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Socratic Economics V: Supply and Demand

by Migeru Wed Nov 7th, 2007 at 11:14:38 AM EST

Migeru:

I am beginning to have serious problems with that most basic of economic truths, the crossing of supply and demand curves.
ChrisCook:
Diary
Okay.


In that little diagram, the "equilibrium" or crossing point is observed, namely a (price, volume) point. The rest of the diagram is counterfactual. I suspect people are using consumption as a proxy for demand and production as a proxy for supply. The difference between consumption and production is the change in inventory. But ignoring that difference for a minute, consumption is just the demand at the "equilibrium" point. Nobody is counting all the times someone goes and says "gee, I want to buy some more of this but it's too expensive" or "gee, I wanted to buy some more of this but the shelves were empty" and so the demand curve is unobserved (unobservable?). Similarly with the supply curve.

Does one have to look at the order book at a commodities exchange (or the open interests in futures) to get supply and demand curves for oil?

And, of course, if the supply and demand curves are counterfactual it is going to be rather hard to measure their slopes (the "price elasticity" of supply and demand).

So, if what people are really looking at is (price, consumption) curves, then all they are doing is looking at consumption trends and extrapolating into the future. Which says little about "demand".

What am I missing?

Socratic Economics is an occasional series of questions posed in a Socratic effort to understand economics. Previous entries:

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Does one have to look at the order book at a commodities exchange (or the open interests in futures) to get supply and demand curves for oil?

What you are getting there is market participants' hopes, fears and expectations as to future price.

Futures markets are risk transfer mechanisms, that's all. The tail, not the dog.

I think that inventory in the oil markets is probably de minimis - I don't know the figures for commercial inventory - that tends to depend on whether or not the market is in backwardation, as now - but the US Strategic Reserves are limited.

A great deal of global oil is locked up in long-term supply deals, with prices set using agreed pricing formula's benchmarked against either "Dated" (not futures) Brent - around 60%, I think - and most of the rest using NYMEX WTI.

What this means is that there isn't much of a tradable "free float" (as they call it in the equity market) of crude oil, and that means that a relatively(!) small amount of money can have a disproportionate effect in relation to the segment of oil production actually tradable - and trading - on the market.

This ties in with my original rationale for the good old Iran Oil Bourse and the continuing efforts by the usual suspects to come up with a viable "Gulf " benchmark price.

Unless and until the Saudis and the Iranians put a sizable chunk of their production into the market without restrictions on re-sale there is bugger all chance of a successful "Gulf" market, or of a credible benchmark price.

But I digress.

Maybe an "altruistic economics" approach would work better for pricing so that one would look at participants' "indifference value"

ie not "what is this worth if I do buy/sell it"

but

"what do I lose if I don't buy/sell it".

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Nov 7th, 2007 at 12:37:27 PM EST
Perhaps adding a 3rd axis for time?

Otherwise, it is a nice little graph with artistic merit - strongly influenced by Kandinsky's teaching in the Bauhaus basic design course, I feel. The bold use of colour and the fusion of both text and iconography is typical.

You can't be me, I'm taken

by Sven Triloqvist on Wed Nov 7th, 2007 at 12:39:49 PM EST
That is really funny.

It spawns a whole new academic discipline, as well:

The fusion of Art History, Art Criticism, Economics, and Semiotics will investigate the modalities, privileging, and valuations of  a priori and posterior visual representations of Economic equations and Models.


She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre
by ATinNM on Wed Nov 7th, 2007 at 01:10:34 PM EST
[ Parent ]
Is there a Chair in it somewhere, or do I have to start my own university?

You can't be me, I'm taken
by Sven Triloqvist on Wed Nov 7th, 2007 at 01:18:15 PM EST
[ Parent ]
Well, there is this chair:

or this:

in the US this:

would, I think, be more appropriate.

At either Oxford or Cambridge this:

has much to recommend it.

As far as getting a paid position ... you're on your own.  Tho' I will note the University of Helsinki has a forward looking attitude to new, and exciting, research areas.

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Wed Nov 7th, 2007 at 01:58:25 PM EST
[ Parent ]
I think I'll go for Marcel. I will try to locate a picture of a terrible misuse of same.

You can't be me, I'm taken
by Sven Triloqvist on Wed Nov 7th, 2007 at 02:01:59 PM EST
[ Parent ]
I LOVE the first one. My all time favorite. 2 at home, never tired of it.

Rien n'est gratuit en ce bas monde. Tout s'expie, le bien comme le mal, se paie tot ou tard. Le bien c'est beaucoup plus cher, forcement. Celine
by UnEstranAvecVueSurMer (holopherne ahem gmail) on Wed Nov 7th, 2007 at 05:31:40 PM EST
[ Parent ]
Sitting in it, or looking at it?

Words and ideas I offer here may be used freely and without attribution.
by technopolitical on Sun Nov 11th, 2007 at 02:22:38 PM EST
[ Parent ]
Both! perfect for reading, you can sit in thousands of way. And the leather is now a little streched, so it fits your back even better.

Rien n'est gratuit en ce bas monde. Tout s'expie, le bien comme le mal, se paie tot ou tard. Le bien c'est beaucoup plus cher, forcement. Celine
by UnEstranAvecVueSurMer (holopherne ahem gmail) on Mon Nov 12th, 2007 at 12:49:56 PM EST
[ Parent ]
Well, you could plot the path in price-volume space traced out by the "equilibrium" or "clearing" point. But that would not be a supply or a demand curve.

If you added a third dimension you would get surfaces traced by the supply and demand curves, which away from their intersection would be just as counterfactual as the lines are on the chart at a given time.

We have met the enemy, and he is us — Pogo

by Migeru (migeru at eurotrib dot com) on Wed Nov 7th, 2007 at 01:49:47 PM EST
[ Parent ]
What you are missing is price. If the price goes high enough the demand is supposed to decrease. If it fails to perform according to theory then economists add a fudge factor called "elasticity". This is supposed to explain the slope of the curve.

If things really don't perform as expected then they invoke "market failure". The markets have failed, not the theory. That's why they don't call it "theory failure". It's also why we physical scientists don't think much of their "theories". And from this follows why we get purged from some economic blogs and/or scolded for not understanding economics.

Personally, I'm getting a bit tired of tweaking the most hide bound economists. Perhaps you would like to join me. I suggest Mark Thoma's blog as a good starting point. He is liberal, but posts discussions about all sorts of economic positions. He only has one sore point, that's when someone (me) calls into question economic modelling.

Take a look and see if you want to participate:
Economist's View

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Wed Nov 7th, 2007 at 03:26:26 PM EST
I am not "missing price". It's right there in the vertical axis of the supply and demand chart.
If the price goes high enough the demand is supposed to decrease.
Do you mean if price increases with time, or if we counterfactully suppose that the price now is higher than observed?
If it fails to perform according to theory then economists add a fudge factor called "elasticity"
I though "price elasticity" played a different role than a fudge factor that allows demand to stay constant as  price increases. I thought the price elasticity of a quantity (Q) was the logarithmic derivative (actually, d log Q / d log P), that is, a description of the local shape of the curve. But as I point out, the logarithmic derivative of demand at constant supply is unobservable because at constant supply there is only one price and demand that are in equilibrium.

Anyway, even if the price elasticity of demand is calculated as time varies we get strange results. Both price and demand for oil have increased (on average) over the past two years. So the price elasticity of demand has the wrong sign in this case: it would seem that to reduce demand one would have to bring prices back to what they were two years ago.

But it is not "demand" I'm actually talking about in the previous paragraph, it's "consumption". "Demand" actually seems unobservable.

The markets have failed, not the theory. That's why they don't call it "theory failure".
Economists are in good company.
Albert Einstein - Wikiquote
Then I would have felt sorry for the dear Lord. The theory is correct.
  • As quoted in Reality and Scientific Truth : Discussions with Einstein, von Laue, and Planck (1980) by Ilse Rosenthal-Schneider, p. 74
  • When asked by a student what he would have done if Sir Arthur Eddington's famous 1919 gravitational lensing experiment, which confirmed relativity, had instead disproved it.
I don't know what perverse pleasure you derive in tweaking economists. Thanks for the offer, but I'm not really interested.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Wed Nov 7th, 2007 at 04:29:00 PM EST
[ Parent ]
The point of tweaking economists is two fold. One is to do what you just did, point out the deficiencies in their models.

The second is to encourage the younger generation of economists to break out of the dogma and examine things afresh. There is some progress on this front. In France there are the post-autistic economists (although I can't quite figure out what their viewpoint is). In the US there are various groups including the heterodox economists, the environmental economists and the ecological economists.

There has been a similar activity with regard to the hold of religion in the US. Several writers have come forth (Sam Harris, Richard Dawkins, Daniel Dennett, etc.) and attempted to debunk religious dogma. Once they broke the ice many who were afraid to speak up joined in the discussion. They also provided forums where such discussions could take place. I won't say that the power of the religious right has been eliminated by this effort, but there has been a noticeable change in tone in the US. The entry on YouTube with the most comments (over 200,000!) is a clip of a woman condemning Islamic dogma in Arabic (with English subtitles). This shows the power of bold ideas when presented in the right forum.

As for your discussion of elasticity and oil, you ignored the fact that the market for oil has been increasing over the same period. That's why use and price can both go up at once. I suggest looking at the rise in auto ownership in both India and China over the past decade as an example.

I don't see why, if you feel strongly that the axioms of economics are wrong, you are unwilling to discuss this in an economics forum. You won't get much disagreement on this site, nor will you get much detailed criticism of your remarks from professionals in the field. One should always be willing to have one's ideas tested in the proper setting.

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Wed Nov 7th, 2007 at 05:39:55 PM EST
[ Parent ]
As for your discussion of elasticity and oil, you ignored the fact that the market for oil has been increasing over the same period. That's why use and price can both go up at once. I suggest looking at the rise in auto ownership in both India and China over the past decade as an example.
I have no problem with use and price to go up at the same time. The problem is that I suspect consumption is generally used as a proxy for demand, and a sort of "ergodic" hypothesis is made whereby time changes can be used to estimate elasticities, with nonsensical results.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Wed Nov 7th, 2007 at 05:46:49 PM EST
[ Parent ]
I don't see why, if you feel strongly that the axioms of economics are wrong, you are unwilling to discuss this in an economics forum. You won't get much disagreement on this site, nor will you get much detailed criticism of your remarks from professionals in the field. One should always be willing to have one's ideas tested in the proper setting.
I don't know that I feel strongly about this stuff. This series is called Socratic for a reason: all I know is I don't know. And I'm afraid I expect if I say these things in a forum full of academic economists they're going to just tell me go read a textbook.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Wed Nov 7th, 2007 at 05:51:48 PM EST
[ Parent ]
And I'm afraid I expect if I say these things in a forum full of academic economists they're going to just tell me go read a textbook.

And the problem with that would be...  ???

by asdf on Sat Nov 10th, 2007 at 12:05:11 PM EST
[ Parent ]
I've read textbooks. They are crap. They don't address the questions of whether the quantities in the theory are actually observeble, or how. It would be argument by authority.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Nov 10th, 2007 at 12:23:47 PM EST
[ Parent ]
"Elasticity" isn't a fudge factor added to save the theory, it is a parameter of the theory. Playing with it can, of course, be used to fudge results, just like fiddling with any other parameter to fit data to a theory in an illegitimate fashion.

Also, "market failure" isn't necessarily a failure of the theory, it is a situation where theory itself predicts that various lovely results will not hold, because the necessary preconditions are not present. Market imperfections (transaction costs, imperfect information, imperfect competition...all those universal realities) differ from market failure. A classic case of market failure is that there is no price for polluting (despite the cost imposed on others), resulting in its overproduction. Simplistic marketists tend to ignore both imperfection and failure.

At least, this is how I understand the use of the terms.

Words and ideas I offer here may be used freely and without attribution.

by technopolitical on Sun Nov 11th, 2007 at 03:00:47 PM EST
[ Parent ]
Once again, textbook economics is bullshit. (How many times does this need to be said?)

The curve isn't a curve, it's a metaphor.

There is no curve. There is a rough inverse relationship. The relationship will very likely have discontinuities in it. It will not be smooth. For small sales volume, it will suffer from statistical noise.

The only way to plot the graph (not curve) is empirically. The graph cannot be calculated accurately ahead of time.

Given very large sales volumes and steady conditions, it may be possible to estimate the graph usefully based on historical conditions and a rational assessments of the effects of price points. I'd expect this to be true for large corporations selling many units of a single item in a mature market without any external shocks. In those conditions, you may get a significant figure or two out of a numerical estimate given an existing empirical base of price change data.

For more open conditions - don't waste your time. The relationship is metaphorical at best, and just plain wrong at worst.

Really? Oh yes.

Here's a data point - at this year's Big Green Gathering a company was giving away free bottles of water.

Water is a very desirable resource at festivals, especially on hot days. If supply and demand were true you'd expect the stall to be mobbed. People would rather get something free than not, wouldn't they?

In reality - not so. The stand got some interest, and it did - eventually, after a week or so - run out of water. But it didn't get a lot more interest than other stands, and people were still paying for bottles of water elsewhere on the site.

You can explain this by looking at how and why people buy water. (There's more going on than simple thirst.)

You can't explain it by looking at a simple-minded supply and demand curve, because it really is much too crude and clumsy a tool to be useful as a model in most real situations.

Alternatively - will some stall holders charge more for water when it's hot? At some festivals, yes they will.

Can you calculate how much more? No, you can't. You can guess based on what you think is likely and reasonable - and the chances are their guess will be similar to yours, at least within 50p or so.

No one is going to sell water for £10,000 a bottle. They might try £3 if they think they can get away with it. £2 is more likely.

And so on.

But empirically, from first principles? No.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Wed Nov 7th, 2007 at 04:41:25 PM EST
There is no curve.

And no spoon?

Come to think of it, the similarities between Economics and the Matrix are rather eerie.

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Sun Nov 11th, 2007 at 11:34:09 PM EST
[ Parent ]
But ignoring that difference for a minute, consumption is just the demand at the "equilibrium" point. Nobody is counting all the times someone goes and says "gee, I want to buy some more of this but it's too expensive" or "gee, I wanted to buy some more of this but the shelves were empty" and so the demand curve is unobserved (unobservable?). Similarly with the supply curve.

In the simple equilibrium models of textbook economics, individuals do not set the price (both for consumption and production). The times that someone did not consume don't matter, because someone else will. Same for production.

AFAIK...

by nanne (zwaerdenmaecker@gmail.com) on Sat Nov 10th, 2007 at 11:53:03 AM EST
So, in simple equilibrium models, are the variables of interest consumption and production instead of demand and supply?

The only market where anything like textbook supply and demand applies is a Dutch auction. Er, well, nearly

Dutch auction - Wikipedia, the free encyclopedia

This type of auction is convenient when it is important to auction goods quickly, since a sale never requires more than one bid. Theoretically, the bidding strategy and results of this auction are equivalent to those in a Sealed first-price auction; however, experiment indicates that a Dutch auction typically results in lower sale prices [1].


We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Nov 10th, 2007 at 12:26:56 PM EST
[ Parent ]
No, they are supply and demand, I'm just substituting. I think a Dutch auction is not a textbook example of a market where there is no price-setting because there is only a small number of suppliers (at a single auction).

See perfect competition.

Theoretically, the 'lead time' it takes for a producer to change supply to deal with shifting demand is not relevant on a market when there is a sufficiently large number of producers and consumers (there also is no real shifting demand on a market with perfect competition).

by nanne (zwaerdenmaecker@gmail.com) on Sat Nov 10th, 2007 at 12:54:11 PM EST
[ Parent ]
How is the supply curve measured? Ditto for the demand curve.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Nov 10th, 2007 at 02:02:37 PM EST
[ Parent ]
The demand curve measures what happens to the price if there is a shift in supply and the supply curve what happens if there is a shift in demand :-)
by nanne (zwaerdenmaecker@gmail.com) on Sat Nov 10th, 2007 at 02:27:13 PM EST
[ Parent ]
The curves don't measure anything: they express relationships. How are the relationships measured so they can be expressed by curves?

When people talk of a "shift" in demand or supply they normally refer to a movement of the whole curve. So half the time "demand" refers to the whole "demand curve" and the rest of the time it refers to a quantity (apparently, to "consumption"). Similarly Supply" can refer to "supply curve" or to "production".

We have met the enemy, and he is us — Pogo

by Migeru (migeru at eurotrib dot com) on Sat Nov 10th, 2007 at 04:06:07 PM EST
[ Parent ]
The curves are part of a model, the model expresses idealised relationships. How these are measured seems to be an empirical question?
by nanne (zwaerdenmaecker@gmail.com) on Sat Nov 10th, 2007 at 05:00:10 PM EST
[ Parent ]
Empirical questions seem to fall outside economics.

The point is, of the model only the intersection of the curves, that is, the clearing price and the production = supply = demand = consumption are observable.

We have met the enemy, and he is us — Pogo

by Migeru (migeru at eurotrib dot com) on Sat Nov 10th, 2007 at 05:07:29 PM EST
[ Parent ]
Yes, and it is important to distinguish a theoretical construct intended to predict patterns of results, from a predictive scheme that gathers and crunches data, outputting numbers and dates. To be a falsifiable scientific theory, the former need only predict what patterns of behavior may occur (or equivalently, what patterns won't occur).

The idea that economic theory is necessarily about prediction, like celestial mechanics applied to planets, is the source of much confusion. "Economists can't predict recessions, so what do they know?" The answer is that, in principle, they could know a lot, yet never predict a price or an economic fluctuation.

That economists commonly think they know many things that aren't actually true is a different issue.

Words and ideas I offer here may be used freely and without attribution.

by technopolitical on Sun Nov 11th, 2007 at 02:34:49 PM EST
[ Parent ]
Forget about prediction. If the demand and supply curves cannot be observed the theory doesn't even describe what is observed.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sun Nov 11th, 2007 at 04:27:41 PM EST
[ Parent ]
of supply or demand curves is the dispatch curve for electricity:

That reflects the production capacities available, ranked by their production cost. So this is, in a very real sense one hal of your supply-demand graph.

For a given level of demand, you can determine very precisely the price that will be needed to fulfill that demand (that of the producer that allows you to reach that same number of MW at that moment, adding all the cheaper producers in the list before that producer's capacity is needed).

And all producers will get that price - and all consumers will pay that price (noting, of course, that the market is for wholesale electricity, and is likely to apply only a 1-hout slot of demand or other similarly short period).

With capacity essentially fixed in the short term, it is demand that varies and sets price as a first approximation. Of course, power plants can decide to bid for power at prices that are different from their actual cost, for various technical or other reasons, and modify the curve - but you can still rebuild a curve based on their bids.

If you look at the demand side, it may look flat (ie demand is not sensitive to price) but within ranges. Industrial users will have cutoff prices (and may thus take out a big chunk of demand is prices go above a certain level). Some may have storage capacity and similarly drop out of the market at some prices (and become sellers). etc...

And of course, long term decisions will be affected by how the short term S-D curve looks like, and will in turn help shape it differently.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Nov 11th, 2007 at 08:01:00 AM EST
It's interesting to think about the relative speed with which operating point on the demand and supply curves might change. In Jerome's supply example, the costs are connected to long-term availability of power plants, fuel, and regulations. But the demand is controlled by the consumer.

So if the supply curve changes for some reason, then the demand should be able to change immediately in response. On the other hand, there is some hysteresis in the demand curve also, because the consumer is not likely to make a quick change in usage habits.

For example, when the price of gasoline jumped from $2.90 to $3.10 per gallon last week, I did not suddenly reduce my driving to compensate. That is, there was a change in the supply curve (downwards), but I continued to demand the same amount as I did previously.

If it takes energy consumers a while, say perhaps two months, to change their consumption habits, then the operating point will be offset from the theoretical operating point for that period. I suppose that my demand would be expected to gradually move down my demand curve until it intersected with the newly changed supply curve. So this would be an example of where my small part of the economy is operating outside of the simplistic "intersection of the supply and demand curves" model.

I suspect that this is dicussed in one of the later chapters of my old copy of Samuelson's Economics...

by asdf on Sun Nov 11th, 2007 at 08:55:15 AM EST
[ Parent ]
there was a change in the supply curve (downwards)

Actually the supply curve moves to the left, which makes it move "upwards" on the S-D curve...

by asdf on Sun Nov 11th, 2007 at 08:58:27 AM EST
[ Parent ]
The gasoline consumer sees a price every time he drives by a gas station (not even every time he stops at the pump), but the electricity consumer doesn't see the instantaneous wholesale price of electricity when he switches an appliance on. He gets a monthly bill. And then again, the monthly bill is often a flat rate (possibly by tiers: the first so many kW-h cost this much, the next so many cost that much, etc). so the wholesale supply curve is invisible to the consumer, even industrial-scale consumers. And even the gasoline consumer with his frequent information updates on the price of gasoline won't be likely to reconsider his driving habits more often than once a month, when looking at the state of his accounts, unless he sees a price spike in which case he may engage in panic buying or decide to park the car altogether for a few days. Finally, energy is akin to a Giffen good in that people are likely to consider their energy consumption "fixed" and not part of their "disposable income" that they shuffle around. So increasing energy costs just lead to lower disposable income and so in the short term reduce demand of other consummables, not demand for energy. Energy is not a Giffen good in that people don't consume more energy when it is more expensive.

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sun Nov 11th, 2007 at 09:40:53 AM EST
[ Parent ]
To be a Giffen good, energy consumption would have to rise when the price increases. Inelastic demand is not enough: elasticity must be negative.

Words and ideas I offer here may be used freely and without attribution.
by technopolitical on Sun Nov 11th, 2007 at 02:44:59 PM EST
[ Parent ]
Bus tickets should be a Giffen good. As the price of oil increases, demand for bus services goes up, in spite of the increasing bus fuel surcharges.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Sun Nov 11th, 2007 at 11:34:30 PM EST
[ Parent ]
If you look at the demand side, it may look flat (ie demand is not sensitive to price) but within ranges. Industrial users will have cutoff prices (and may thus take out a big chunk of demand is prices go above a certain level). Some may have storage capacity and similarly drop out of the market at some prices (and become sellers). etc...
Are industrial users charged on the basis of the marginal wholesale price?

We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sun Nov 11th, 2007 at 09:52:57 AM EST
[ Parent ]
The big ones are - aluminum smelters, metal bashers, petrochemical manufacturers, independent power plants, possibily some local heating companies...

EDF has and had some interesting tariff arrangements with some of them - like interruptible supply pricing: such users get a low price, close to wholesale, but may be cut off (or have to pay punitive prices) at EDF's discretion, when it needs to deal with demand spikes. That reflects that they have processes that are not sensitive to cutoffs, or that they have alternative (and flexible) ways to get power at hand, and they act as 'peak supply' providers for EDF.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Nov 11th, 2007 at 11:39:29 AM EST
[ Parent ]


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