How Demand and Supply Together Set a Price

The rule to remember. When demand moves, price and quantity move in the same direction. When supply moves, they move in opposite directions. If you remember nothing else about this chapter, remember that sentence, because it lets you answer a question you have not seen before.

When both curves move at once, one of the two results is certain and the other is ambiguous. If demand and supply both increase, quantity certainly rises and price may rise, fall or stay the same depending on which shift is larger. If demand increases and supply decreases, price certainly rises and quantity is ambiguous. A complete answer says which is determinate and which is not.

What a legal price control does

This is where a law student earns the chapter. A price fixed by law is a price that is not the equilibrium price, and the consequences follow mechanically.

A price ceiling is a legal maximum. It is imposed to protect buyers, and it binds only if it is set below the equilibrium price. In India the general power is in section 3 of the Essential Commodities Act 1955, which allows the Central Government to control the price at which an essential commodity may be bought or sold. Rent control statutes do the same for housing.

What follows from a binding ceiling, in order.

1. Excess demand, that is a shortage, because the quantity demanded at the low price exceeds the quantity supplied.
2. Rationing by something other than price: queues, quotas, permits, ration cards, or a seller's personal preference for one buyer over another.
3. A black market, in which the good is sold above the legal price to those willing to pay, because the excess demand does not disappear when it is made unlawful.
4. Deterioration of quality, since the seller cannot compete on price and has no reason to compete on anything else.
5. A fall in supply over time, because the return to producing the good has fallen.

None of this shows that price control is wrong. A ceiling on the price of a life saving drug during an epidemic distributes a scarce good more equally than an auction would, and that is a decision about equity, not efficiency, of the kind [Why a Law Student Studies Economics] describes. What the economics shows is that a ceiling must be accompanied by a rationing mechanism and by a plan for supply, or the shortage will do the rationing on its own and do it worse.

A price floor is a legal minimum. It is imposed to protect sellers, and it binds only if it is set above the equilibrium price. A minimum support price for a crop and a statutory minimum wage are the two examples every Indian student needs.

What follows from a binding floor.

1. Excess supply, that is a surplus. In the crop case, unsold grain; in the labour case, unemployment among the workers whose output is worth less than the minimum.
2. A need for the State to buy the surplus if the floor is to be maintained, which is exactly what procurement at the minimum support price does, and why India holds buffer stocks. [Food Security: What It Means and How India Provides It] follows this through.
3. Storage and disposal costs, and eventually the question of what to do with grain that has been bought and cannot be sold at the floor price.

A worked example: an onion price ceiling

The facts. Onions in a city market are in equilibrium at 60 rupees a kilogram, with 400 quintals a day bought and sold. After public complaint, the State fixes a maximum price of 35 rupees under an order made in exercise of the power in section 3 of the Essential Commodities Act 1955.

Step 1, is the ceiling binding? Yes. 35 is below the equilibrium of 60, so it will have effects. A ceiling of 80 would have had none.

Step 2, what happens on the demand side. At 35 rupees households want far more onions than at 60. Suppose the quantity demanded is 640 quintals.

Step 3, what happens on the supply side. Traders will not bring the same quantity to a market where they must sell at 35. Suppose 300 quintals arrive.

Step 4, the shortage. 640 wanted, 300 available: a shortage of 340 quintals a day. Shops sell out by mid morning.

Step 5, how the 300 quintals are actually distributed. Not by price, because price is fixed. By queueing, by limits of one kilogram a household, by preference for regular customers, and by sale at a higher price to those who ask quietly.

Step 6, the second round. Traders divert onions to the neighbouring district where the order does not apply, or hold them, or sell them for processing. Arrivals fall further.

What a lawyer should take from it. The order achieves its stated object, a low legal price, and fails its real object, which was that households should be able to buy onions cheaply. Making the black market an offence does not close the gap between 640 and 300; only more onions, or a rationing rule the State itself administers, will do that. A well drafted control therefore comes with a distribution mechanism, which is precisely what the public distribution system is.

What beginners get wrong

"A price ceiling reduces the price paid." It reduces the legal price. The effective price, once queueing time and black market premiums are counted, can be higher for many buyers than the free price was.

"Equilibrium is a fair price." It is a clearing price. It carries no claim to fairness, and where incomes are very unequal the market clears at a price many households cannot pay.

"A ceiling above the market price protects buyers." It does nothing at all. Only a ceiling below equilibrium binds. The same in reverse for a floor.

"If demand and supply both rise, price rises." Not necessarily. Quantity certainly rises; price depends on which shift is larger.

Limits of the analysis

It assumes a competitive market. Where one seller sets the price, the analysis of [Monopoly] applies instead.

It assumes buyers and sellers are informed and can move freely, which is not true where information is poor and transport is costly, as in many rural markets.

It says nothing about how long adjustment takes. In agriculture the response is delayed by a whole season, which produces the alternating glut and shortage known as the cobweb.

It ignores distribution. Two markets can clear at the same price with completely different consequences for who eats.

Quick revision

1. Equilibrium price is where quantity demanded equals quantity supplied. Below it there is excess demand and price rises; above it there is excess supply and price falls.
2. The four shift cases: demand up, price and quantity up; demand down, both down; supply up, price down and quantity up; supply down, price up and quantity down.
3. The rule: demand shifts move price and quantity the same way; supply shifts move them opposite ways.
4. Both curves moving: one result is certain and the other is ambiguous, and the answer must say which.
5. A price ceiling binds only below equilibrium and produces shortage, non price rationing, black markets, falling quality and falling supply. Section 3 of the Essential Commodities Act 1955 is the Indian statutory power.
6. A price floor binds only above equilibrium and produces surplus, which somebody must buy. Minimum support price plus procurement is the standard Indian example; a minimum wage is the labour example.

Test yourself

1. Define equilibrium price and explain why the market returns to it. Equilibrium price is the price at which the quantity demanded equals the quantity supplied, so that there is no excess on either side and no tendency for price to change. Below it, excess demand causes buyers to bid against each other and sellers to raise their asking price, which contracts demand and extends supply until the gap closes. Above it, unsold stock accumulates and sellers cut prices, which extends demand and contracts supply. Both movements are self correcting, which makes the equilibrium stable.

2. What happens to equilibrium price and quantity if (a) demand increases, (b) supply increases, (c) both increase? If demand increases, both price and quantity rise. If supply increases, price falls and quantity rises. If both increase, quantity certainly rises but the effect on price is ambiguous and depends on which shift is larger: a larger increase in demand raises price, a larger increase in supply lowers it, and equal shifts leave it unchanged.

3. What is a price ceiling? State four consequences of a binding one. A price ceiling is a legal maximum price, imposed to protect buyers, and it has effects only if it is fixed below the equilibrium price. Its consequences are a shortage, since more is demanded than supplied at the controlled price; rationing by non price devices such as queues, quotas and personal preference; the appearance of a black market at a price above the legal one; and, over time, a decline in quality and in the quantity supplied because the return to producing the good has fallen.

4. What is a price floor, and what must accompany it? A price floor is a legal minimum price, imposed to protect sellers, and it binds only if it is fixed above the equilibrium price. It produces a surplus, because more is offered than is bought at that price. It can therefore be maintained only if somebody buys and holds the surplus, which in India is done by procurement at the minimum support price and by the holding of buffer stocks, with the storage and disposal costs that follow.

5. Onions are in equilibrium at 60 rupees. The State fixes a maximum of 80 rupees. What happens? Nothing. The ceiling is above the equilibrium price and therefore does not bind: the market already clears at 60, which is lawful. A ceiling has effects only when it is set below the price at which the market would otherwise clear. The same point in reverse applies to a floor set below equilibrium.

6. "The equilibrium price is the just price." Comment. It is not. Equilibrium means only that the market clears, so that everybody who is willing and able to pay that price is served and everybody willing to supply at it finds a buyer. It carries no judgment about fairness and takes the existing distribution of income as given, so where incomes are very unequal the clearing price for a necessity may be one that many households cannot pay. Whether that outcome is acceptable is a normative question of the kind separated out in [Positive and Normative Economics], and it is why legislatures intervene in the markets for food, housing, medicines and labour.