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SUPPLY & DEMAND This chapter examines the core economic mechanism of supply and demand. Although sometimes presented as a “Law,” how supply and demand operate varies from one type of market to another. In addition, markets interact and so we think not simply about the partial equilibrium of a single market, but the general equilibrium that results from the balancing of all markets. Charting supply and demand is a simple method of describing the structure and pattern (the “what”) of economic activity that enables us to “tell stories” (the “why” and “what if ”) about the causes and likely consequences of different choices. Therefore, imperfect as they may be factually, they can still act as models and guides to help us think through the causes and consequences of economic activity. This chapter will present five models of supply and demand and explain constituent concepts such as elasticity, returns to scale, and consumer and producer surpluses.

1.0 PATTERN-SEEKING, STORYTELLING ANIMALS The economist Edward Leamer recently observed that humans are “pattern seeking, storytelling” animals. Leamer meant ot emphasize that when we look at human behavior or environments, we seek impose order on the flow of events, actions and circumstance sin which we find ourselves; we look for a pattern to give it meaning. For example, if I think that studying improves performances on tests, I might look at two things: the number of hours studied and the test grade and plot them on x-y axes to determine the pattern. If studying improves performance, I should see the observations cluster along a northeasterly vector from the origin (y = x). If I think that studying decreases performance, the dots should cluster in a southeasterly direction, from North to East (y = -x + c). If I think there is no relationship, then we should observe a random “buckshot” spray pattern. We can collect data and discover which pattern best fits the observational data.

1.1 PATTERN-SEEKING However, due to the disposition to seek patterns, we tend to impose structure and patterns that may not be there. Most are familiar with projective psychological tests like the Rorschach test. Individuals are asked to see patterns in a random inkblot like the one on the right. Even though there is no real pattern, each person can "see" something in the blots just like people see shapes in clouds. The pattern we see may say more about the observer than the object. The same is true of information we get from our social and natural world. For healthcare providers, physical symptoms can be elements of a larger syndrome, or not. For teachers, a correct choice "A" on a multiple choice test may demonstrate knowledge or just a really lucky guess. Simply finding a pattern does not tell us how or why the pattern exists. “Correlation does not equal causation” is the frequent refrain in criticisms of social research. For example, the winner -- AFC or NFC -- of the Super Bowl is a near perfect predictor of the stock the following Monday. As a teacher, I witness a miraculous pattern every day, where every 45 minutes a bell rings and students show up in my classroom. I may conclude from this pattern that the bell caused the students’ arrival. Another pattern is that hospitals have much higher concentrations of sick and ill individuals than average. One could conclude that hospitals make people sick. In the 1980s, it was famously observed that trees cause climate change because they are the largest source of atmospheric CO2. To make sense of patterns, we must have narratives that puts patterns in their proper context. In the case of hospitals, the simple narrative is that patients are brought to hospitals to heal. In the case of the Super Bowl, NFC teams tend to be located in larger cities, which has a disproportionate impact on the postgame euphoria. The carbon cycle is the scientific narrative that explains the relationship between plants and atmospheric carbon and the desire to graduate is probably the real cause of the students’ attendance, not the bell. In short, facts do not “speak for themselves,” and most common error is not seeing the wrong pattern, but seeing a pattern where none exists. 1

1.2 STORYTELLING Humans also tell stories or "narratives." Stories gives actions and events context and meaning. Take the following sentence. Jack killed Jill. By itself, this simple sentence does not tell us a lot. Immediately, you may think Jack is pretty bad because killing is bad, but we don't know about the context, the motivations, the setting to inform us about making a judgment. Perhaps Jill is a terrorist and Jack (Bauer?) is a soldier, then perhaps Jack is a hero. Or, Jill is suffering from a terminal disease and Jack is an anguished spouse who, against his own wishes, does what Jill asks. Or, like Othello & Desdemona, Jack killed Jill because he was tricked into believing Jill was unfaithful and he “loved not wisely but too well." Or, Jack is sent from the future to stop Jill the scientist from inventing a technology that will lead to the end of the human race. Each of these narratives provides a different context and interpretation, but all are consistent with the simple factual observation. As humans, we not only construct narratives in fiction, but also create self-narratives that explain our own actions and those of others. In economics, there are many narratives embedded in the basic models. The shape of the supply and demand curves depend on what factors an observer believes influences supply and demand. Liberals tend to focus on quantity movements (ex. employment, GDP, income distribution) in supply and demand dynamics, while Conservatives emphasize price movements (ex. inflation, tax rates, incentives) even when describing the same data pattern. “Just So� stories about the origins of money often reflect how we think money operates in the here and now. Narratives about how economic institutions and processes operate help us put data in context and provide the framework to make cause-and-effect inferences. While pattern-seeking and storytelling can lead to self-deception and self-subversion, it also provides us distinct advantages. Identifying patterns allows us to perceive reality and use language in a way unlike any species. Telling stories allows us to learn over generations that has made humans today much more advanced than a human 10,000 years ago, while a chimpanzee today is probably just as advanced as a chimpanzee from 10,000 years ago.

1.3 PICTURES, WORDS & NUMBERS There are three basic modes of communication and thought: pictures, words, and numbers. Economics uses all three. The supply and demand diagram is a visual representation (picture) of systems of equations (numbers) that operationalize verbal descriptions of economic processes and institutions. One can express any economic idea or concept using any mode, but some modes are better suited to certain tasks than others and certain individuals are more comfortable using certain modes than others. This chapter will try to express each model of supply and demand in each mode.

Generally speaking, pictures are the best mode for communication of information, while numbers are the best format for analysis. Using numbers ensures the logical consistency and describe phenomena that are hard to visual like multidimensional variables. Pictures, including graphs, diagrams and charts, require the least of audience and can show the interrelation of several phenomena, like the intersection of supply and demand curves and provide good first approximations of economic dynamics. Words occupy the middle ground: neither logically precise or transparently communicative. Economic insight lies at the intersection of the three. 2

1.4 MATH AS A LANGUAGE Math is a language with its own vocabulary, grammar, and style. Since the “marginal revolution� in the late 19th century, economics has been a discipline largely written in mathematical formulae and identities and displayed in its counterpart: Cartesian-grid diagrams. As a result, much of economics is applied physics and calculus and math literacy and numeracy is necessary to grasp much of economics.

1.5 FUNCTIONS A statistic is a single measurement like your height at age 18 or the average grade in geometry. A variable a vector of individual statistics such your height at ages 1, 2, 3, . . . or average grades in geometry across high schools in Westchester and Putnam counties. Key thing: Variables vary, statistics do not. Statistics are photographs, variables are movies. Functions define the mathematical relationship between two variables, x and y. For our purposes let's say that x is the hours students studied for a test and y is their grade on that test. We can hypothesize two relationships: 1) Studying more will increase your grade on the test or y = x 2) Studying more will decrease your grade on the test or y = -x These two functions are linear, meaning that for every in the value of x, the value of y increases a constant amount. Examples of linear functions are y = 3x or y = -5x. Functions can also be non-linear. In economics, non-linear functions include patterns including increasing returns to scale, diminishing returns to scale, and diminishing marginal utility. Increasing returns to scale are usually written as exponential or power functions such as y = x2 or y = 102x 1. Adam Smith's idea of the Division of Labor is an example returns to scale. When one organizes work in a division of labor the productivity of individual workers increase exponentially as more workers are added to the process. Logarithmic functions such as y = ln x or y = 10 log x express decreasing returns to scale. For example, my demand for pizza may be linear, but if consumption has decreasing returns to scale, this can be expressed by taking the natural logarithm of the linear function. Interaction effects produce non-linear functional forms. Studying a foreign language helps one learn to read, write, and understand English and vice versa. If this is true, that means that one hour studying both English and Japanese could have a positive non-linear effect on my English grade. Conversely, studying while listening to your I-Pod Nano may have a negative non-linear effect on the relationship between hours studied and your grade. Some students claim -- erroneously -- that listening to music makes them work better, but what they may really is that they can study longer while listening to music. This does not mean they are studying more effectively. The slope of the function tells you how effectively you are studying -- how much your grade improves for each hour studied -- while the number of hours studied tells you what the x-value (hours studied) for an individual student. A good comparison is the economies of China and the USA, the second largest and largest economies in the world respectively. In total, the economies are both large, but China has 4 to 5 times the population of the United States. Obviously, if you have 5 times the number of people, you should be 5 times more work. However, if you looked at the economy in per capita terms, the average Chinese earns about $5000 per year, while the average American earns $30,000 to $40,000 per year. Political units come in all shapes and sizes, and therefore, aggregate comparisons sometimes only tell you that a country is bigger. 3

2.0 RETURNS TO SCALE The basic competitive model of the market economy assumes constant returns to scale (linear functional form). Constant returns are implicit in economic arguments for free trade and the efficacy of the “invisible hand” of the market. When constant returns cannot be assumed, many of the general conclusions about economic relationships break down. Unfortunately, there are many known examples of economies and diseconomies of scale in economics. The tension between constant returns and increasing/decreasing returns to scale lie in the origins of economic thought. Adam Smith’s Wealth of Nations presents two basic pillars of modern capitalist economies: the “invisible hand” of competitive markets -- an example of constant returns -- and the division of labor of industrial organization -- an example of increasing returns. Understanding when increasing (or decreasing) returns matter is a good key to grasping the exceptions to conventional economic theories and why markets often do not work in practice even when they should work in theory. Increasing returns to scale are primarily applied to production functions. For every unit of input of a factor of production (i.e., land, labor, and capital), output increases more than one unit. The division of labor shows how the organization of the production process can produce increasing returns. However, increasing returns can shape other types of economic behavior. Positive externalities, such as network effects, can make a networked good disproportionately valuable to a prospective entrant. Mobile phone or social networking products become more valuable as they add users. Environments that promote more interactions may be more valuable than isolated counterparts. Education is another example. One’s existing stock of knowledge facilitate the flow of new knowledge. Positive feedback loops such as global warming and compound interest can produce greater output as stocks accumulate. The most common example of decreasing returns is the diminishing marginal utility of consumption. Even for desirable goods, the consumption of the second unit produces less satisfaction than the first, the third less than the second, and so forth. Congestion and crowding effects, where enjoyment decreases as more participate, such as fashion trends, road traffic, or a roundtable discussion are examples. Bureaucratization, professionalization or micro-management can reduce the efficiency of labor; one boss is helpful, two bosses is not twice as helpful. Professions -- law, medicine, education -- and service occupations more generally, have constant returns, but compensation costs give them decreasing returns. Most natural resources have declining returns due to the tendency to use the easiest to extract mineral or most productive land first. Knowledge can have decreasing returns if prior knowledge makes one closedminded. Drug resistance is another example of decreasing returns where constant doses yield a smaller effect. The other reason that non-linear returns to scale are important is that they raise the possibility of multiple equilibria. When supply and demand have constant (linear) returns, there is only one unique equilibrium. However, if one or both of the curves are non-linear, there can be two or more intersections, which means that there can be sub-optimal equilibrium traps that prevent the economy from reaching full employment. In addition, feedback loops -- multiplier effects -- can accentuate booms and busts during the business cycle. 4

3.0 SUPPLY & DEMAND BASICS The basic supply and demand chart consists of four elements: a supply curve, a demand curve, an equilibrium at the intersection of these two curves, and vertical and horizontal axes labeled “price” and “quantity” respectively. The supply and demand curves intersect where the marginal cost of producing an additional unit to producers equals the marginal value of consuming an additional unit to consumers. Movements along the supply the demand curves reflect changes in price or quantity, while shifts of the supply and demand curves reflect changing conditions of supply and demand unrelated to price, such as the adoption of new technologies, increases in population, or changes in tastes. The standard supply and demand diagram, pictured to your right, only shows supply and demand in one isolated market. However, since supply and demand in one good or service can affect supply and demand in related markets (inputs, substitutes, complements), a more complete description would require a general equilibrium result.

3.1 DEMAND CURVES Ordinarily, demand curves slope downward, reflecting the opportunity cost tradeoff between money (price) and the good purchased (quantity). In most cases, the higher the price, the lower the quantity of a good or service will be demanded; the lower the price, the more will be demanded. The chart to the left pictures the intuition behind the downward-sloping demand curve. At a high price, only one ice cream cone is demanded, but as the price drops, more ice cream cones will be demanded. The functional form of the demand curve is influenced by the presence of substitutes, wealth of buyers, the extent of the market, and diminishing marginal utility of consumption.

3.2 SUPPLY CURVES In most cases, sUPply curves slope upward reflecting the opportunity cost tradeoff between the money spent (quantity) and the revenue earned from sale of a product (price). Ordinarily, the higher price, the more willing producers are to make a larger quantity of a good or service. The chart to your right shows the results of an “applause auction” where students “bid” on $1 and $5 dollar mystery prizes. Some students were willing to “supply” more minutes of applause for the same payoff. The slope of their supply curves reflects their individual willingness to trade time for money. Assuming constant returns, it is assumed that they will produce 5x the quantity of applause for a $5 prize compared to a $1 prize. The functional form of the supply curve is shaped by the scarcity of factors, the technology of production, substitutes, the size of the producing sector, other costs to bring the product to market, and the presence of economies and diseconomies of scale. In the short-run, supply curves have unit elasticities, but long-run supply curves are thought to be inelastic due to the finite supply of natural resources. 5

3.3 KINKED CURVES Ordinarily, supply and demand curves are thought to be continuous and differentiable. However, in markets for certain goods, these conditions may not hold. If a good or service is not divisible, then its supply and demand curve should not be continuous. A good example is the supply and demand for grades. There two basic ways to record grades are: numeric (100, 99, 97 . . .) and alphabetic (A, B-, C+ . . .). Numeric grades are continuous and can be represented with the basic supply and demand because both student effort/ability and the grading scheme are continuous variables. However, this is not true for alphabetic grading schemes. The chart to your left shows the supply and demand curves for an alphabetic grading framework. The “quantity” supplied is the grade and the “price” paid is the student’s effort and ability. The student’s demand for grades is represented by the red diagonal; the blue stepped supply curve shows the teacher’s supply of grades. The supply and demand curves intersect at the “C” plateau, but just short of the threshold of becoming a “B.” Suppose a teacher seeks to elicit more effort from students by using grades as an incentive system and resolves to evaluate student assignments 5% more rigorously. This is equivalent to a small horizontal shift of the supply curve to the left (makes high grades scarce). According to this chart, even a small change in grading standards should evoke a greater effort from students due to the vertical (inelastic) segment of the curve. However, a greater laxity -- 10% -- in grading rigor would have no effect on student effort due to the horizontal (elastic) segment of the “C” plateau. In the conventional supply and demand framework, a 5% decrease or a 10% increase in the quantity supplied would yield a proportionate movement in price. This was not the case in alphabetic framework because grades were no longer divisible (continuous) goods. Perhaps the starkest example of the alphabetic grading system is the “pass/fail” thresholds for high-stakes tests or the minimum attendance to graduate. In essence, this reduces the grading system to two steps: “pass” and “fail.” This explains, in part, the common student question of what is the minimum level of acceptable work, instead of questions of how to improve their performance. The other situation that encounters kinked supply curves are industries that have high fixed and low variable costs. The classic examples of this is energy generation. The large fixed cost for an energy company is the construction of the plant or simply having online or offline. Once a plant is online, the variable costs of its operation are minor by comparison. As a result, the supply of energy is basically elastic -whether one uses ten or ten hundred kilowatts, the unit charge is the same -- because of the low variable costs of producing energy. The costs come with the necessity of putting another plant online and therefore there are sharp price spikes at peak energy use times to discourage aggregate energy use that would break this threshold. This is also why one could extract windfall profits by selectively taking plants “offline” during peak demand times as Enron did during the California Electricity Crisis of 2000 and 2001. It is also why energy use at the margin by the consumer has little effect on the level of energy production. Marginal tax rates and oligopolistic kinked demand curves are also examples of discontinuous supply and demand curves and will be described in more detail in the chapters on taxation and imperfect competition respectively.

4.0 VARIANTS OF SUPPLY & DEMAND In the following sections, five different models of supply and demand will be covered in detail. They can be remembered by the acronym ACCORD for Auctioneer, Cobweb, COrrider, Rocking horse, and Disco. 6

5.0 AUCTIONEER The inspiration for supply and demand is Adam Smith’s “invisible hand,” but Smith did not specify the mechanism through which the invisible hand generated prices. One of the first, and most successful, attempts was by Swiss economist Leon Walras. Walras is best known for reworking the insights of the Classical economists into mathematical format. For supply and demand, he suggested the process of tatonnement, the French word for “groping” or “trial-and-error.” Walras imagined an auction with a fixed set of goods to be sold. The auctioneer would announce prices and then take bids from all the buyers regarding the quantity they want at that price. If the quantities demanded exceed the stock of goods, the auctioneer announces a new higher price; if the quantities are less than the stock of goods, the auctioneer announces a second lower price. The process continues until all the goods are distributed. The market clears. The auction can simultaneously engage both buyers and sellers with each side announcing the amount they would and buy at given prices. The price that equalizes the quantities of good demanded and goods supplied is the market equilibrium price. Mathematically, this process can be represented as the solution to series of simultaneous equations. In Walras’ example, the solution process was simply plugging in numbers (prices) until the equations were solved. However, the more efficient way is to use algebra to solve the unique solution to the system of equations as shown in the box to the right. This framework is useful because it allows the economist to identify the equations for component processes, such as the consumption and production function of demand and supply respectively.

5.1 THE MODEL APPLIED The diagram above can illustrate how this may work. Suppose that Charlie Brown is a “good” in dating market and he wants to recoup the full worth for his quantity of prom date. To simplify, assume that there are only three qualities that prospective “buyers” care about: “outer” beauty (parameter A), “inner” beauty (parameter B), and cash on hand (parameter C) and there is an objective number that can be assigned to each of these parameters. Each buyer offers a bid on the good, represented in the diagram in the cloud bubbles. However, each bid is simply the result of each buyer’s “demand function” shown in the yellow bubble in the diagram. Each buyer puts a different weight, represented by the equation coefficients and their demand functions can be solved by plugging in the good’s parameters (A, B, & C). Using matrix algebra, the Walrasian auctioneer can sum all the buyers demand functions into a single demand function. A parallel process can be accomplished on the supply side. The market equilibrium can be determined by setting the supply and demand matrix equal to each other solving for quantity and price. 7

5.2 PROBLEMS The auctioneer model illustrate the “Law of One Price” that holds that all identical goods must have the same price in a market. The auctioneer model produces a single, unique and deterministic equilibrium. However, it makes several large assumptions to do so. First, it assumes there are no transaction costs; the auctioneer works for free. However, in the real world, transactions are not costless and in most exchanges there is a broker who gains compensation from identifying buyers and sellers and facilitating the transaction. Second, it assumes perfect information on the part of the auctioneer -- the auctioneer knows all the information necessary to conduct the calculation -- and the market participants -- buyers and sellers know perfectly their own utility, market prices and goods and services available for sale. These are fairly heroic assumptions given what is known about economic agents and real world markets. In addition, the model is static. Once the market is in equilibrium, there is no reason for prices or quantities to change. However, in real markets we know that prices are constantly fluctuating. The Auctioneer Model has little to offer to understand how supply and demand change over time. However, the biggest problem with the auctioneer model is that it is just as consistent with “market socialism” as it is with a free-enterprise, competitive market economy. The calculations of the auctioneer could be the result of a central government planner or the product of market processes.

6.0 THE ROCKING-HORSE MODEL The second model of supply and demand is the “rocking-horse” model developed by economists Ragnar Frisch and Jan Tinbergen, the first recipients of the Nobel Prize in Economics. The Rocking-Horse Model addresses the problem of dynamic change and fluctuating prices and economic activity. The model starts from the observation that there are observable business cycles that show swings of increased and depressed economic activity that cannot be explained by the Auctioneer Model. The movements of the key elements of both the supply and demand curves do not conform to observable economic activity. In addition, there are many instances of seemingly random or irrational movements in markets, such as several hundred point swing up and down of the stock market on successive days. In short, the economic system does not appear to be one in equilibrium. In addition, there seems to be little connection between cause and effect -- in both sequence and magnitude -- between exogenous forces in the real economy and supply and demand equilibria in markets. The Rocking-Horse Model creates an analogy between the economy and the movements of rocking horse or pendulum. The rocking horse, sitting on its skids, has an internal equilibrium if not disturbed. However, if its equilibrium is disturbed by an outside force, it will rock back and forth before returning to its equilibrium. The key insight of Frisch and Tinbergen was to separate the impulse (outside shock) from the propagation mechanism (internal adjustment). They anticipate “disequilibrium” approaches to supply and demand that do not assume that economic markets are in equilibrium and the process of returning to equilibrium is not simple or eventual. However, they do advance the notion that the market is a cybernetic mechanism that serves as a shock absorber for various supply an demand shocks that buffet the economy. Although the market is never in equilibrium at rest it is in dynamic equilibrium because it oscillates around the equilibrium just as a pendulum swings around its pivot. One way to visualize the model is to think of marble (price-quantity) sitting at the bottom of a bowl. If the bowl is undisturbed, the marble will sit at the bottom in equilibrium. If disturbed, the marble will rock back and forth inside the bowl as shown by the double-sided arrow. However, the equilibrating forces of the bowl’s sides will eventually return the marble to the at-rest equilibrium at the bowl’s bottom. 8

6.1 THE MODEL APPLIED Exogenous impulses can be either demand or supply shocks. Demand shocks include credit collapses due to mass bankruptcy or bank closures, collapses in asset prices, government policy or seasonality. As the graph to your right shows, there are identifiable seasonal demand oscillations in employment and sales in retail every December. As a result, most public economic data is seasonally adjusted to take into account the natural oscillations in the economy. Supply shocks include changes in core technologies, changes in the structure of the economy (i.e., shift from agriculture to manufacturing) and boycotts, embargoes, and shortages, such as the 1973 Oil Embargo. However, the propagation mechanism need not simply be an equilibrating and proportionate translation of the original impulse, but can have cancelling or reinforcing dynamics leading to distortion and disorientation of supply and demand signals in the market. An example of this would be a vehicle without shock absorbers. Reinforcing vibrations may not only make it difficult, but impossible, to control. This has implications for the ability of policymakers to “fine-tune” economic activity. Perhaps the greatest example is the 1973 Oil Embargo which delivered a supply-side shock to the economies of the developed world by raising energy prices that lasted long after the embargo was lifted and affected more than just energy prices.

6.2 PROBLEMS One problem with the application of the Rocking-Horse Model is that economies, especially monetary economies, are not constructed like a single pendulum, with discrete impulses and single, passive equilibrating mechanisms. Instead, they may resemble a double pendulum because individuals are actively, but incompletely, trying to stabilize the supply and demand movements in the economy. The picture to the right shows the motion path of a double pendulum (a pendulum suspended from another pendulum). As can be seen, the adjustment path is chaotic and there is no tendency toward equilibrium. Another problem is that not all prices are equally flexible in practice, creating at least two sets of interacting markets governed by “flex-prices” and “fix-prices” respectively. The adjustment of supply and demand can occur through a change in quantity or a change in price. Some economists, usually of a conservative (Classical) persuasion, assuming that supplies are finite and quantities fixed argue that adjustment should occur primarily through price changes. This is the world of flex-prices. Others, typically of a progressive (Keynesian) perspective, argue that prices are “sticky” or “fixed” and the adjustment will occur through quantity movements. This is the world of fix-prices. Some markets, usually ones with decreasing marginal returns, are characterized by flex prices. Examples include gasoline, fresh produce and dairy (milk / eggs), and financial markets where prices fluctuate on a day-today, even minute-to-minute, basis. Other markets, particularly labor markets (nominal wage rigidity) and markets for manufactured goods display inertia. Prices are not set in competitive markets, but as a mark-up on production costs. The chart to the left shows changes in wages during the recent (2008-) economic crisis. Despite high unemployment (quantity), there was little downward movement in wages (price). This may be why movements in the minimum wage have little impact on the level of employment as predicted. 9

7.0 THE DISCO MODEL & SEARCH EQUILIBRIUM The third model of supply and demand are search equilibrium models developed initially by recent Nobel Laureate Peter Diamond. In the previous two models, there is an implicit assumption that all buyers and sellers are present at the Walrasian auction or riding Frisch-Tinbergen’s rocking horse. As the aphorism goes, “half of life is showing up,” but there is no guarantee that a market will exist even if there exists ready buyers and sellers because they do not “show up.” In this formulation of supply and demand, the process is principally one of matching. However, the process of matching is not costless. Firms expend significant resources marketing their products and buyers spend time shopping to identify the best purchase. It is possible that individual buyers and sellers, discouraged by the cost of looking, give up the search or settle (“satisfice”) on a sub-optimal choice rather than expend more resources. While some goods and services are transacted in complete and liquid markets, most purchases are webs of ad hoc local contracts made for convenience, not optimality. One can illustrate the process of search equilibrium by thinking of a disco or nightclub as a “dating market” that works through matching single individuals. The attractiveness of a particular nightclub is the presence of potential dates. If there are more women, the club will be more attractive to men and if there are more men, more attractive to women. The scarcer gender will command a higher price from the more plentiful one. One can compare this to a “predator-prey” ecological model, where a larger supply of prey attracts a greater number of predators, but having killed off its food supply, the number of predators declines, giving rise to the population of prey. The problem this model uncovers is that there is no need for everyone to stay in the market. For example, if the club patrons are 2/3 male and 1/3 female, the female patrons may be happy, but half of the male patrons may find that their chances of a successful search are low and decide to leave, changing the attractiveness of the club to the women as they do, causing more women to leave. The same dynamic exists if the shares are reversed. If the shares are uneven, there is a pressure for the club to become 100% male or 100% female, extinguishing the dating market. This suggests at least three possible equilibria: a unstable, optimal equilibrium when the composition of the market is 50-50 and two stable, sub-optimal equilibria where the composition is either 100% buyers or 100% sellers. In the later two cases, no market is formed, despite the desire to buy and sell. The key is finding a way to keep market participants from bailing when their chances of a successful search decline. “Ladies’ Night” promotions are an example of this dynamic. Clubs offer free drinks to women to raise the share of their female clientele to attract more men, who are then gouged for overpriced drinks. Since the club owner makes money off volume, he is willing to subsidize the “dating market” at the club, keeping the shares of women and men proportional. Another example is the practice by casinos of comping “high-rollers” to encourage them to keep betting even when they face unlucky streaks. The existence of real estate brokers, job “headhunters” and college counselors -not to mention the entire marketing and advertising industries -- all suggest that there are lucrative opportunities to be had simply by assisting the supposedly automatic processes of market. 10

Another way to visualize this model is to return to the marble and bowl example used in the previous section. However, this time, the bowl is open face down, as shown by the diagram to the right, and the marble is perched on top. The equilibrium that maximizes aggregate social welfare is the marble perched on top of the bowl, but it is unstable, because even the slighted perturbation chances knocking it off its spot and trapping it in a stable (difficult to escape) suboptimal equilibria as the market becomes dominated by either buyers or sellers. The previous models of supply and demand assumed that the stable equilibrium (naturally occurring and sustainable was also the optimal (most desirable) one. The “disco” search equilibrium model shows how markets can stay depressed for extended periods of time.

7.1.1 THE MODEL APPLIED I: LABOR MARKETS Many key economic markets are characterized by search and matching, perhaps none is as important as the labor market. Employers -- especially in the service sectors -- do not buy labor by the hogshead based on prevailing wages, but seek to fill specific positions with specific workers. Similarly, workers are not looking for any job, but a job that promises them compensation and work requirements they desire. As a result, the labor market is not simply matching an aggregate quantity with the aggregate price level. To effect this match, both workers and employers invest resources just to identify the ideal individual and job. Workers polish resumes, purchase interview clothing, research firms, and look through want ads. Employers also expend resources to determine job requirements, advertise for applicants, interview candidates, and, for high-skilled workers, “sell” their firm to potential employees. These are significant expenses which are undertaken even if the ideal candidate or job manifests. As a result, both employers and workers use employment agencies and headhunters to reduce the cost of a search. Willingness to bear these costs is related to the probability of a successful search. What makes a successful search more probable? One factor is prevailing economic conditions. When the unemployment rate is low, employers must work harder to find suitable employees because most workers are already employed. When unemployment is high, the unemployed must work harder because more applicants compete for a smaller pool of jobs. The relationship between job vacancies (demand for workers) and the unemployment rate (demand for jobs) is known as the Beveridge Curve and is shown on the left. Vacancies and unemployment are inversely related and movements along the curve occur as the economy booms and busts. Shifts inward or outward from the origin reflect the match (or mismatch) of skills to the jobs available and suggest a growth or reduction of structural (supply-side) unemployment instead cyclical (demand-side) unemployment. Matches between job vacancies and workers are easier when they are more compatible (i.e., skills supplied = skills demanded). However, the search may become so onerous that either or both employers and workers may give up the search. Workers can become “discouraged” from looking for work after prolonged stints of unemployment and employers may train within for positions for which good applicant are scarce. While both employers and workers benefit from a successful match, they would prefer that their counterpart bear the cost of the search. The ability to shift costs depends on the state of the labor market. Practices such as signing bonuses exist for scarce high-skilled workers as a means of defraying the cost for workers (and high employer-specific benefits 11

to prevent valued employees from leaving). This shared burden also arises in discussions about “who is to blame?” for current unemployment. From the employers’ side, the blame is put on applicants who either are not applying for the jobs available or do not have the skills to meet the job requirements. If the unemployed only worked harder -- and did not have “cushy” unemployment benefits -unemployment would disappear. The data tells a different story. The first chart to the right shows the job-filling rate and the intensity (effort) of recruiting by employers. Since the onset of the last recession, it is clear that the job-filling rate rose before falling again, while the intensity of recruiting has fallen and stayed low. This data is consistent with the theory that employers are taking advantage of poor labor market conditions and economizing on recruiting. However, even with low levels of recruiting by firms, there could still be a structural employment problem of a skill-jobs mismatch in the labor market. This argument often goes hand-in-hand with arguments that schools do not provide students with the requisite skills for 21st century workforce or that they do not graduate “career and college ready.” This, too, is a nice story, but is not supported by the available evidence. As the graph to the right shows, the level of mismatch rose temporarily during the height of the recession (2009), but has returned to previous levels while unemployment has continued to stay at elevated levels. As one scholar noted, the problem is that employers are looking for “purple squirrels” and are having problems because they create unreasonable and utopian job requirements that cannot possibly be filled. The second dimension to search equilibrium in labor market is the size of the “labor wedge.” The wedge is the ratio between the marginal rate of substitution of work for leisure and the marginal product of labor. In other words, the ratio between the “use-value” workers put on their time and the “exchange-value” that their labor commands in the labor market. The labor wedge acts as a tax on work, discouraging workers from seeking employment because they cannot find adequate compensation for their time (paid less than their value). The lower the labor wedge, the higher the penalty for working. As the chart to the left shows, the labor wedge has falls in times of recession (because firms have less use of workers without demand for their products) and has dropped precipitously in the last recession. A lower labor wedge implies a higher cost of searching for work. If the costs of searching for work exceed the compensation of the job that search produces, a worker may rationally decide to stop searching even at high penalties to income.

7.1.2 THE MODEL APPLIED II: COLLEGE SEARCH Another application of search equilibrium theories is the college search. A college education is not a good that 12

can simply be bought on the market; there is an admissions process that seeks to determine whether the student is a “good fit” for the college and whether the college is a “good fit” for the student. In short, it is a matching process. If colleges were a simple supply and demand proposition, the best colleges would experience higher demand and they could raise tuition (price) until they had the desired class size (quantity). Worse colleges would lower tuitions to fill their seats and institutions that had to lower prices below costs would close. Clearly, this is not the world we live in. Both colleges and students (and parents and teachers) invest a large amount of resources to make the right match. The chart above shows the cost of the college search for one NJ parent for one child. None of these costs guarantees acceptance or even that one will make the correct math. Colleges also invest in finding applicants, and, if you are a high school senior, you have probably been deluged by a flood of glossy brochures from colleges you never knew existed during the past year. In addition, travelling college representatives, college admissions offices (which are as much marketing as evaluation agencies), alumni relations departments, interscholastic sports programs and merchandising, etc. are all expenditures to attract applicants and have little to do with the quality or quantity of the core goods and services transacted. Also not negligible is the cost expended by K-12 institutions by keeping student records, writing recommendation letters, offering “advanced placement” course options, and assisting students to choose the “right” college. Given the substantial cost of the college search and application process, it is little wonder that many students (and some colleges) forego the entire search process and simply attend local universities and community colleges. As a result, it is likely that most students do not attend the best matching college for their abilities, preferences, and resources, in many cases because they never know or never apply.

7.1.3 THE MODEL APPLIED III: HEALTH INSURANCE In modern societies, most do not purchase healthcare directly, they buy insurance to defray the costs of healthcare. Purchasing insurance is the classic case of a “market for lemons,” or its more technical name, adverse selection. If you are a highmedical risk, the cost of insuring you would be above the policy’s cost, while if you are low-medical risk, the cost of insuring you would be below the policy’s cost. Knowing this, why would any insurance company sell a policy to a highmedical risk and why would any low-medical risk person purchase insurance? In the market for insurance, there are two competing searches: one by insurance companies looking for healthy individuals to insure and a second by sick people looking for companies that will insure them. It is highly unlikely that this market will form because both buyers and sellers must deceive their counterparty about the real cost of their purchase. Insurance policies in the US were first offered through employers because, in part, workers -- as demonstrated by their ability to work -- were probably a healthier segment of the population than the population as a whole. In parallel, the largest pool of uninsured are young adults who generally have the lowest-medical risk profile in the population. If the insurer only offers the average policy, the low-medical risks would refuse to purchase and only high-medical risks would purchase the policy. This would lead the insurer to raise the premium, making it moderate-medical risks refuse to purchase. Eventually, only the highestmedical risks would purchase a policy and the insurer would go bankrupt, extinguishing the insurance market. The only optimal equilibrium is one where everyone purchases insurance and everyone is insured, but this equilibrium is unstable, because if insurers begin to discriminate or individuals refuse to pay, the insurance 13

market becomes unsustainable. It either becomes a market will all buyers, no sellers or all sellers, no buyers. A similar dynamic may be at play in the choice of two courses of treatment. Imagine two courses of treatment: one relying on drugs and the other focusing on physical therapy. The physical therapy is more effective, but is less likely to done correctly. The drug therapy is less effective, but is easily understood. If a physician cannot know whether the patient can carry out the more complicated therapy, he may prescribe the treatment for the average patient. Eventually, the simpler, but less effective, therapy becomes dominant and the more effective is abandoned. Likewise, if there are two therapies, one effective one that requires a highly-skilled (but scarce) professional and a second, less effective alternative that can be accomplished by minimally competent (but plentiful) professional, the standard of care may gravitate toward the simpler procedure. There is some evidence that this is how caesarean sections replaced forceps delivery.

7.1.4 THE MODEL APPLIED IV: PREDATOR-PREY MODEL A relative to the search equilibrium theories in economics is the predator-prey (P-P) model in ecology. The P-P model is used to model the interaction of two species in an ecosystem where the size of one population depends on the size of its counterpart. Predator species depend on prey species for food, so their size is limited by the size of the prey species population. However, the size of the prey species population depends on the size of the predator population. As the predator population grows, they feed on more prey species, reducing their number. This makes the predator species size unsustainable, decreasing its size and giving new rise to the prey species. If the size of the predator and prey are plotted on x and y axes respectively, it draws a circular path over time as shown by the graph above. Plotted over time, the predator-prey model produces harmonic oscillations, similar to boom-bust cycles of the business cycle as shown by the graph below. The P-P model has three basic states: steady-state equilibrium (unstable, but sustainable) where the populations are in balance and two stable, but unsustainable equilibria, that consists of all predator or all prey species. If the equilibrium is not found, the ecosystem collapses, just as a market would not form. Predator-prey models have been used to model the growth of gang territory and the spatial distribution of gang violence and have been used in economics to model the activity of business competitors in the same sector competing over market share. However, the core intuition the search equilibrium family of models and applications emphasize the key role played by coordination and cooperation, rather than competition, distinguishes it from other models of supply and demand.

7.2 PROBLEMS The main problem with search equilibrium models is that they imply that reaching equilibrium is difficult if 14

not impossible. However, most of the time, economic agents seem to manage to overcome these dilemmas. In addition, not all markets are about matching. Many transparent and liquid markets do exist and the insights of search theories are not particularly helpful. In addition, they are more helpful at identifying ways that market equilibrium break down than providing guidance for how to restore equilibrium.

8.0 THE CORRIDOR MODEL Corridor models, associated with the work of Robert Clower and Axel Leijonhufvud, are a hybrid of the Rocking-Horse and Disco Models presented in the previous sections. The key innovation of this approach is to identify in what circumstances supply and demand behave in the self-equilibrating and stabilizing manner of the Rocking-Horse and Auctioneer Models and when it has the destabilizing and disequilibrating properties suggested by the Disco Model. In the previous models, there is an implicit assumption that all transactions occur at the market equilibrium price and quantity. Although the Auctioneer model “finds” the market price through a process of trial-and-error, no goods are exchanged until the market-clearing price is found. While the Disco Model suggests that prices and quantities can diverge from an optimal equilibrium, it argues that markets quickly evaporate if they cannot maintain that position. The common assumption is that the supply and demand curves move simultaneously and instantaneously, like the two blades of a scissors, from one position to another. In contrast, the Corridor Model views the process of supply and demand as sequences of moves and the sequence order matters. In most supply and demand models, it is implicit that prices change first and quantities second. This ensures that all quantities in the market are cleared and each agent has the maximum purchasing power possible. However, if quantities adjust first, sellers may not have “cash-in-advance” to buy the goods supplied to others, who now have less purchasing power to buy the goods of still others, and so forth. This is a destabilizing and disequilibrating spiral akin to the Disco Model. Deprived of the ability to earn money to finance purchases, the market falls apart. The Corridor Model specifies a zone -- the “Corridor” -- where the normal laws of supply and demand appear to be in force, but outside the corridor, price and quantity signals produce disequilibrating dynamics -- vicious cycles -- that impair the ability of buyers and sellers to coordinate their decisions. The “Corridor” is defined by the ability to liquidate one’s goods and services (or use them as collateral for credit), an ability that is undermined when prices are rising or falling too fast for individuals to coordinate their actions. In short, the real damage of inflation and deflation is not the appreciation or depreciation in the value of money as a commodity, but its irrelevancy as a numeraire, a unit of account. The diagram above sketches out the basic shape of the Corridor theory. In the zone of the corridor -- roughly inflation levels between 2% - 10% or unemployment levels between 5% - 10% -- the surface is concave or bowlshaped. Like the Rocking-Horse model, prices, left to their own devices, will tend toward the bottom of the bowl and find a stable equilibrium. Outside the corridor, however, the model takes on the form of the Disco Model, with steep drops into sub-optimal equilibria of inflationary and deflationary traps. A key feature are the “speed bumps” or “guard rails” that border the Corridor. These speed bumps are policies that keep selfreinforcing processes from reaching their full power such as central bank’s monetary policies, “automatic stabilizers” such as unemployment insurance, food stamps and Medicaid (which restore purchasing power to those who cannot sell their goods and services), deposit insurance, agricultural price supports, and bankruptcy and courts of equity. It is necessarily difficult to enter an inflationary or deflationary spiral as a result, and only a substantial supply or demand “shock” should be able to knock the market out of the Corridor. 15

8.1 PRICES & PHYSICS Economics grew out of the application of physical and natural laws to social phenomena using math as the grammar and vocabulary of this enterprise. Not surprisingly, many of the concepts (equilibrium, inertia) of Newton’s Laws of Motion, calculus (marginal analysis), and gravity are distributed throughout economic analysis. Economic incentives work like gravitational forces upon behavior and Say’s Law seems like an economic version of the conservation of energy and matter. The visual analogies used here to illustrate different models -- marbles moving along bowl-shaped surfaces -- can be compared to Einstein’s concept of gravity in the time-space continuum, pictured to the right. Mass creates depressions in surface that warp the time-space surface. Just as these depressions create the gravitational paths that draw or repel objects, incentives create their own push and pull effects. In the visual analogies, the marble is the price-quantity equilibrium and as it travels over the warped surfaces created by “incentive-depressions” it moves from one area to another. The corridor model emphasizes the warp and woof of the surface to identify when incentives will be equilibrating (stabilizing) or disequilibrating (destabilizing). In stabilizing areas (depressions), market incentives have a centripetal force, but outside, they can have centrifugal forces that are destabilizing.

8.2 THE MODEL APPLIED As a hybrid of the Rocking-Horse and Disco Models, the applications of the Corridor Model can be seen as a general model that decomposes into its component models depending on the economic context. Inside the Corridor, it is the Rocking-Horse model; outside the Corridor, it is the Disco Model. The key difference is the presence or absence of inflation or deflation. Since inflation and deflation will be discussed in greater detail elsewhere, only a quick presentation of real examples of inflation and deflation will be presented here to illustrate how supply and demand can break down. The graph to your right shows the exchange rates (relative to $US) for the former Yugoslavia, Zimbabwe, Argentina and Brazil since the early 1980s The foreign exchange rate tracks the domestic level in inflation in these countries (inflation = slope of the rise in exchange rates). As can be seen, these countries experienced inflation rate in the thousands, even millions, percent in a short period of time. Anyone who knows the economic history of these countries understand how destabilizing inflation levels of this magnitude can be. The period of the greatest rise -- the 1980s -- is known in Latin America as the “Lost Decade.” Markets -- supply and demand -- break down because prices become unreliable. On the other end of the spectrum is the approaching two “lost decades” of Japan since the bursting of its stock market and real estate bubbles in the early 1990s. The chart to your left shows the trend of disinflation for Japan (blue) during the 1990s and the US in the 2000s (red). The correlation of the trends does not bode well for the next decade of the American economy. Japan was able to cushion internal deflation by running trade surpluses, the United States does not have this advantage. Many experts see Japan’s 1990s as a portent of what lies ahead for the US. 16

9.0 THE COBWEB MODEL Like the Corridor Model, the Cobweb Model is principally concerned with potential disequilibrating forces related to supply and demand. However, while the Corridor Model holds that within the Corridor, supply and demand function normally and is only affected by substantial direction changes in price (up = inflation; down = deflation), the Cobweb Model notes problems within the supply and demand framework itself and is more concerned with price volatility than price levels or the rate of price changes. The Cobweb kernelizes the insight of the Corridor Model that quantity adjustments may occur before price adjustments, by examining the relative elasticities (slopes) of the supply and demand curves. It is known as the “cobweb” model because of the spiral paths of price-quantity adjustments around the supply and demand curves resemble the shape of a spider web and its primary application are markets where the costs and benefits are temporally segregated. In other words, when the costs are incurred upfront, but the benefits materialize in the future. In between, the material conditions undergirding the production of supply may change, causing the market equilibrium to reset. One example is agriculture where farmer must undertake the costs production before they know the demand for their product. Another is shortages of highskilled workers, such as nurses (2000s), engineers (1970s) or IT workers (1990s). A shortage may cause a rise in compensation to attract individuals to these occupations, but there is a lag because one cannot train a nurse or engineer immediately. During the lag, the shortage may be remedied, leading to lower compensation when newly trained professionals are ready to enter the market. Finally, stock markets and venture capital (especially in technology and pharmaceuticals) are also structured with high upfront costs and uncertain and delayed revenues. As a result, many individuals in these situations seek to stabilize prices either through futures contracts (in agriculture and equity markets) or by contracts that reward investments in education (independent of ability), signing bonuses, salaried compensation or tenure contracts. In general, the cost-benefit time problem is not an issue because deviationdampening adjustments would make current price-quantities a time-path to risk-adjusted future price-quantity equilibria in competitive markets. As new information about the probable future becomes available, the information would become “baked in” the current market price. However, if the slope of supply is less (more elastic) than the slope of demand (more inelastic), then quantity changes in supply will induce a disproportionate larger movement in price, resulting in deviation amplifying adjustments in price as shown by the graphs to the left. The graphs to the right show the conventional convergence on the market equilibrium price for the same supply changes with a different structure of supply and demand. The deviation-dampening pattern is the same as found in the Rocking-Horse Model. The deviation-amplifying pattern has the same oscillation axis, but the deviations (volatility) grow over time, making it increasingly difficult to base decision based on price movements. This different than high or low prices, but the accelerating pace of price changes, both high and low around the presumed market equilibrium. 17

9.1 ELASTICITY Elasticity is the sensitivity of prices changes to changes in quantity. It is similar, but not the same, as the slope of the supply and demand curves. While slope is the simple ratio of “rise over run,” elasticity is the percent change in the in the change quantity over changes in price. While elasticity has many applications in economics, three levels of elasticity concern us for the moment: perfect elasticity, unit elasticity, and inelasticity. An inelastic supply or demand curve is a vertical curve perpendicular to the x-axis (quantity). It can be remembered because it position forms an “I” on the supply and demand graph as shown below. A perfectly elastic curve is a horizontal curve perpendicular to the y-axis (price). One can remember it by the “E” shape it makes on the graph of supply and demand. A unit elastic curve is one that forms a 45-degree angle, indicating there is a “one-to-one” relationship between quantity and price changes. When a curve is inelastic it mean the quantity demanded or supplied does not vary with price. When a curve is perfectly elastic, it mean the price will not change no matter what quantity is supplied or demanded. These situations are important “special cases” in economics because Elastic Curve Inelastic Curve when supply or demand has elastic or inelastic properties the commonsense operation of supply and demand do not apply.

9.2.1 INELASTIC SUPPLY & DEMAND In the long-run, supply is thought to be inelastic because there is a finite supply of resources. At some point, the supply curve is vertical. A vertical (inelastic) supply curve suggests a technological or resource constraint. Supply curves should become more and more inelastic as resources become exhausted over time. Technological constraints also create vertical supply curves: the supply of time machines, no matter how great the demand, is firmly fixed at quantity = 0. However, technological change can shift an inelastic supply curve outward by using resources more efficiently, recycling resources, or finding new uses for unused resources. Inelastic demand reflects “addictive” behavior. Consumers demand a certain quantity regardless of price. One may think of a “junkie” given their first drug free that creates an addiction. Once addicted, they will pay any price -- and not just monetary costs -- to service their addiction. The dealer can raise the price confident that the junkie will continue to demand the same fix. This behavior can be found in smaller addictions as well: gambling, fandom of sports teams, or alcoholism. Another type of inelastic demand can be found in monogamous human relationships. We want a partner; two is not better than one; zero is unacceptable. The practices of “playing hard to get” is a way of raising value by restricting supply knowing that invariant demand will not change. However, the economically most serious example of inelastic demand may be the market for healthcare. We are all, understandably, “addicted” to our own lives: we need one; we cannot have two, we will probably spend anything to prevent ourselves (and those we care for) from having zero. The most direct “market” for this is healthcare, which allows us to have a longer and higher quality life. However, at any given time, the quantity of “sickness” -- the demand for healthcare services -- is fixed.* People do not demand a second heart transplant or an extra tetanus shot because a clinic offers a “two for one” special. The main factor driving healthcare costs is supply. One way to raise prices is to restrict supply of medical professionals -- a main reason why medical and nursing schools are hard, another is to rise of drug patents (and restricting generics). The second way is to shift demand outward by creating “new” *Dentistry and elective/cosmetic surgery may be an exception to this generalization, which is probably the reason that these procedures are not covered by general insurance. In addition, diet and fitness may not have inelastic demand curves.


diagnoses that find new diseases and illnesses that require treatment -- treatment provided by medical professionals. Some have argued that Americans have become “overmedicated” as mood and behavior disorders have become medicalized. Medical writer and physician Atul Gawande observed that two Texas towns with the same level of health and sickness, but different levels of medical spending.

9.2.2 ELASTIC SUPPLY & DEMAND The price of “free” is probably the best example of perfectly elastic demand. This can be seen in the case of Halloween candy (has anyone met a child who thought they had enough candy?), “all you can eat” specials, water at restaurants, or subsidized healthcare. In addition, when “utilities are included” in the price of rent, individuals have virtually no limit to their use of electricity, hot water, or heat. However, if the price was raised even slightly (charging children 1¢ for each piece of Halloween candy or restaurant patrons for beverage refills), the demand might disappear. Perfectly substitutable goods, like paper clips or No.2 pencils, also have perfectly elastic demand. Consumers are willing to pay a certain price, but, in general, will completely abandon a product that has a slightly higher price. This is the logic of “dollar stores” (or, in an earlier age, Five and Dimes): people will buy more if they know the price is fixed. Goods and services that have uniform cost and characteristics -commodities -- and manufactured goods that have high fixed and low variable costs tend to have elastic supplies. As noted above, electricity tends to have elastic supply since flow of the power grid must be maintained regardless of incremental use. Grades, because they have no natural scarcity, can have elastic supplies (teachers can give an infinite number of “A” at a fixed price [grade]), and menu items have an effective elastic supply. However, the economically most critical example of perfectly elastic supply is money. In a liquidity trap, discussed in the chapter on money, there is effectively an endless supply of fiat money. The elasticity of the overall price level is a major difference between Classical and Keynesian economists. Classical economists, with their emphasis on scarcity, tend to see the elasticity of supply in the long-run as vertical (inelastic), while economists of Keynesian bent tend to see the elasticity of supply as more nearly horizontal. In an essay, “The Economic Possibilities of our Grandchildren,” Keynes concluded that we too often sacrifice important values because of a supposed, but imaginary, “economic problem,”: “do not let us overestimate the importance of the economic problem, or sacrifice to its supposed necessities other matters of greater and more permanent significance.” As a result, they see money supply as effectively elastic.

9.3 GIFFEN GOODS & CONSPICUOUS CONSUMPTION Ordinarily, when the price of an item rises, the demand for that item decreases. However, certain goods seem to defy this logic. Two types of these good are Giffen goods and Veblen goods, named after the economists who first identified the respective phenomena. In both cases, they have price elasticities of demand that are positive (they slop upward). This may because they are “backward bending” demand curves (they have both a positive and negative elasticity), but the upward-sloping demand curve presents a strange phenomenon: the higher the price, the greater the quantity demanded! Giffen goods are inferior goods that are usually discarded when incomes rise: they are only bought because they are 19

all that can be afforded, like bad microwave dinners. If they rose in price, the expectation would be that consumers would demand less. However, contrary to conventional economic wisdom, they demand more. Veblen goods are (mainly useless) luxury items that increase in value (the quantity demanded) when their prices rise. They have “snob value” as the economist Thorstein Veblen documented in his famous study, The Theory of the Leisure Class. Perhaps the best illustrated is the Peanuts characters Lucy and Charlie Brown. Lucy dares Charlie Brown to kick a football, only to pull the football away at the last moment. The more Lucy does this (raises the price), the more Charlie Brown wants to kick it. This type of behavior can only be seen as masochistic. In the case of Giffen Goods, the question is why would consumers prefer an clearly inferior good at a higher price? The original example was the consumption of bread by Irish peasants. The price of bread was rising, consuming more of their budgets and curtailing their consumption of higher calorie and protein food items. Not only did they not reduce their share of bread, they increased their consumption. Examples of individuals in relationships who seem to be more enthralled with their counterpart the worse they are treated (especially when they have alternatives) would also qualify as Giffen good behavior. There are individuals who insist on using earlier software versions -- and are willing to pay more to do so -- than use upgrades -- even at reduced prices. Perhaps less rare of Veblen goods. The purpose of purchasing Veblen goods is a) their “snob value” or b) conspicuous consumption. The consumption of certain goods and services confers status. For example, going to see the opera because you think it will make you seem sophisticated, even though you dislike opera, paying more for brand-name merchandise even though there is no quality difference, or paying more for a “name” private school because others will think you are smart are all examples of Veblen goods. Another example occurs is the choice of physician. Many people want the “best” physician -- and pay a premium for it -- even though the quality of service is probably as good with the “2nd best” physician. The payment of exorbitant sums for sports memorabilia or original art are also examples of status goods that confer snob value. In short, the broad spectrum of phenomena that may be considered “materialistic” fall under the rubric of Veblen goods. Karl Marx’s notion of “commodity fetishism” from the concepts of “use values” and “exchange values” provides another explanation. Instead of determining price from one’s “use value” of a good or service, one would use the price to infer its value. In short, in a money economy, consumers would assume that something that is higher priced must ipso facto be of better quality. However, Veblen attributed the dynamic to conspicuous consumption. We do not buy these items for our own consumption, but for others. We consume them to be seen by others consuming them. Wedding gifts, perfume, or “flowers and chocolates” are mainly bought for their value to others. For example, one would be likely offended, not pleased, if one received a gift of flowers only to be told that they were purchased at a 50% discount.

10.0 AREAS The supply and demand chart is not only useful for determining the price-quantity market equilibrium, but can be used to determine the welfare effects of different supply and demand schedules. The most basic of these is the producer and consumer surpluses. As the chart to the left shows, the consumer and producer surpluses can be derived from bisecting the eastern quadrant formed by the supply and demand curves at the level of the equilibrium price. The consumer surplus is the utility of the good purchased minus the price paid for the good. The producer surplus is the price of the good sold minus 20

the cost of producing the good. A more common name for the producer surplus is profit. Another way to conceptualize this is to split the supply and demand chart vertically so that only the left side of the chart remains. The total expenditure in the market is equivalent to the price x quantity and the total revenue in the market is also the price x quantity. These price-quantity squares can be found in the upper left and lower left quadrants of the supply and demand chart. They are split by the demand and supply curves respectively. Although not monetized, the consumer surplus reflects the welfare gain to the consumer for purchasing a good or service at a price below its value to the consumer. In other words, the consumer would have paid more, but fortunately did not. In a competitive market, both the consumer and producer surplus should be competed away as producers try to sell their products at the highest price possible and consumers try to purchase goods at the lowest cost possible. In short, this means that in a competitive market economy, there should be no long-term profits. The areas can also be used to estimate the amount of welfare loss that occurs from taxes and tariffs. Taxes and tariffs add to the market price of goods and services. As a result, transactions that would occur without the tax do not occur. This raises prices and reduces quantities transacted. The box formed between the consumer and producer surpluses is equivalent to the revenue gained by governments in taxes, however, the “Harberger Triangle� or deadweight loss remains as the triangle formed to the right of the tax revenue rectangle.


SUPPLY & DEMAND: Five Models  
SUPPLY & DEMAND: Five Models  

Draft Chapter for HS Economics Text