Covid-19 - Part 3: Predicting the impact economic forces will have ...

Hi Everyone,

Considering the serious threat that Covid-19 poses to our physical health as well as our social, financial and economic health, I am putting together a series of posts that will investigate the impact this virus is having and will likely to have in the short, medium, and long run. I am not a medical doctor or a scientist. I am an economist. I will be using my economics background to analyse the expected impact this virus will have on our lives. This series of posts will cover the following.

In Part 3 of this series, I will be analysing the impact Covid-19 and social distancing has on demand, supply, price and quantity of goods and services sold. This post will take a broad overview of the impact on groups of goods and services rather than analyse any particular good or service.

Pressure on prices

Many factors determine the price and quantity of goods and services sold. These factors can be divided into demand and supply factors. Some factors affect both demand and supply. The Covid-19 pandemic affects both demand and supply of almost all goods and services. Demand for some goods and services will increase such as healthcare, non-perishable food, face masks, hand sanitizer, on-demand televisions services, gardening tools, and the internet. However, demand for most goods and services will fall. This is because of the restrictions put in place as well as the loss in income. When demand falls, both price and quantity fall. See Figure 1 below.

Figure 1: Fall in Demand

Note: I believe the best way to explain shifts in demand and supply is through graphs. These graphs describe changes in both price and quantity of goods and services provided.

Covid-19 will have an impact on the supply of goods and services. The quantity supplied of some goods and services will increase as the demand has increased. For example, the supply of medical equipment such as ventilators has increased to meet demand. Supply has been able to increase further as firms that do not normally produce ventilators have switched to producing them. However, the supply of most goods will fall as the virus and restrictions put in place hinder production. When supply falls, price increases and quantity falls. See Figure 2 below.

Figure 2: Fall in Supply

Not only will demand and supply change because of Covid-19 but elasticities for both demand and supply will change as well. I predict in most cases, both demand and supply will become less elastic. Price elasticity is the sensitivity of quantity (demand or supply) to changes in price. I predict a reduction in price elasticity of demand for most goods and services for several reasons. These reasons include:

panic buying and hoarding
limited access to some goods and services
less choice and availability of substitute goods
redefining of what goods and services are essential

When people panic buy or hoard, price becomes less of a factor and simply just acquiring the item becomes more important. The hoarding as well as closures has resulted in some goods becoming more difficult to find. Instead of shopping around, people will buy wherever they can even if the price might be higher. A smaller variety of choices decreases elasticity of demand as people cannot substitute at will. Some goods such as soap, hand sanitizer, toilet paper, and canned food have become essential items that people would be willing to pay more than what they would have done previously. Inelastic and elastic demand curves are shown in Figure 3.

Figure 3: Elastic and inelastic demand

I predict a reduction in price elasticity of supply for most goods and services for several reasons. These reasons include:

inability to maintain or increase capacity because of sick or isolating staff
inability to maintain or increase capacity because of imposed restrictions such as the two metre rule
increased costs of production because of inefficiency caused by imposed restrictions
some businesses forced to close because of imposed restrictions
some businesses closing because of lost income

When supply is inelastic, firms are unable to increase the amount supplied when demand increases. This instead puts pressure on the price to increase. Lack of capacity and business closures makes it very difficult for firms to increase or even maintain production. Increasing marginal cost of production decreases the incentive to produce more even when demand increases. To cover the increasing costs of production requires price to increase. Inelastic and elastic supply curves are shown in Figure 4.

Figure 4: Elastic and inelastic supply

Applying theory to analysing pressure on prices

The demand and supply graphs illustrate changes in price and quantity if the market is immediately allowed to determine the equilibrium price and quantity. In the real world, price and quantity are influenced by intervention as well as lags. In this post, I have assumed no direct intervention in price and I have described the movements and changes in demand and supply as pressure on price rather than actual changes. However, quantity will adjust quicker to the changes in demand and supply and the graphs will indicate if quantity is increasing or decreasing.

For the purpose of this post, I have divided goods and services into two group. The first group of goods and services face falling demand and the second group faces increasing demand. The graphs are intended to show the relationship between movements in demand and supply. The change in demand is used as a reference point to be compared with changes in supply, which could be greater or less than the change in demand. In reality, the extent of the change in demand will vary for different goods and services.

Goods and Services with falling demand

As mentioned early in the post, the demand for most goods and services will be falling. This fall in demand will reduce quantity of good and services sold as well as put downward pressure on price. For many of these goods, elasticity of demand will fall as availability and choice is reduced. For goods and services with falling demand, the impact on elasticity is likely to be less than goods and services with increasing demand. This is mostly because less hoarding or panic buying is taking place. The effect on demand is shown in Figure 5.

Figure 5: Fall and decrease in elasticity of demand

For most goods and services with falling demand, supply is also falling. These goods and services are generally not considered essential and many firms providing them have closed. The firms that remain open are operating at reduced capacity because of social distancing requirements and staff absent because of self-isolation. The reduced capacity and additional costs reduces the supply and the price elasticity of supply. Figure 6 includes possible changes to both demand and supply.

Figure 6: Possible impacts of changes to demand and supply

In Figure 6, there are three supply curves. SS1 is the original supply curve. The SS2 supply curve represents a fall in supply, which creates less of an effect on price than the fall in the demand (P1<P3). The SS3 supply curve represents a fall in supply, which has more of an effect on price than the fall in the demand (P1>P4).

For goods and services with demand DD2 and supply SS2, quantity will fall and there will be downward pressure on price. In the short-run, for goods and services described by DD2 and SS2, there is unlikely to be a change in price. In the medium-run, if the pandemic continues for more than just a few months, I predict price will fall for many of these goods and services. If the pandemic does not last long, I predict price will not change and quantity demanded will increase but will be less than prior to the pandemic. In the long-run, if the pandemic continues for many months, SS2 is unlikely to hold as many firms will be forced to close. Under these circumstances, prices will be forced up.

Clothes and footwear may fall into this category as stores are closed but these goods can be sold online (The Guardian).

For goods and services with demand DD2 and supply SS3, quantity will fall and there will be upward pressure on price. In the short-run, for goods and services described by DD2 and SS3, there is unlikely to be a change in price. In the medium-run, I predict price to increase; this increase will be greater if the pandemic persists. The sharp decrease in supply indicates many firms have failed and left the market. It will be difficult for surviving firms to make up for the lost capacity. It will also take time for new firms to enter the market. In the long-run, shortages may persist. Different industries will recover at different rates. The longer the pandemic persists, the more difficult it will be for these markets to return to normal.

Restaurants are likely to fall into this category as many Governments have ordered them to close and restaurants have a high rate of failure even during ordinary times. Some restaurants might be able to survive from revenue from delivery orders (pymnts.com). After restrictions have been lifted demand for eating at restaurants will increase but it will take some time for new restaurants to open to meet that demand.

Goods and Services with increasing demand

This increase in demand will increase the quantity of goods and services sold as well as put upward pressure on price. For most of these goods, elasticity of demand will fall as panic buying and hoarding will reduce access and choice. Urgency of obtaining these goods and services will make people less sensitive to price. For many goods and services with increasing demand, I would expect the impact on elasticity to be quite strong as many of these goods and services are deemed both urgent and essential. For goods and services with increased demand such as on-demand television or services provided virtually, I would expect less of a change in the elasticity of demand. The effect on demand is shown in Figure 7.

Figure 7: Increase in demand and decrease in elasticity of demand

For most goods and services with increasing demand, supply will be struggling but the outcome could be either increased or decreased quantity supplied. Even though these goods and services will face less enforced restrictions, production could still struggle, as some workers will still be absent, extra equipment is required and there could be breaks and stoppages in the supply chain. Figure 8 includes possible changes to both demand and supply for goods and services that experience an increase in demand.

Figure 8: Possible impacts of changes to demand and supply on goods and services with increased demand

In Figure 8, there are four supply curves. SS1 is the original supply curve. The SS2’ supply curve represents a fall in supply, which still results in a net increase in quantity supplied (Q1<Q3'). The SS3’ supply curve represents a fall in supply, which results in a net decrease in quantity supplied (Q1>Q4'). The SS4’ supply curve represents an increase in supply and increase in quantity supplied (Q1<Q5'), as firms have switched production to produce more of these goods.

For goods and services with demand DD2’ and supply SS2’, quantity will increase and there will be upward pressure on price. In the short-run, for goods and services described by DD2’ and SS2’, there is unlikely to be a change in price. In the medium-run, if the pandemic continues for more than just a few months, I predict price will increase for many of these goods and services. If the pandemic does not last long, I predict price to remain the same and quantity demanded is likely to fall to similar levels prior to the pandemic or possibly lower if people have stocked up or buying less because of reduced income. In the long-run, if the pandemic continues for many months, I believe demand for many essential goods and services will continue to increase putting even more pressure on price. Supply may or may not be able to cope with the increased demand. If supply cannot cope price will be forced even higher.

Hand sanitizer and soap are likely to fall into this category. The demand has increased but production and distribution is likely to be hindered by the virus and restrictions (European Parliamentary Questions). However, quantity should still be able to increase but not to the full extent it could have if production was unimpeded.

For goods and services with demand DD2’ and supply SS3’, quantity will fall and there will be upward pressure on price. In the short-run, for goods and services described by DD2’ and SS3’, there is a possibility that price will increase but unlikely to the extent to create a new equilibrium. In the medium-run, if the pandemic continues for more than just a few months, I predict price will increase considerably for many of these goods and services. If the pandemic does not last long, I predict price to remain constant and quantity demanded will return to a level similar to before the pandemic. In the long-run, if the pandemic continues for many months, I believe supply will continuing falling, thus putting even more pressure on price to increase. Many firms are likely to close, the remaining firms will gain a larger portion of the market and gain more monopoly power. If there are fewer firms, prices are likely to remain higher even after the pandemic is over.

Home and social care services could fall into this category. Supply of specialised services are normally inelastic. Increasing supply involves recruiting and training people, which takes time. The pandemic will reduce the number of available home and social carers even though the demand for them would have increased. Additional costs for providing personal protective equipment is also putting home and social care firms under pressure financial pressure which could put them out of business (BBC).

The SS4’ supply curve represents an increase in supply. The increase in supply is caused by firms being able to shift production from goods that are now in less demand to goods that are considered essential. A quick change in production will require additional costs and some inefficiency; this is likely to cause supply to be less elastic. For goods and services with demand DD2’ and supply SS4’, quantity will increase and there will be minimal pressure on price. In the short-run, for goods and services described by DD2’ and SS4’, there is unlikely to be a change in price. In the medium-run, if the pandemic continues for more than just a few months, I predict quantity will continue to increase and upward pressure on price will increase. If the pandemic does not last long, I predict demand to fall and price is likely to fall. In the long-run, if the pandemic continues for many months, I believe supply may struggle to meet demand and price could begin to increase as quantity produced increases.

Essential medical equipment such as ventilators are likely to belong to this category. Demand for ventilators by hospitals has greatly increased because of the pandemic. In the United Kingdom a consortium of over 20 companies have switched to producing ventilators (ITV) and Tesla, General Motors and Ford have switched production to ventilators in the USA (techcrunch.com).

Quick summary of predictions

I have predicted that demand for some goods and services will increase while most others will fall. I have predicted that supply will fall for almost all good services with the exception of essential equipment, which are being produced by companies that have switched production. Table 1 summarises my predictions.

Table 1: Summary of predictions

The next question is how many markets will fall into each group. The DD2 and SS3 and DD2’ and SS3’ groups are the most dangerous as these involve firms going out of business, or greatly cutting back operations. After the pandemic, these markets will take a long time to recover. As a result, we will see higher prices and increased unemployment. The longer the pandemic persists the more markets will fall into these groups. Even after the pandemic, demand for many good and services will not recover quickly because of the loss of income during the pandemic.

Final Thoughts

In this post, I have analysed possible shifts in demand and supply and the changes in quantity sold as well as the pressures on price. The impact will vary between markets. Overall, both demand and supply will fall during the pandemic. Demand and supply is unlikely to make an immediate recovery after the pandemic. The loss of income will reduce demand. The closure and failure of businesses will reduce supply.

This analysis has not included any effects from any Government intervention. Government intervention is likely to come in the form of stimulus packages to businesses and individuals. This type of intervention will cause some shifts in both demand and supply but the fundamentals of demand and supply presented will not change. Government could also intervene by putting a price ceiling on goods and services that are or will be faced with considerable upward pressure on their price.

In the next post in this series, I will investigate actions that Governments are or could be taking to address the economic problems caused by the pandemic and the responses to the pandemic. The post will not analyse groups of markets but will instead focus on the macroeconomic picture.

Covid-19 - Part 3: Predicting the impact economic forces will have on prices of goods and services