Wednesday, 3 July 2013

Supply and Demand: Does the Law Always Hold?

 

The laws of supply and demand are probably one of the most important concepts in economics. In essence, it explains the nature of the relationship between demand, supply and price. The law of supply, in particular, states that the higher the price, the higher the quantity supplied. In other words, the relationship has an upward slope.

The laws of supply and demand, however, relate price to supply and demand when all other factors remain equal. The problem is that only on rare occasions all factors are equal. This means that rather than of laws we should be speaking of theories. Let's see an example. Below is a table illustrating 20 years of data relative to coffee supply/production (the period is 1990-2009, source: http://www.ico.org/).





The Business Structure Map relative to the above data is illustrated below.






The surpising fact is that the "ICO indicator price" is not related to any other parameter in the data, and, in particular, it presents no correlation with any of the supply/production parameters. The scatter plot "Supply Production - ICO indicator price", shown below, indicates why this is the case.






The plot is chaotic, with a tiny generalized correlation coefficient of 0.09. Because all the other parameters in the data are not constant, the theoretical relationship which one would want to see, is masked. In other words, supply and production in this case are not drivers of price. Is this a violation of the laws of supply and demand? Wrong question. The laws of supply and demand are theoretical and as our global economic crisis shows, one thing is a (mathematical) theory another is reality.



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