be really precise about the final Quantity and Price the market will settle on. For example, if a certain model of shoes go out of fashion, of course the Quantity demanded would decrease, and those shoes will be on sale. This is pretty predictable. Where the model adds value to our analysis, is to keep in mind that as the price goes down, a few more people will buy those shoes. The quantity decrease, in the end, will not be as drastic as a simple analysis would predict. To see this in more detail, we have to look at a graph.
Graph
The graph shows that the market equilibrium production level could have dropped to 50. That's where the new demand curve sits, at the unchanged price of 600$ per pair of shoes. Of course this situation is untenable, because it creates a surplus condition on the market, of 50 pairs of shoes per month. This overstock needs to be liquidated so prices will drop. As we can see on the graph, to which we've added a supply schedule for clarity, the lower price on the new demand curve allows for a little more quantity demanded than we might have initially anticipated. Also, the lower price discourages producers a little bit. In the end, the model predicts a new equilibrium at 75 pairs per month, at a price of 550$.
Keep in mind that when a market is disrupted, economists have to make assumptions about the slope of each curve, in order to find a new equilibrium. If the demand and/or supply curves were steeper, or flatter, the final equilibrium won't end up at the same place.
Market Changes and the Reaction of Sellers
|
Market Change |
Seller’s Reaction |
On graph |
|
A - Price increases |
Encouraged |
Qs slides to the right |
|
B - Price decreases |
Discouraged, |
Qs slides to the left |
|
C - External factor increases Supply |
Capacity to produce more, for the same unit price |
Qs jumps right |
|
D - External factor decreases Supply |
Capacity to produce less, for the same unit price |
Qs jumps right |
- New Equilibrium
The shifts in Demand and Supply create disruptions on the market for any good or service. But before you shift any curves, make sure you understand what to do, and the proper sequence of the model.
Supply and Demand Algorithm
The first step is to identify what's going to move on the graph.
Who is affected first and foremost?
> Producers: Supply curve
> Buyers: Demand curve
Is this a price change?
Yes > Price shock: Quantity will slide
No > External shock: Curve will shift
Which direction?
> More quantity: Right
> Less quantity: Left
Let’s say a sunny heat wave is increasing demand for sunglasses.
1- This will affect buyers, so it affects the demand curve (DD).
2- This is an exogenous shock, so the Demand curve will shift.
3- Buyers will buy more, at all prices, so DD will shift right.
The second step is to identify the market condition that will move the price, and generate adaptation.
Is it a shortage or a surplus?
> Shortage Price increases
> Surplus Price decreases
Adaptation
> Price increases Qd slides left, Qs slides right
> Price decreases Qd slides right, Qs slides left
Let’s say a sunny heat wave is increasing demand for sunglasses.
1- The shift in demand creates a shortage, which increases prices. New Qd slides left, Qs slides right, to new equilibrium.
2- End result, higher prices, higher quantities.
- Green Policy
Many economists believe that you can use the market mechanism, the Marshallian Supply and Demand model, to reduce pollution. The trick is to include the social cost of pollution into the final price of the product. By taxing BADS, you can swiftly impact meaningful change without sending anyone to jail, or having the government make critical allocation decisions. The market can solve the problem.
How this works is simple. A tax is a supply factor. An increase in taxes will shift the supply curve to the left. As markets adapt, part of the increased tax will turn into a higher price for consumers, and part of the tax will decrease the quantity of sales of the BAD product.
Note that this type of policy works best when there are alternatives which are ready and waiting to be consumed. If you tax, without preparing an alternative product, the consumers will bear the brunt of the tax and there won’t be a reduction in quantity.
- Climate Change Solution
Most economists agree that a tax on carbon is a fair and efficient solution to reducing GHG emissions. Rather than ask consumers to stop using their cars, implementing a tax on gasoline would have a direct impact on demand for gasoline, and for cars. It’s fair because those who are responsible for emitting GHG’s have to pay for it.
The capitalists and the industrialists will receive a clear signal that these products are doomed, and their efforts show be going towards GHG-free production. One would expect consumers, as well as producers, to look for alternatives (substitution effect).
- Democracy Booster
It is obvious that many industries stand to lose millions and billions of dollars if carbon taxes were to be implemented. However, it is not economical to leave the situation as it is. Money never disappears. It would be invested in cleaner projects. This is not a lose-lose scenario. It is a win-win scenario.
- Wrap-Up
Markets are stable, but society is not. An outside change will disrupt markets. But markets do stabilize, in theory, at a new equilibrium because of the market forces behind the theory of supply and demand.
This new combination of price-quantity will be stable. To find it, and predict it properly, shift the proper curve according to the relevant factors. Suppliers and demanders will meet once again at the new equilibrium combination of price and quantity.
- Cheat Sheet
Price shock:
A change in price that affects the quantity demanded or supplied of a particular product.
External shock:
A social or natural event that deeply affects the supply or demand curve.
Demand shifters:
Income, Tastes and Preferences, Expectations, Demographics, Supply of Related Goods.
Supply shifters:
Number of producers, Change in technology, Demand for Related products, Expectations, Input costs.