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Saturday, November 27, 2010

Getting More From Supply and Demand

Supply and demand is, for good reason, the most recognizable graph in economics. Much of economic analysis, however, simply gets lost in the system of simultaneous equations, which mathematically represents supply and demand. Markets clear in equilibrium at the price and quantity where supply meets demand. Austrian economist Fritz Machlup used to even joke, in his classes, that he only draws supply and demand as an X so those in the back could see. Meaning, in equilibrium, supply and demand is simply a point. When we are not in equilibrium these equations show us that market forces will work to bring us there.

This is certainly a useful tool but what makes supply and demand so amazing is the human action and process of exchange that takes place, which makes it work. Supply and demand is a starting point of analyzing human action. In today’s document, a letter from F. A. “Baldy” Harper to Henry Hazlitt on April 3, 1946, Harper illustrates this well through an example of unintended consequences of rent control.

Supply and demand tells us that if a rent control policy is enacted below the market price, which is a price control, there will be a shortage. Meaning landlords are not allowed to raise the rent to the market-clearing price. There is a shortage because at this lower rent more people will want to rent apartments than people are will to supply. This is all we can say using the simultaneous equations of supply and demand but this is far from the end of the analysis. Many more questions are important. What does this do to the incentives of the landlords? The renters? What further unintended consequences will this produce? Etc.

In this letter to Hazlitt, Harper points to one unintended consequence that effects the very people the price control is meant to help. The policy is meant to give renters a lower price so more can rent apartments but what happens is it compels individuals to sell the houses to homeowners rather than renting it out. Thus cutting out the renters all together. This example Harper raises is just one of many. Rent control affects people in many ways from quantity of housing available to quality (many studies have even shown pictures of bombings from world war II and rent controlled housing side by side, with it being difficult to tell which is which!). And rent control is, itself, just one example of disturbing the market process.

The laws of supply and demand have amazing explanatory power but its important to remember why. It is not simply a story of X marks the spot but the consequences of human action as people respond to the incentives of market forces at work. It is for this reason the lessons of economics should never be ignored.

Download the April 3, 1946 letter from Baldy Harper to Henry Hazlitt here.

  • Nicholas Snow is a Visiting Assistant Professor at Kenyon College in the Department of Economics, and previously a Senior Lecturer at The Ohio State University Economics Department. His research focuses on the political economy of prohibition.