Like any science, economics is concerned with explanations of observed phenomena. Economic theories are ideas or principles that aim to describe how economies work. Economic models are formal statements of theories—usually mathematical statements of presumed relationships between variables. These models naturally become the basis for making economic predictions.
Students of economics are trained in expressing models in words, equations, and graphs. All three can be used to describe the basic market model, which illustrates how the forces of supply and demand interact to determine prices and quantities of output. Today’s exposition simply focuses on graphs, so readers who are interested in this guided review might want to use pen and paper.
In the basic market model, two axes are drawn perpendicular to each other. The vertical axis measures the unit price of output (either a good or a service), while the horizontal axis measures the quantity of output. On the one hand, the law of demand presumes an inverse relationship between price and quantity demanded. If price increases, quantity demanded decreases (and vice versa). This inverse relationship is graphically represented by a downward sloping line from left to right. On the other hand, the law of supply presumes a direct relationship between price and quantity supplied. If price increases, quantity supplied also increases. This direct relationship is graphically represented by an upward sloping line from left to right.
The equilibrium point is where the two lines intersect. It shows the price level where quantity demanded and quantity supplied are equal. A shift of either curve means that a change takes place corresponding to a new relationship between price and quantity. A leftward shift of the demand (supply) curve means that consumption (production) of output decreases at all price points, while a rightward shift of the demand (supply) curve means that consumption (production) of output increases at all price points. Shifts of these curves lead to changes in equilibrium points.
Two cases are worth examining. In the first case, both the demand and supply curves shift to the left. This can describe what happened during the Enhanced Community Quarantine, when restrictions on the movements of people and output were tightest. As theory predicts, equilibrium output unequivocally decreases, but the effect on equilibrium price is ambiguous (i.e., can stay the same, increase, or decrease).
The effect on equilibrium price depends on how the shifts are drawn. If the demand curve shifts to the left just as much as the supply curve does, equilibrium price stays the same. If the supply curve shifts to the left more than the demand curve does, equilibrium price increases. This depicts stagflation, which is the combination of lower equilibrium output (higher unemployment, hence, stagnation) and higher equilibrium price (inflation). This means that available output has become even more scarce, and buyers of such output, including those who have lost their jobs and are cutting expenses, will have to face higher prices as well.
Now, if the demand curve shifts to the left more than the supply curve does, equilibrium price decreases. This deflationary episode implies that there is not enough demand for output at the given level of production, forcing producers to accept lower prices and cut down on production, jobs, and, eventually, workers’ wages, which would mean lower incomes and ability to buy output. Left unchecked, it could turn into a downward spiral in the economy and a full-blown recession.
In the second case, the demand curve shifts to the right, but the supply curve shifts to the left. This can describe today’s attempt at reopening the economy to prop up demand in the midst of external pressures affecting the supply side. As theory predicts, equilibrium price unequivocally increases, but the effect on equilibrium output is ambiguous.
The effect on equilibrium output depends on how the shifts are drawn. If the demand curve shifts to the right just as much as the supply curve shifts to the left, equilibrium output stays the same. If the demand curve shifts to the right more than the supply curve shifts to the left, equilibrium output increases. This is precisely what the government wants to happen as it undertakes its fiscal consolidation and resource mobilization plan. The economy must generate more income from which more revenues can be collected to sustain public spending and pay off debts. As the Department of Finance sternly warns, having either no tax reform or diluted tax reform will have dire economic consequences.
Now, if the supply curve shifts to the left more than the demand curve shifts to the right, equilibrium output decreases. This, again, depicts stagflation, which is the worst possible scenario.
It is hoped that today’s exposition has been helpful.
Dr. Ser Percival K. Peña-Reyes is the Director of the Ateneo Center for Economic Research and Development.