Like the weather, markets are dynamic, subject to periods of storm and calm and constantly evolving. Yet, as with weather forecasting, a careful study of markets will reveal certain forces underlying the apparently random movements. To forecast prices and outputs in individual markets, you must first master the analysis of supply and demand.

Take the example of gasoline prices, illustrated in Figure 3-1 on page 47. (This graph shows the “real gasoline price,” or the price corrected for movements in the general price level.) Demand for gasoline and other oil products rose sharply after World War II as people fell in love with the automobile and moved increasingly to the suburbs. Next, in the 1970s, supply restrictions, wars among producers, and political revolutions reduced production, with the consequent prite spikes seen after 1973 and 1979. In the years that followed, a combination of energy conservation, smaller cars, the growth of the information economy, and expanded production around the world led to falling oil prices. The real price of gasoline fell from over $2.50 per gallon in 1980 to around $1.00 per gallon in 1999. The most recent turn came when production cutbacks by
the oil cartel and booming demand led to , a sharp spike in oil prices in early 2000,angering truckers and motorists and putting upward pressure on inflation.

‘What lay behind these dramatic shifts? Economics has a very powerful tool for explaining such changes in the economic environment. It is called the theory of supply and demand. This theory shows how consumer preferences” determine consumer demand for commodities, while business costs are the foundation of the supply of commodities. The increases in the price of’ I gasoline occurred either because the demand for gasoline had increased or because the supply of oil had decreased. The same is true for ever}’ market, from Internet stocks to diamonds to land: changes in supply and demand drive changes in output and prices. If you understand how supply and demand work, you have gone a long way toward understanding a market economy.

This chapter introduces the notions of supply and demand and shows how they operate’ in competitive markets for individual commodities. We begin with ‘demand curves and then discuss supply curves. Using these basic tools, we will see how the market price is determined where these two curves intersect-where the forces of demand and supply are just in balance. It is .the movement of prices-the price mechanism-which brings supply and demand into balance or equilibrium. This chapter closes with some examples of how supply- and-demand analysis can be applied.

Gasoline prices have fluctuated wildly ‘oyer the last four decades. Supply reductions in the 19705 produced ‘~o dramatic Moil shocks,” which provoked social unrest and calls for increased regulation: Reductions in demand from new energy saving’technologies led to the long decline in price after 1980. When the oil cartel reduced supply in late 1999, oil prices once again shot up sharply. The tools of supply and demand are crucial for understanding these trends. (Source: U.S. Departments of Energy and Labor. The price of gasoline has been converted into 2000 prices using the consumer price index.)

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