• Supply, Demand, and the Endogeneity of Prices

    In a comment, steve (not co-blogger Steve) reminded me of a very good post by Scott Sumner that illustrates the endogeneity of prices with respect to quantity. It turns out I had read it, but I’m glad to be reminded of it.

    So what do we know about prices? We know that if the price falls because supply increases, then consumption will increase, and if the price fell because demand fell, then consumption will decrease. In other words we know that if the price (or interest rate or exchange rate) changes, we can predict with 50% confidence that quantity will increase, and 50% confidence that quantity will decrease. So that’s progress, I guess.

    This ambiguity is precisely why Sumner advises to never reason from a price change. The problem is price and quantity are both related to supply and demand factors. Thus, knowing only that prices changed one can’t draw a conclusion about quantity without knowing something about supply or demand. Doing so is like trying to infer reading comprehension from foot size. Both are related to age, among other things. In a word, price is endogenous. Sumner could have just as easily said, “Never reason from a change in an endogenous variable.”

    As Angrist and Krueger described in a Journal of Economic Perspectives paper I summarized recently, the earliest known application of instrumental variables was to address the endogeneity of prices in estimating supply and demand elasticities of flaxseed.

    If the demand and supply curves shift over time, the observed data on quantities and prices reflect a set of equilibrium points on both curves. Consequently, an ordinary least squares regression of quantities on prices fails to identify—that is, trace out—either the supply or demand relationship. P.G. Wright (1928) confronted this issue in the seminal application of instrumental variables: estimating the elasticities of supply and demand for flaxseed, the source of linseed oil. Wright noted the difficulty of obtaining estimates of the elasticities of supply and demand from the relationship between price and quantity alone. He suggested (p. 312), however, that certain “curve shifters”—what we would now call instrumental variables—can be used to address the problem: “Such additional factors may be factors which (A) affect demand conditions without affecting cost conditions or which (B) affect cost conditions without affecting demand conditions.” A variable he used for the demand curve shifter was the price of substitute goods, such as cottonseed, while a variable he used for the supply curve shifter was yield per acre, which can be thought of as primarily determined by the weather. …

    Wright (1928, p. 314) observed: “Success with this method depends on success in discovering factors of the type A and B.” … Wright’s econometric advance went unnoticed by the subsequent  literature. Not until the 1940s were instrumental variables and related methods rediscovered and extended.

    References

    Angrist, Joshua and Alan Kreuger. (2001). “Instrumental Variables and the Search for Identification: From Supply and Demand to Natural Experiments,” Journal of Economic Perspectives, 15(4), 69-85.

    Wright, Phillip G. (1928). The Tariff on Animal and Vegetable Oils. New York: MacMillan.

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    • Thanks for this different perspective on the issue. We economist wannabes need all the help we can get.

      Steve

      • @steve – You are welcome. I don’t think my perspective is different. At best I’m just explaining the issue in a different way, and perhaps more clearly. However, any economist who says something about quantity based on price changes alone is either implicitly assuming something about supply or demand or doesn’t understand those concepts.

    • I am not sure that many, if any, economist would say anything about quantity based on price changes. I would suspect that most economists agree that price rises (declines) in a competitive market because demand increases (decreases) and supply either remains the same or declines (increases). Noneconomists, however, often wrongly draw conclusions about quantity based on price.

      • @Rex – In the link Scott Sumner provided an example from Greg Mankiw’s textbook that motivates the whole discussion. “Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt. At the same time you will probably buy less ice cream.”

        I do not think for a second Mankiw doesn’t understand the issue. No doubt he was assuming that price fell due to a shift in the supply curve. But he didn’t say so. I think this is pretty common.

        Maybe most economists aren’t confused about this (who knows; it’d make for an interesting poll), but a lot of folks who discuss the economy and economics are.