Economists Make Mistakes, Everybody Has Those Days

Economists Make Mistakes, Everybody Has Those Days

For a moment, let's pretend you are the Owner and CEO of Goodyear, the tire manufacturer.  Suppose the price of rubber goes up.  At the shareholder's meeting, you are asked how you expect this price change to affect profits this quarter.  More specifically, what is the effect on the quantity bought and sold of tires?  Economists and business owners ask themselves these types of questions routinely and the success of their firm often depends on their ability to correctly answer.  Do you think that more tires will be bought and sold or do you think fewer tires will be bought and sold?

The following is what a friend said would occur.  "When the price of rubber goes up, supply decreases because the price of an input has increased; this alone would raise the price of rubber. When people see the price of rubber go up, they decrease their demand for tires, lowering the price." He went on to clarify, "The supply of tires will decrease (resulting from the more expensive rubber), which will increase the price of tires.  The increase in the price of tires will decrease consumer demand, which will then lower the price of tires." 

If you agree with my friend's explanation then you should continue to read my blog more often since you would be mistaken.  Albeit, a mistake made by professional economists more often than you would imagine.  My friend confused a movement along the curve with a shift in the entire curve.  The increase in the price of tires decreases quantity demanded, it doesn't decrease demand. 

 

The supply curve for tires shifts in and to the left, the equilibrium price then rises to meet the excess demand at the old price. The increase in price seen here reduces the quantity demanded while increasing the quantity supplied.  The new equilibrium point, the point at which the supply curve intersects the demand curve, the price is higher and the quantity bought and sold is lower.  

As you can see from my friend's explanation, the circular logic of reasoning from a price change forced him to make false conclusions. The fact that fewer tires will be bought and sold does not indicate that demand decreased.  Rather, fewer tires bought and sold is due to an increase in the price of tires which is caused by a decrease in supply caused by the increase in the price of rubber. 

Major news organizations and politicians make this mistake on a regular basis.  It is incumbent upon readers, investors, and entrepreneurs to identify their sloppy analysis so we avoid making costly mistakes.  In markets, prices are the effect.  Scott Summers, a popular modern-day economist, warns against this flawed analysis by reminding his readers to never reason from a price change.  

Suppose you notice a surge in home building in the city you live in with new developments popping up all around you.  What do the laws of supply and demand predict will happen to home prices in your area?

It may seem intuitive and is commonly posited that the newly built homes indicate an increase in supply, which would subsequently lower the equilibrium price in the market.  But is that true?  Not particularly. 

An increase in the number of houses is not an increase in supply.  An increase in supply, the movement of the entire supply curve to the right, occurs when at every price point of housing, builders want to build.  If the price of lumber were to decrease that would suggest an increase supply and lower prices.  However, the simple observation that more houses are being built is not sufficient to justify an increase in supply followed by lower equilibrium price.  

Suppose a few companies chose to relocate to your area bringing new employment opportunities and increased demand for housing.  An increase in demand would also increase the equilibrium number of homes being built in your area.  However, increased demand (a shift in the demand curve to the right) would make housing more expensive.  

The observed market behavior, such as the increased quantity of a good, only paints a partial picture; a wise investor sees the unseen by diving deeper.  

Likewise, it would be wrong to associate higher gasoline prices with lower consumption.  This is another example of reasoning from a price change.  Gasoline prices increased sharply in the 1970s and again in 2007.  Without knowing the cause of this price change (or not properly analyzing the crude oil market) many people mistakenly assume that less people will purchase gasoline.  

The cause of the increase in the price of gasoline in 1974 was a decrease in the supply of oil. Alternatively, increased consumer demand in 2007 caused the prices at the pump to increase.  To arrive at the correct analysis one cannot solely consider price.  

The demand curve is downward sloping, representing the nature of an individuals' demand; as the price decreases, the quantity demanded for that good will increase at each and every price point.  For example, at $2/apple, the quantity demanded by Zoe is 0 because she finds the price absurd.  At $1/apple the quantity demanded by Zoe increases to 5 for a total of $5.  For $0/apple the quantity demanded by Zoe may be 10 apples, justified by the fact that they would rot before consumption if she demanded much more.  

There is a significant distinction between demand and quantity demanded.  An increase in demand occurs when the quantity demanded increases at every price.  A fall in price increases quantity demanded.

Congrats, you are now a better informed investor!

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