Supply and Demand

andrea.parisi | Published: 8 Mar 2025, 8:10 p.m.

Theory

The theory of Supply and Demand is at the heart of modern economics, and is somehow shared from most schools of economics. Yet, I always found it hard to reconcile it with what happens to prices in the real world.

The theory dates back to the 1750s and is based on the intuition that the more a good is on demand, the higher the price will be, while the more supply is available of a given good, the lower the price is going to be. However there are many instances in which the real world seems to disagree with the theory of Supply and Demand. Take for instance the prices of goods at a shop. When a good is in high demand and a shop runs out of it, the shop owner will just tell you that he is awaiting a new shipment. The last customers who got the last pieces will not have been subject to a price increase, nor the producer will ask the shop for a higher price. The question thus is: is Supply and Demand still valid? If yes, then what mechanisms are there preventing the change in price? And if not, what is thus at work and what are the limits of validity of the theory of Supply and Demand?

There is no doubt that prices are subject to some level of pressure in some contexts. For example, prices of some electronic components may vary from month to month: for instance, monitoring the price changes of hard drives or memory cards, will reveal a change in price over some periods. For other goods however, for instance the price of mayonnaise, these changes might be less frequent.

For the purpose of this discussion, any economic text on the theory of Supply and Demand would do. For the purpose of clarity, I searched the web for an available text, and I found some freely available (at the time of writing) teaching material by Jón Steinsson of the University of California in his: Money, Inflation, and Output: A Quantity-Theoretic Introduction. In his exposition, Steinsson uses the typical idea of an isolated society, economically based on the gold standard (pages 17—22). In this economy, businesses post the price of the goods they sell at the start of a "period", which is taken to be daily (I believe without loss of generalization). There are two assumptions: the first is the fact that prices are unresponsive to demand in the short period, and the second is that sellers are willing to meet demand at the posted prices. With these premises, it follows that when demand is high the inhabitant of this place need to work very hard in order to meet demand, and at some point they must think to ways of lowering their work schedule. They can do this by rising prices: evidently there is some price level at which demand and supply equilibrate, and that sets the price of goods.

This exposition follows the canonical description of the theory of supply and demand that is found in most textbooks of economics. Notwithstanding its large diffusion and adoption, it seem to diverge from what the real world behaves. First, prices rarely act as an equilibrium between supply and demand. Steinsson acknowledges that price adjustments are usually sluggish: this is known as the "stickiness" of prices. For example – he notes – if you visit a restaurant often you will notice that its prices rarely change, despite the business being subjected to varying costs.

In fact, for most products, prices rarely change – so rarely that economists try to investigate the reason behind the sluggish update of prices. The theory of supply and demand assumes that for a given product there are two potential curves of equilibrium: the Supply curve and the Demand curve. The first, describes the change in price that would be observed for a change in supply for fixed demand. The second, describes the change in price that would be observed for a change in demand for fixed supply. The price of a good is thus an intersection between the supply and demand curves. It is worth pointing out that this is all a theoretical framework: the Supply and Demand curves cannot be traced. Indeed I was unable to find a single measurement of a demand/supply curve in the literature.¹ In other words this is a theory that we may believe, but we cannot prove. Even if we believe the theory, we do not know its limits: where does it break down? Or else what is at play when we do not observe a change of price as a result of a change of demand? Take for instance, how economics deal with the fact that retail prices rarely change. Economists tend to say that the item is price inelastic, as a change in demand or supply does not change the price. This, however, does not reveal anything regarding what is going on: it is only a mathematical artifice that allows to extend the theory of Supply and Demand to cases where this theory is of no particular use. If the price is independent of Demand or Supply, then clearly it makes little sense talking about "supply" and "demand". Yet, by stating that the item is price inelastic, this case can still be incorporated within the theory of supply and demand. We can now insist that the theory of Supply and Demands is at work even when it is actually failing.

I want to be clear here. The problem is with the terms "Supply and Demand", which are used even when the price is not driven by supply and demand. It is this naming and lack of clarity that creates confusion, as you are naturally brought to think that supply and demand are the only mechanisms controlling the price level of a good, while it is clearly not the case. This lack of clarity, unfortunately, spills over explanations provided by economists or economic journalists: when prices go up, owing to the fact that prices are driven by supply and demand, it is clearly demand that is increasing, even when in reality it is not. The idea that prices are driven by the change of these two curves is predominant, whereas in reality the theory applies only to certain contexts. This confusion is an example of a process that is found often in economic theory where mathematics is translated into language, losing the constraints and underlying bases that clarify the validity of the mathematical statements. In other words, generic language statements override the underlying stricter mathematical description. This unfortunately creates a lot of incorrect statements found everywhere, including in economic books.

A case of interest occurs when a new product is created, for which no supply existed. In this case, the price given to the product is not determined by supply and demand, since there is no demand yet for the non-existing product. It could be argued that the non-existing product might have a potential demand curve, for instance given by existing similar products. This might be true, but there is no way we could verify and, most of all, measure such curve.

A long time ago, I was exploring the possibility of opening a company, and I disussed with an accountant about how to proceed. The accountant was the head of the local branch of an international accounting firm. During the discussion he mentioned that I would at some point have to trace the supply and demand curve to get the sell price of the product I was planning to sell. At the time this seemed a logical suggestion, despite not knowing how to do it. My business idea later on subsided: I got a new research job, and had no time to develop it any longer: I exchanged a complex technical challenge of uncertain outcome with a safer option, and never dealt with the problem of setting the right price for that product. Nowadays, however, I know that the price an entrepreneur assigns to a product is typically not set through an analysis of supply and demand curves (which are not observable anyway). When an entrepreneur decides to open a business, he does so with the prospective that the business will be profitable (or at least will not make a loss). To achieve that, he needs to earn more than the costs. Suppose the business is to produce and sell certain goods, then the sell price of goods will have to exceed the cost to produce them. Suppose that there is demand for those goods, the business owner might decide to rise prices: that is what economic theory seems to tell us. In the real world however, businesses do not increase prices except in specific circumstances: competition, including potential competition, prevents businesses from increasing prices. A business that sells a certain good, will maintain prices to a level sufficient to discourage competitors to enter the market, and will invest profits to expand and increase production. The moment the business increases prices, it gives the possibility to potential competitors to get into the market with a margin (due to the selling price being sufficiently higher than costs) sufficient to repay their investments. Thus a business, producing a new product, typically prefers limiting the entry of competitors, and it does so by maintaining its prices to a sufficiently low level. The only cases when prices increase are:

1. when costs increase
2. when the business operates in a regime of monopoly

a. When costs increase

Increasing costs means that a company may become no more profitable. It is thus forced either to find ways of decreasing costs, or increase prices. If the problem of increasing costs is shared within the industry (for instance an increase in costs of commodities required to produce the goods) then these costs can be simply passed to the consumers by an increase in prices, as all companies within the industry will be subject to the same problem.

b. When the business operates in a regime of monopoly

Pharmaceutical companies often have high prices with respect to costs for their products, granting large revenues that they typically invest in research activities. They can maintain high prices because pharmaceuticals are typically covered by patents that grant exclusivity for a certain number of years. In this case thus, they need not to worry about competition for the duration of the patent.

Taking into account all the above, we can also finally deal with the question:
when is the supply and demand theory at work?

When is supply and demand at work?

Prices are driven by supply and demand when either the demand or the supply are constrained. Suppose you are the owner of a unique large diamond. There is no other diamond like yours: in this case you cannot be undercut in price, and you can keep prices high as long as you have people willing to buy your diamond. You can achieve maximum price through an auction, which simply makes individuals compete in real time for that diamond. The same occurs for unique pieces of art, clothes, furniture, anything unique.

However, the concepts can be applied broadly: if supply increases rapidly, demand cannot adapt to it even if there were people or companies willing to. Same, if demand increases rapidly, supply cannot adapt to it even if there were people or companies willing to. An example are domains where there is a barrier to entry, like in the mining sector. If there is an increase in demand, it is hard for new actors to enter the business. First, you cannot open a mine wherever you would like: only certain areas are licensed from governments for mining. Additionally, in order to be profitable for certain minerals, the area must be rich of those minerals: thus only selected areas might be mined for specific minerals. Third, mining is an energy and labour intensive industry, requiring large investments in order to work. As a result, if demand largely exceeds supply, it is not straightforward for new companies to fill the gap. Mining companies cannot tune production rates at ease, they compete with each other, and inventory buildup incurs considerable costs. What this means is that they are more subject to supply and demand than other companies. Another example that I mentioned at the start, is the case of some electronic components. I was monitoring the cost of a hard drive of a notorious brand because I needed it professionally. I needed specifically that one, because it granted a certain speed, durability and reliability. In this sense, it is not surprising that the cost is more subject to volatility, as this specific good cannot easily be substituted: there might be many kind of hard drives, but the specifics make good drives a small monopoly for the producing brands. On the contrary, mayonnaise is not that essential: it is easier to find good mayonnaise, and failing that, unlike a hard drive, we can do it ourselves. Even more, if we do not wish to make mayonnaise, it is a good that we can forgo, or substitute for something else. This is a good that does not suffer the same level of constraints that mined goods suffer: as such, it is largely unaffected by supply and demand. It is rather costs that set the price for the good.

As a result of these considerations, we might say that the theory of supply and demand is somehow an incomplete description of what drives prices. While supply and demand might be behind many of the changes in price of goods, these changes are limited by the amount of available competition in producing those goods. In other words, competition acts as a deterrent on keeping prices the lowest.

1. To clarify, companies may be able to estimate 'market demand', and produce 'sales forecasts' but these are not an estimate of either the Supply or Demand curves. They only hint to what, assuming the theory is correct, the equilibrium between supply and demand might be. Companies might also try to estimate Supply and Demand curves based on how many units they sell following a price change, or how prices change following an increase in Demand for row materials. However, this estimate would be acceptable if no other quantity was going to change, for instance salaries or purchasing power. However this is rarely the case.