The Science of Supply and Demand

Science Is Everywhere

We live in a world governed by the laws of science.

From gravity to electromagnetism to sound waves, our lives are filled with scientific phenomena that structure and affect every facet of our daily routine. As a species, we have attempted at every turn to channel the laws of science to our own benefit, constantly working to build better products and to develop improved means of manufacturing. However, sometimes science unveils itself in unanticipated ways—ways that often force its will on the distribution of goods in markets.

Few events demonstrate this fact better than the COVID-19 pandemic of 2020. As this new viral strain spread around the globe, many businesses in the United States closed or reduced workers' hours, sometimes by the choice of businesses—to prevent employees from catching the virus—and sometimes due to government stay-at-home orders.¹ In the early months of the pandemic, virtually no industry or market remained unaffected as the economy declined: Consumer spending on goods and services dropped by 6.7 percent in March and 12.7 percent in April (Figure 1) and the unemployment rate rose from a 50-year low of 3.5 percent in February to a post-Great Depression record of 14.7 percent in April (Figure 2).

Supply and Demand

COVID-19 affected markets the same way they are affected by any outside force—through supply and demand. In competitive markets, supply and demand govern the ways that buyers and sellers determine how much of a good or service to trade in reaction to price changes.

The law of demand describes the behavior of buyers in markets: As the price (P) of a good or service rises, the quantity demanded (Q_D) of that good or service falls. Likewise, as the price of a good or service falls, the quantity demanded of that good or service rises. Consider your favorite snack food. A downward sloping demand curve indicates that as the price of the snack increases, you would be able and/or willing to buy a smaller amount. This relationship is demonstrated by the downward sloping demand curve in Figure 3. When the price increases from P₁ to P₂, the quantity demanded decreases from Q₁ to Q₂.

Figure 3: Demand for Your Favorite Snack

Figure 4: Supply of Your Favorite Snack

Similarly, the law of supply describes the behavior of sellers in markets: As the price of a good or service rises, the quantity supplied of that good or service rises. Likewise, as the price of a good or service falls, the quantity supplied of that good or service falls. Therefore, as the price (as determined by the market) of your favorite snack rises, firms are willing to produce more units. This relationship is demonstrated by the graph of the upward sloping supply curve in Figure 4. When the price increases from P₁ to P₂, firms are willing to supply a greater quantity. That is, the quantity supplied increases from Q₁ to Q₂.

Figure 5: Equilibrium in Your Favorite Snack Food Market

Market prices are constantly adjusting to bring into balance the amount desired by buyers and the amount sold by sellers. This balance is found at the equilibrium price, where supply and demand intersect (Figure 5). At this point we have our equilibrium price (P_e) and equilibrium quantity (Q_e).

Scientific Events

Biology: COVID-19

The COVID-19 pandemic and the associated lockdowns hit the Leisure and Hospitality sector particularly hard (Figure 6). A recent study looked at hours worked by sector in the immediate aftermath of stay-at-home orders—March 2020.² As shown in Figure 6, the effects on hours worked are separated into supply factors (red bars) and demand factors (blue bars) and measured as the percent change in historical growth rates of hours worked in each sector. Supply factors are related to businesses partially or fully shutting down. Demand factors are related to reduced consumer spending, such as from customers not shopping, to avoid catching the virus, or simply cutting back on spending due to income loss.³ For most sectors, hours worked dropped compared with historical trends due to both supply and demand factors.

Figure 6: Shock Decomposition of the Growth of Hours Worked by Sector, March 2020

When a factor other than price affects supply or demand, it is modeled by shifting the supply or demand curve, respectively, rather than moving along the curve. For increases in supply or demand, the curves are shifted to the right to higher quantities. For decreases, the curves are shifted to the left to lower quantities.

Figure 7: The Leisure and Hospitality Market

Although supply factors contributed to most of the almost 10 percent drop in the Leisure and Hospitality sector in March 2020 compared with historical growth, demand factors also contributed (see Figure 6). The change in this sector is demonstrated in Figure 7: Demand decreases (shifts to the left) and supply decreases more (also shifts to the left), resulting in a lower quantity of goods sold at the new equilibrium (Q₂).⁴

Meteorology: Hurricane Sandy

In the fall of 2012, Hurricane Sandy hit New York City and surrounding regions, with millions of citizens and thousands of businesses losing power. In New Jersey, only 40 percent of gas stations tracked by AAA had power and were operational in the immediate aftermath of the hurricane.⁵ As a result, consumers faced a severe shock to the supply of gasoline.

Figure 8: Gasoline Market Prediction in the Aftermath of Hurricane Sandy in 2012

Applying the laws of supply and demand, one can predict how this event would change the quantity and price of gasoline at the pump: Assuming unchanged demand,⁶ the supply curve would shift to the left (Figure 8). The equilibrium quantity would decrease from Q₁ to Q₂, with the price increasing from P₁ to P₂.

Did this occur? Not exactly. New Jersey Governor Chris Christie promised to punish gas stations that significantly increased prices above their pre-hurricane levels (P₁).⁷ As a result, prices remained low because they were not allowed to reach equilibrium, so oil firms had no incentive to bring extra gasoline to the market at the lower price, long lines of vehicles formed, and many stations sold out due to limited supply.

Chemistry: The Ethanol Fuel Boom

In the late 2000s, ethanol experienced a boom as an alternative fuel. Compared with gasoline, ethanol was believed to be cleaner burning (produce less carbon dioxide) and could be produced from renewable crops such as corn and sugar cane.⁸ With subsidies provided by the U.S. government to produce fuel ethanol, production facilities sprouted up across the Midwest and supply increased in this growing industry.⁹

With more and more ethanol being blended into gasoline for use in everyday car engines, many believed that yearly production would continue to grow for years to come. Then, consumers began noticing that their gas engines were being damaged by gasoline mixtures with large percentages of ethanol.¹⁰ As it turns out, the chemical nature of ethanol makes it very attractive to water. When water gets into an engine's fuel, it increases the corrosion of metal and degrades the engine. As a result, regulators decided that gasoline for normal car engines could only contain up to 10 percent ethanol by volume.^11,12

Figure 9: Ethanol Market with 10 Percent Maximum Volume in Gasoline

Using supply and demand to analyze fuel ethanol markets is a little tricky due to the volume ethanol limit. In Figure 9, the desire of producers to increase the supply of ethanol is indicated by the rightward shift of the supply curve. Producers would expect ethanol buyers to continue increasing their demand as ethanol becomes more and more popular. However, all else being equal, once buyers are running their vehicles with gasoline with 10 percent ethanol, their desire to purchase more would dramatically decrease and the demand curve would become a nearly straight vertical line.¹³ That is, the quantity demanded wouldn't increase much beyond this limit even if the price of ethanol were to decrease because people won't use gasoline with more than 10 percent ethanol. Thus, no matter how much producers wish to increase supply, buyers would not buy much more ethanol and increased production of ethanol would drive down prices.

Figure 10: U.S. Fuel Ethanol Consumption and Percent of Motor Gasoline Consumption, 1981-2019 (June 24, 2020)

Figure 10 confirms this analysis of supply and demand. Fuel ethanol consumption increased dramatically during the 2000s and then flattened out when it reached about 10 percent of motor gasoline consumption.¹⁴

Conclusion

Markets provide a means by which individuals and businesses can trade goods and services. Though goods and services come in many shapes and sizes, they are all governed by the laws of supply and demand. Of course, unanticipated scientific events, such as pandemics and hurricanes, can alter the course of markets. Yet, the same laws that make markets function every day will exert their will—the laws of supply and demand.