10 May 2011

Supply, Demand, and Distortion

In theory, all prices are determined by supply and demand.  If there is a large supply of product x and little demand for product x, the price will be very low.  If, on the other hand, there is a small supply of product x and high demand for it, the price will be rather high.  This assertion is not new, but it can lead to a puzzling question.
Specifically, the question that can arise on occasion is:  if prices are determined by supply and demand, why do economists talk about prices being impacted by taxes and regulations?  Two reasons come to mind.

First, taxes reduce supply of a product.  As has been discussed elsewhere, taxes are a way of redistributing resources.  If a government directly taxes a product, it is essentially claiming some of the resources used to make the product for itself.  If the government makes use of other taxes, it is still laying claim to some resources, and consumers then determine which resources are eventually consumed.

Second, regulations change the type of product.  In the unfettered market, there might be times when, say, a car company would offer a two-ton car that gets twenty-five miles per gallon and produces 240 HP.  Once the state begins to regulate the market, the car company might be forced to meet, say, a fuel efficiency target, and will thus seek to cut the car’s weight and decrease the car’s horsepower.  As such, the product is no longer the same, and thus faces a different supply schedule and demand schedule.

Thus, it should be easy to see that the law of supply and demand is ironclad, and that there is no inherent contradiction between claiming that all prices are set by supply and demand and also claiming that taxes and regulations affect prices.  Of course, it would be more accurate to claim that taxes and regulations directly impact supply and demand and indirectly impact prices.  Still, the final assertion is correct, and there is no contradiction between the two claims.

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