Dispelling Supply Chain Myths: Talk of supply chain woes and shortages hides the crucial role of prices.

• Author: Lemieux, Pierre

Bare store shelves and waiting lines for goods began appearing in the early months of the COVID pandemic in 2020. More recently, another economic problem has appeared: inflation. Official statistics show there was a drop in U.S. gross domestic product in the first quarter of 2022. And rippling throughout the global economy, disruptions in production have followed strict lockdowns in China and the war in Ukraine.

All these problems and others have been or are being blamed on "the supply chain." But as we will see, this concept is not very useful in economic analysis.

"Supply chain" (also called "value chain") is a relatively new expression. Google Books Ngram Viewer shows the term wasn't used much until the 1980s, reached a peak in 2008 and, after a lull, began growing again in the mid-2010s. Now it's everywhere. A few weeks after entering the White House, President Joe Biden issued Executive Order 14017 on "America's Supply Chains" and a few months later created a Supply Chain Disruption Task Force. We are told that Americans need "resilient, diverse, and secure supply chains." It seems that each time some economic problem is perceived, "the supply chain" becomes the incantatory explanation.

The New Palgrave Dictionary of Economics first devoted an entry to "supply chains" in 2008, stating that the concept "encompasses all the resources and processes required to fulfill the demand for a product." Thus, it basically corresponds to what economists call "production." Recall that in economic parlance, "production" means transforming intermediary products into final goods and includes transportation, distribution, and sales. One can argue that the new expression is useful as a management concept for planning supplies at the level of the firm, but the danger is to think that supply chain analysis reveals secret recipes for government to plan the economy just as executives and managers run a business enterprise. Economics suggests looking at these things differently.

The supply chain seems to be visualized as a network of pipes through which goods move. When a pipe gets clogged, the flow stops, deliveries back up, and users see out-of-stock notices and face a shortage. Yet, this vision of the economy is very misleading because it ignores price signals, a crucial component of a market economy.

SUPPLY CHAINS DON'T CREATE SHORTAGES

Basic microeconomic theory, also called "price theory," suggests that shortages are not caused by "the supply chain." It offers a more meaningful explanation for why shortages appeared during the COVID pandemic. The accompanying sidebar (pp. 28-29) presents a formal explanation, but the ideas can be intuitively summarized as follows.

Suppose that, in a market for a specific good or service, supply (that is, the whole schedule of quantities produced and supplied at different prices) decreases for some reason. The price for available units of the good will be bid up by buyers who prefer to have some (or more) of it instead of none (or less). Suppliers rapidly realize that they can ask for a higher price and still sell everything they have. At the higher price, suppliers will find it profitable to increase the quantity they provide. A new supply-demand equilibrium results, where the market-clearing price is higher and the quantity demanded and supplied are lower than before. Note that a free market and a free economy work like a continuous and invisible auction where any consumer can get anything by bidding up its price or, what amounts to the same, paying the price paid by the highest bidders.

What is a shortage? / If price increases were prohibited or limited by some constraint external to the market, a shortage would appear because producers would not increase their quantity supplied and demanders would not decrease their quantity demanded. This is how economics defines a shortage: a situation where the quantity supplied falls short of the quantity demanded, and consumers (or users, if we are considering the market for an input) cannot get what they want even if they are willing to pay more. Would-be buyers must wait in line for the good (in a physical or virtual queue), hoping that there will still be some left when their turn comes.

A shortage does not simply mean that the price of something is "high," because the price of anything is deemed high by some consumers. Although diamonds are too expensive for most consumers, there is no shortage of them; anybody can walk into a jewelry store and buy one if he is willing to pay the going price. Of course, one can define "shortage" however one wants, but if it is defined as "high price," we would need another word to label what economists call a shortage. Note also that "shortage" is not synonymous with "price increase"; on the contrary, a price increase eliminates a shortage.

An increase in demand (that is, the whole schedule of quantities demanded at different prices) will, other things being equal, cause a similar effect on the equilibrium or market-clearing price. The reason is the same: consumers bid up the price until the quantity demanded matches the quantity supplied. Quantity supplied will increase only if incentivized by a higher price. When the price increase is caused by higher demand instead of lower supply, the equilibrium quantity demanded and supplied will be higher. (The sidebar below explains more precisely why we need to distinguish between demand and quantity demanded and, similarly, between supply and quantity supplied.)

During the pandemic, we have often observed a combination of lower supply and higher demand. Supply decreased because producers (individuals and corporations) in lockdown or in voluntary isolation produced less. Demand increased for certain goods: sanitizer, masks, home computers, etc. Both factors pushed prices up. If the free-market price adjustment is prohibited or limited by government--by an "anti-price-gouging" law, for instance--then a shortage appears.

As an illustration that a price must increase in some way for producers to increase their quantity supplied, consider the case of toilet paper at the beginning of the pandemic. Paper goods manufacturer Georgia Pacific, for example, could only produce more toilet paper by supporting a higher marginal cost. A new worker added to the production line adds less productivity than the previous one did. The newly added night shift imposes additional cleaning and maintenance costs. More overtime needs to be paid. Retooling production lines that produced lower-quality, bulk-sale toilet paper for work restrooms so they instead produce softer toilet paper in packaging convenient for home use also implies higher unit costs.

Note that a...