Remember that one time, back when we had a global pandemic, when interest rates fell really low and everyone was borrowing and refinancing? Good times. But they were also times of surging demand for durable goods, supply chain disruptions, and shortages. Specifically, the price of lumber surged by 54% between 2019 and 2022. There were stories of contractors who were unable to do their jobs at their typical prices. Some of them went without work. Others did much less work. Theft of precious lumber was in the news.
As we know, sudden price spikes often make the front pages and the social media rounds. But they peter out and the subsequent decline in prices hardly ever gets coverage in the same way. People used to talk about higher gasoline prices all the time, but never discussed with the same enthusiasm when prices fell. The same is true for lumber. We heard hysterical stories of record high prices, alleged shortages, and the sawmills that lacked adequate capacity to keep up with demand.
I’ve written about coffee consumption during US alcohol prohibition in the past. I’ve also written about visualizing supply and demand. Many. Times. Today, I want to illustrate how to use supply and demand to reveal clues about the cause of a market’s volume and price changes. I’ll illustrate with an example of coffee consumption during prohibition.
The hypothesis is that alcohol prohibition would have caused consumers to substitute toward more easily accessible goods that were somewhat similar, such as coffee. To help analyze the problem, we have the competitive market model in our theoretical toolkit, which is often used for commodities. Together, the hypothesis and theory tell a story.
Substitution toward coffee would be modeled as greater demand, placing upward pressure on both US coffee imports and coffee prices. However, we know that the price in the long-run competitive market is driven back down to the minimum average cost by firm entry and exit. So, we should observe any changes in demand to be followed by a return to the baseline price. In the current case, increased demand and subsequent expansions of supply should also result in increasing trade volumes rather than decreasing.
Now that we have our hypothesis, theory, and model predictions sorted, we can look at the graph below which compares the price and volume data to the 1918 values. While prohibition’s enforcement by the Volstead act didn’t begin until 1920, “wartime prohibition” and eager congressmen effectively banned most alcohol in 1919. Consequently, the increase in both price and quantity reflects the increased demand for coffee. Suppliers responded by expanding production and bringing more supplies to market such that there were greater volumes by 1921 and the price was almost back down to its 1918 level. Demand again leaps in 1924-1926, increasing the price, until additional supplies put downward pressure on the price and further expanded the quantity transacted.
We see exactly what the hypothesis and theory predicted. There are punctuated jumps in demand, followed by supply-side adjustments that lower the price. Any volume declines are minor, and the overall trend is toward greater output. The supply & demand framework allows us to image the superimposed supply and demand curves that intersect and move along the observed price & quantity data. Increases toward the upper-right reflect demand increases. Changes plotted to the lower-right reflect supply increases. Of course, inflation and deflation account for some of the observed changes, but similar demand patterns aren’t present in the other commodity markets, such as for sugar or wheat. Therefore, we have good reason to believe that the coffee market dynamics were unique in the time period illustrated above.
*BTW, if you’re thinking that the interpretation is thrown off by WWI, then think again. Unlike most industries, US regulation of coffee transport and consumption was relatively light during the war, and US-Brazilian trade routes remained largely intact.
When I was a graduate student, I paid for my tuition by tutoring for the university athletics department. I tutored stat, math, micro, macro, excel, and finance. I tutored the same students each week, so I got to know them pretty well over the course of the semester. I also got to know their strengths and weaknesses. It was at this time that I realized most quantitative or even analytical ideas could be described in 4 potentially equivalent ways:
Mathematically
Using logic in English
Graphically
With a Table
In this post I want to share the Supply & Demand cheat-sheet that I use to help my students learn about the effects of supply and demand.
Economist Writing Every Day 