Are the laws of supply and demand broken?

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Everywhere, one hears about shortages. Not enough trucks to pick up goods at ports. Six-month waits for appliances. Car dealers with empty lots. Grocery shelves with missing goods. Book releases postponed because of lack of paper and printing facilities.

None of that is supposed to happen. When you have an adverse supply shock, prices are supposed to rise to clear markets. Even if a higher price does not summon more supply, it serves to ration demand. A shortage, where people have to wait or the quantity is rationed, only takes place when the price is artificially held down.

Why are markets not clearing? More remarkably, why aren’t economists talking about it?

The best explanation this economist can offer is that firms do not want to raise prices because they are afraid of blame. If you walk into a store and the price has gone way up, you blame the owners and managers, because the store has discretion over the price. But if the store runs out the stuff, a typical customer will think, “They couldn’t help it. It’s a supply shortage.”

Of course, if you had internalized freshman econ, you would not blame the store for high prices, because the the price comes from market supply and demand conditions. And you would blame the store for being out of stuff and thereby making you wait or else run all over town trying to find stuff. They are just as responsible for setting their price too low. But because most customers have not internalized freshman econ, stores think they will have better customer relations if they run out of stuff than if they raise prices.

If this is the explanation, then I think that the price stickiness will not last forever. Over time, firms will gradually raise prices. I believe that what we are seeing right now is a considerable amount of repressed inflation, and it won’t stay repressed for much longer. By the end of next year, I predict that “shortages” will have been replaced by higher prices.

35 thoughts on “Are the laws of supply and demand broken?”

  1. Could this also help to explain the labor shortage? Firms could raise wages without blowback, but until they raise prices they don’t have the revenues to support it.

  2. What about when there are big lags in expanding capacity. This seems to be happening to the microchip industry. The marginal cost of making chips hasn’t changed, and they are spending hundreds of billions trying to ramp up production all around the world as quickly as they can, but due to the inherent nature of the field, it just takes a long time to build it out when it turns out there is a major gap because of a demand shock.

    They may be locked into current prices both by some long-term contracts and the risk of loss of good-will from ‘gouging’ and ‘taking advantage’ of the profit opportunity of temporary supply constraints. So until supply ramps up over the next few years, there is little option but to ‘ration’ out the supply in a way that tries to manage the value of these long term relationships.

    In the meantime, it’s very hard to quickly adjust production processes to minimize or do without chips while still hitting price points of a viable business model, so a lot of manufacturers downstream are simply suspending production until things get better.

    There have been some stories of this happening in the form of “quality inflation”, but in general it’s hard. For example, Cadillac Escalades are being built and sold by getting rid of the “Super Cruise” feature so as to eliminate the need for the chips necessary to run the software. But the street prices seem more or less the same, so it’s a slightly lower quality Escalade, so the real price has increased. A kind of “money illusion” for goods where there is lots of opportunity to “sweat the product” by reducing the quality/price of many dimensions of features. Grocery stores continue to do this with “shrinkage inflation” – reducing the size of containers but keeping the price the same to avoid sticker shock.

    Finally, no matter how severe a labor shortage may be, there are plenty of places that employ lots of ZMP or NMP dead-weight workers who for various reasons are hard to get rid of in ordinary circumstances. Shutting down production and then slowly ramping it back up by selectively rehiring is a good way to dump these folks without taking the hit of looking like you fired them.

    In general, I think social-psychological-management factors are taking on increasing importance in economic decision-making in firms. Just like more and more things being intangible is generating a qualitative change in economic dynamics in general, more and more concern for social-psychology factors is having a likewise transformative influence.

  3. It might last of ever if America has internalised socialism as a kind of religion with distributed, informal enforcement, but only indirect government enforcement.

    In that case these store managers, and even CEOs are obeying the (canon) law of the land, one which will be all the more enduring for being unwritten and customary.

    And don’t say that it is economically unsustainable. A law affects all competitors alike, and they can just pass the cost on to the rest of society.

  4. Labor shortages?

    When I took Econ 1, right after telegraph poles were planted in front of campus, we trained, and trained hard, that there are no shortages, only where supply and demand lines cross.

  5. I have been buying the “buy one, get one free” special for McDonald’s breakfast sandwiches (not available everywhere) for at least 4 years. The price has always been between $4 and $5, often around $4.50. At some point in the past couple months it jumped to $5.20.

  6. How does “firms will gradually raise prices”, applied to many sectors, square with the idea that inflation will remain low? I understand “never reason from a price change”, but there’s got to be some correlation, right?

  7. The shortages I’m hearing about right now are shipping-related. There are hundreds of container ships waiting to get into America’s ports and be unloaded, mostly because ports were closed for a while due to Covid and are now short of people to do the unloading. In some cases the ports or longshoremen’s unions have imposed vaccine requirements and many workers don’t want to comply.

    The port of Long Beach estimates it will take them 4 weeks to unload the ships that are already there.

    I have not heard of a shift to alternative modes of shipping for all these goods. Maybe it isn’t practical, or they have congestion issues of their own.

  8. I think the blame game is highly relevant when the difficulty in getting goods affects all stores. To the customer who expects to pay X for a good, a bare shelf is about as useless as a full shelf with a price tag of X++. If you are willing to pay more the full shelf is better. If you think the supply issues will sort themselves, or are willing to order and wait, you aren’t getting the good right now in any case, so an empty shelf with a price you like is just as well. So long as there is enough revenue from sales to keep the lights on and people believe the line that “price increases and shortages are temporary” they will hold down prices. As jdgalt pointed out there are huge backlogs in ship unloading, so it is not entirely unreasonable to think that in a few months there will be a deluge of goods to sell, and no reason to get customers grumpy about high prices now.
    I don’t think that normalcy is right around the corner myself, as I don’t see how the freight situation gets resolved quickly with the current state of government policies, so unless new ships start going to a different port there is going to be a backlog for a long, long time. I also am inclined to think there are sources of inflation that are not temporary.

    But more on point, first year economics should say that shortages cannot persist in a free market where prices and supply are free to adjust. No word on how fast the necessary adjustments will happen, and we sure as hell do not operate in a free market. Any economist that would argue that the USA and especially California has a free market for labor needs his head checked.

    • }}} Any economist that would argue that the USA and especially California has a free market for labor needs his head checked.

      So, Paul Krugman and every neoKeynesian out there needs their head checked?

      Was there any question? 😀

  9. If you can’t get the products unloaded at the port, higher prices won’t help. The price for shipment was set months ago and offering to pay more won’t get a ship unloaded faster at a government controlled port. It’s not like they can pay more port fees to move ahead of the line. Once unloaded, then higher prices can induce some increase in truck/rail movement but not by much as there are work-hour limits on drivers.

    Why are their shortages? Because there are a lot of government-control points in the chain that can’t be opened up by higher prices.

    Lumber prices did go through the roof during the pandemic and the higher prices are clearing the shortages now.

    • At which port do I pick up the workers for literally every single small business in my town which has a help wanted sign?

      • }}} Lumber prices did go through the roof during the pandemic and the higher prices are clearing the shortages now.

        Actually, lumber has plummeted to about half its max (still above where it was ca. 2.5y ago, mind you, but there are other factors which may affect that).. the big boost of late is in steel.

        I found this out about a month ago when I was, after waiting for lumber prices to drop, taking a look at steel “2x4s” — they pointed out that lumber had dropped, while their prices were up over 50% from recent times.

  11. That is an interesting hypothesis. However, the Walmart data do not bear the idea that retailers are protecting the consumer from inflation. For the quarters that end on July 31, Walmart’s gross margins for the years 2019, 2020, and 2021 are very consistent: 24.9%, 25.4%, 25.4%.

    There is the potential to add 5 million workers in recovering to the pre-pandemic level. FRED series PAYEMS gained 194K jobs in September. If that rate continues, perhaps it will take 2 years to add 5 million jobs but that seems implausibly slow. Regardless, these people will experience a substantial increase in their own consumption, but that will be small compared to the increase in their own output which starts at zero for an idle worker. That is a force that will tend to weaken inflation.

    Most of those jobs will be added between now and the end of 2022 so we have a force that will tend to weaken inflation between now and then.

    • Is it possible that the pandemic simply eliminated these people as productive workers?

      The social and physical effects (just see how much obesity has increased) of the lockdown may have permanently idled many workers, much as whole towns in coal country are in SSDI.

      Many of these also had skills (maybe low skills, but still skills) for jobs that no longer exist. Is the cost of training them for new jobs greater then what they receive on the dole?

      • If they stay on a disability benefit then their consumption level is unchanged so there is no short term effect on inflation.

    • }}} There is the potential to add 5 million workers in recovering to the pre-pandemic level. FRED series PAYEMS gained 194K jobs in September.

      OK, and you think this hasn’t been substantially affected by the Brandon, (cough! cough!) sorry, “Biden” admin keeping payouts for not working in-place, which are well above minwage?

      • The PAYEMS series of datum from 2021 October to 2022 December, inclusive, will increase by “most of” a potential 5 million, meaning literally any amount greater than 2.5 million. If there were a way to place a bet I think my chance of being right is about 80%.

  12. Ignorant question: why now?

    Various folks have been predicting shortages and price squeezes since the beginning of the pandemic. Other than TP, ammo, the PS5 and a few other items, this has not really been true at all…until now.

    So, what changed? Too much sorting in the labor market?

    From our vantage point, it’s actually worse now than at any time in the last 1.5 years since this mess started.

    • Kling lays it out in his other post, but all that paper wealth that people didn’t spend when locked in their houses is now getting spent.

      • For some reason, I find this very answer unsatisfying.

        I kinda get it for durables like appliances or autos, but not at all for normal consumer goods.

        • The amount of money increased. So the price of goods went up.

          Where and when each good goes up may vary a bit. Perhaps it hits autos first, then people decide autos are too expensive, so they shift more to restaurant meals or whatever. It’s a constant game of whack-a-mole as to which part of the inflation ballon is going to pop out at any particular time.

          But the bottom line is that untold trillions were printed during the pandemic and that money eventually gets spent. For awhile people were willing to hold it in their TD Ameritrade accounts while they waited for Fauci to tell them it was OK to go outside and spend, but that day eventually comes.

          Let me give a simpler example if that is too much. My friends bought a house with 3% down. They had to pay a PMI and like 4.X% interest or whatever. House prices are up 20%, so now they refinance and have 20% down based on the new valuation (despite having saved no money or built any equity). They get rid of the PMI and finance for a sub 3% rate. They have an extra $800/month to spend today that they didn’t have a year ago. Maybe they take a vacation. Maybe they eat out more. I’m sure that spending will move around, but they’ve got an extra $800 a month to burn and they are burning it. Multiply that by millions of households.

  13. Of the small business owners I know, most are stubbornly committed to the idea that the supply chain disruptions and high input costs are transitory. Though that confidence is starting to wane – they are starting to consider raising prices, but are worried about how it will effect their volumes.

  14. Prices are sticky? It’s almost like that British economist in the 1930’s was on to something.

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