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Understanding supply and demand

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This blog is the fifth in our series on the key concepts to consider when thinking about local economic growth policies. We’re using the series to test-drive a way of explaining concepts in economic growth that we hope to use in new training and resources. We are keen to hear from readers, particularly those in local and central government, about whether they find these useful and accessible, and if there are other topics you would like to see us cover.  

What is ‘supply and demand’?

Supply measures the amount of a good or service a producer is able and willing to provide at a given price. Think of producers and prices broadly – not just car manufacturers supplying a car but also credit lenders supplying loans at a given interest rate or workers supplying labour at a given wage. Demand is the amount of a good or service consumers are able and willing to buy at a given price. Think of households on the market for a new car, a loan from their bank, or deciding how many hours to work.

When economists talk about equilibrium, they are referring to the way in which prices tend to adjust so supply equals demand. Excess supply – say too many workers chasing too few jobs – will tend to drive prices down reducing supply and increased demand. Excess demand – say too many renters chasing too few flats – will tend to drive prices up increasing supply and reducing demand.

When prices can’t adjust then we end up with gluts or shortages. Setting the minimum wage too high will result in higher wages for some but unemployment for others (too much supply) while rent control that sets rent too low will lead to more affordable housing for some, but housing shortages for others (too much demand). For public goods which anyone can access, excess demand shows up in congestion (too many cars on the road) while excess supply shows up in underutilisation (too few cyclists for a new cycle superhighway).

Why do we need to think about supply and demand?

To design effective policies, policymakers need to decide whether the problem they’re addressing is with supply or demand. Doing so in practice is not always straightforward.

For example, for the UK as a whole, there is a graduate wage premium: the average university graduate earned £10,000 more than the average non-graduate in 2017. High skilled workers are, on average, more productive than low skilled workers, which is why firms are willing to pay a premium. But the size of the graduate wage premium depends on the demand and supply of graduates (which determines graduate wages) and the demand and supply of non-graduates (which determines non-graduate wages). And the situation is further complicated because firms can sometimes choose to substitute between graduate and non-graduate workers.

But recognising that demand and supply matter helps us better understand why there’s a graduate wage premium and why it has been changing over time. For example, technological change and globalisation help explain what’s been happening to the relative demand for these different types of workers. And the expansion of university education and the underfunding of vocational education helps explain what’s been happening to relative supplies.

Many local areas will also pay large graduate wage premiums. But in other areas, we might see similar wage and employment outcomes for graduates and non-graduates, which suggests that in those areas, local demand for graduates is low relative to the supply of graduates (and vice-versa for non-graduates).

Similarly, while lack of finance is often cited as a constraint to SME growth, it is important to distinguish between difficulties in accessing finance due to bad projects, poor business plans or tough local economic conditions (a demand side problem) versus credit constraints which stop firms with good projects from borrowing (a supply side problem).

What to consider when thinking about supply and demand?

Policymakers need a good understanding of constraints on both the supply and demand side before designing policies.

For example, thinking about demand and supply is why many economists recommend avoiding ‘build it and they will come’ supply side strategies. These are policies that supply things in the hope that this will be enough to generate sufficient demand. An example are the attempts US cities made to develop biotech clusters in the late 1990s by building science infrastructure. No matter how much infrastructure was built in terms of science parks and labs, there was not enough demand from firms to generate a new tech cluster. Focus on existing strengths, where there was demand, but not enough supply would have been a way of avoiding these costly mistakes.

Market signals can be good indicators of whether the problem is due to supply or demand side constraints.

Policymakers also need to think about market signals – such as prices, shortages, congestion, unemployment and under-utilisation. They can be good indicators of whether the problem is due to supply or demand side constraints. In the example on the graduate wage premium, high graduate wages with small numbers of graduates indicate that the issue is due to low supply.

However, as the examples make clear prices and quantities are determined by the interaction of supply and demand – careful analysis is needed to determine whether the problem is due to demand or supply. Writing a logic model capturing the underlying economic mechanisms can help policymakers determine whether policy needs to target supply or demand.

How can I learn more?

Our guide to Developing effective local industrial strategies, including our guidance on Using data for local economic policy details on how to assess whether constraints are on the supply side or demand side. Our blog Supply side vs demand side summarises the key points.

Up next

The next blog in our understanding key concepts in local economic growth series will be on market failures. Sign up to our newsletter to get an update on our next blogs, briefings and events.