Supply and demand: reasons for scepticism

Supply and demand is perhaps the best known concept in economics. Much of undergraduate microeconomic teaching is based on this concept, and there is general agreement that it is one of the foundational concepts of the field. Even professors whose work involves challenging some of the assumptions of the field refer to it as the most important concept to know. In fact, recently I saw an earnest discussion on twitter where economists tried to name an economic concept that wasn’t just supply and demand!

However, despite the popularity of the concept, many of the predictions of supply and demand do not seem to match the world we see around us. This is no doubt a source of confusion for hundreds of thousands of first year economics students every year, as they try to match what they are learning in class with what they see in the world around them. Undergraduate economics teaching is often said to be mainly for developing an economic intuition, or learning to think like an economist, and in my opinion what those statements refer to is learning to think primarily in terms of supply and demand, and ignoring all the ways in which the theory does not seem to match the world around us.

A typical supply and demand diagram

Taken seriously, a supply curve implies that at the current price, businesses do not want to sell any more than they are currently selling. In the diagram to the side, as the demand curves move businesses are simply not willing to provide more without raising the price.

Is that what we see around us? If businesses were at the point where their prices are set by supply and demand a customer who makes an unexpected large purchase would either be refused service or charged a higher price. Firms ought not to be willing to sell more than they usually do without raising the price. However it would be difficult to find a business that acts that way in the real world. Being refused service at a particular price is unusual, and most businesses are willing to give large discounts on large orders, even unexpected ones, instead of charging a higher price as the theory of supply and demand would predict.

In addition things like advertising would make little sense in a world governed by supply and demand. Why would firms spend money to sell more if they were already selling the maximum they could at the current price? Why would firms offer sales? Many of the most ubiquitous behaviours of businesses seem difficult to understand in a world governed by supply and demand.

If students express skepticism about supply and demand they are sometimes told that more advanced models justify the assumptions used, or that supply and demand is just a teaching tool. There is some truth to those claims. However, many of the more advanced models still suffer from the same problems that invalidate supply and demand.

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