No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Five: Supply & Demand: Markets at Work 117 begin to build up at production facilities and stores. As the market process unfolds, the suppliers will seek out the market price. When inventories build up, Apple will offer a lower price and decrease their production to eliminate the surplus inventories—they are moving down the supply curve as the blue arrow indicates. Meanwhile as prices come down, more and more marginal buyers will decide the price is low enough to buy the iPhone, and quantity demanded will increase as indicated by the red arrow. One can imagine that Apple has no exact idea how much people are really willing to pay; the market process is a discovery process (discovering the information of true consumer preferences). After the initial price being too high, they might not lower the price exactly to equilibrium—it may take several iterations. Especially since they don’t want to overshoot the equilibrium price and “spoil the market.” Let’s now look at the process in reverse. Perhaps Apple did overshoot in their price and production cuts, or perhaps they initially underestimated demand; the result is in Figure 5.6 . The new iPhone in this situation will be flying off the shelves; Walmart and Best Buy won’t be able to keep them in stock. The quantity demanded exceeds the quantity supplied at P 1 and we will have a shortage. The retailers themselves may increase the price to profit from the demand, and will place more orders with Apple. Apple will respond to this with both increased prices and increased production, and we will move up the supply curve toward the equilibrium price, P* as shown by the blue arrow. With the price increasing, more marginal demanders will no longer make purchases and we will move up the demand curve towards P* as indicated by the red arrow. The previous analysis helps us understand how the market process overcomes ignorance to meet true consumer preferences and find an equilibrium. We had to assume ceteris paribus with respect to the supply and demand curves. But now we can relax a bit and imagine changing one variable (either supply or demand) and trace out the effects. SPOILING THE MARKET Spoiling the market will occur if a company sets the price too low and consumers come to expect that the low price will come back; they may defer purchases in hopes that it will come back lower again, even though they are willing to pay the equilibrium price. This is more a risk if the demand curve is more elastic. You may ask why, but recall that an elastic good has many substitutes. For those goods, it will be easier to wait on a lower price as you can consume the close substitute. Figure 5.6, Shortage in the Market Process. If the price is less than the underlying supply and demand fundamentals, the quantity supplied will be less than the quantity demanded and we will see a shortage (the distance between Q D and Q S bold line above). Suppliers will respond by increasing prices and production, which is reflected in the upward blue arrow. Meanwhile, every increase in price causes additional marginal demanders to stop buying and we travel up the red arrow until we finally reach an equilibrium. P ($) Q (#) Q* P * S D Q S Q D Q S Q D >> Shortage P 1