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Hong Kong ranked as the freest economy in the world. North Korea received the dubious distinction of being the least free. It seems reasonable to expect that the greater the degree of economic freedom a country permits, the greater the amount of income per person it will generate. This proposition is illustrated in Figure 2.12 "Economic Freedom and Income". The study also found a positive association between the degree of economic freedom and overall well-being using a measure that takes into account such variables as health, 2.3 Applications of the Production Possibilities Model 77 Chapter 2 Confronting Scarcity: Choices in Production education, security, and personal freedom. We must be wary of slipping into the fallacy of false cause by concluding from this evidence that economic freedom generates higher incomes. It could be that higher incomes lead nations to opt for greater economic freedom. But in this case, it seems reasonable to conclude that, in general, economic freedom does lead to higher incomes. Government in a Market Economy The production possibilities model provides a menu of choices among alternative combinations of goods and services. Given those choices, which combinations will be produced? In a market economy, this question is answered in large part through the interaction of individual buyers and sellers. As we have already seen, government plays a role as well. It may seek to encourage greater consumption of some goods and discourage consumption of others. In the United States, for example, taxes imposed on cigarettes discourage smoking, while special treatment of property taxes and mortgage interest in the federal income tax encourages home ownership. Government may try to stop the production and consumption of some goods altogether, as many governments do with drugs such as heroin and cocaine. Government may supplement the private consumption of some goods by producing more of them itself, as many U.S. cities do with golf courses and tennis courts. In other cases, there may be no private market for a good or service at all. In the choice between security and defense versus all other goods and services outlined at the beginning of this chapter, government agencies are virtually the sole providers of security and national defense. All nations also rely on government to provide defense, enforce laws, and redistribute income. Even market economies rely on government to regulate the activities of private firms, to protect the environment, to provide education, and to produce a wide range of other goods and services. Government’s role may be limited in a market economy, but it remains fundamentally important. 2.3 Applications of the Production Possibilities Model 78 Chapter 2 Confronting Scarcity: Choices in Production •
The ideas of comparative advantage and specialization suggest that restrictions on international trade are likely to reduce production of goods and services. • Economic growth is the result of increasing the quantity or quality of an economy’s factors of production and of advances in technology. • Policies to encourage growth generally involve postponing consumption to increase capital and human capital. • Market capitalist economies have generally proved more productive than mixed or command socialist economies. • Government plays a crucial role in any market economy. T R Y I T! Draw a production possibilities curve for an economy that can produce two goods, CD players and jackets. You do not have numbers for this one—just draw a curve with the usual bowed-out shape. Put the quantity of CD players per period on the vertical axis and the quantity of jackets per period on the horizontal axis. Now mark a point A on the curve you have drawn; extend dotted lines from this point to the horizontal and vertical axes. Mark the initial quantities of the two goods as CDA and JA, respectively. Explain why, in the absence of economic growth, an increase in jacket production requires a reduction in the production of CD players. Now show how economic growth could lead to an increase in the production of both goods. 2.3 Applications of the Production Possibilities Model 79 Chapter 2 Confronting Scarcity: Choices in Production Case in Point: The Prospects for World Economic Growth © Thinkstock What will happen to world economic growth in the next 10 years? The prognosis, according to economists Dale W. Jorgenson of Harvard University and Khuong M. Vu of the National University of Singapore, suggests that world growth is likely to be somewhat slower in the next decade than it was in the last. The two economists, who have written extensively on the problem of estimating world economic growth, estimate that the world economy (based on their sample of 122 countries that account for 95% of world GDP) grew at a rate of just 2.20% from 1990–1995. That increased to 3.37% per year from 1995–2000. During the period from 2000–2005 the annual growth rate accelerated again to 3.71%. Despite the recession and financial crisis that began in 2008, world growth slowed a bit but was still 3.06% from 2005 to 2009. Growth at 3% would double world economic income every 24 years. Think for a moment about what that implies—world income would quadruple in just 48 years. Growth at the 1990–1995 pace of 2.20% per year
would take 33 years for income to double. 2.3 Applications of the Production Possibilities Model 80 Chapter 2 Confronting Scarcity: Choices in Production Might the world growth rates from 2000 to 2009 of above 3% be repeated during the next 10 years? Under their base-case scenario, the economists project the world growth rate between 2010 and 2020 to be about 3.37%. What do they think the economic world will look like then? They predict that over the next 10-year period: the U.S. growth rate will slow down compared to the last two decades, primarily due to slower growth in labor quality, but the U.S. growth rate will still lead among the G7 countries (a group of seven large industrialized countries that includes Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States); the overall growth in the G7 countries will continue to decline; and growth in the developing countries of Asia (Bangladesh Cambodia, China, Hong Kong, India, Indonesia, Malaysia, Nepal, Pakistan, Philippines, Singapore, South Korean, Sri Lanka, Taiwan, Thailand, and Vietnam) will slow a bit from the recent past but will be high enough that those countries’ GDPs will comprise nearly 37% of world GDP in 2020, as compared to 29% in 2010. In terms of size of GDP in 2020, they predict the following new order: China, the United States, India, Japan, Russia, Germany, and Brazil. If their predictions are realized, it will mark the end of a period of more than a century in which the United States has been the world’s largest economy. Sources: Dale W. Jorgenson and Khoung M. Vu, “The Rise of Developing Asia and the New Economic Order,” Journal of Policy Modeling 33:5 (September–October 2011), forthcoming. 2.3 Applications of the Production Possibilities Model 81 Chapter 2 Confronting Scarcity: Choices in Production Your first production possibilities curve should resemble the one in Panel (a). Starting at point A, an increase in jacket production requires a move down and to the right along the curve, as shown by the arrow, and thus a reduction in the production of CD players. Alternatively, if there is economic growth, it shifts the production possibilities curve outward, as in Panel (b). This shift allows an increase in production of both goods, as suggested by the arrow. 2.3 Applications of the Production Possibilities Model 82
Chapter 2 Confronting Scarcity: Choices in Production 2.4 Review and Practice 83 Chapter 2 Confronting Scarcity: Choices in Production Summary Economics deals with choices. In this chapter we have examined more carefully the range of choices in production that must be made in any economy. In particular, we looked at choices involving the allocation of an economy’s factors of production: labor, capital, and natural resources. In addition, in any economy, the level of technology plays a key role in determining how productive the factors of production will be. In a market economy, entrepreneurs organize factors of production and act to introduce technological change. The production possibilities model is a device that assists us in thinking about many of the choices about resource allocation in an economy. The model assumes that the economy has factors of production that are fixed in both quantity and quality. When illustrated graphically, the production possibilities model typically limits our analysis to two goods. Given the economy’s factors of production and technology, the economy can produce various combinations of the two goods. If it uses its factors of production efficiently and has full employment, it will be operating on the production possibilities curve. Two characteristics of the production possibilities curve are particularly important. First, it is downward sloping. This reflects the scarcity of the factors of production available to the economy; producing more of one good requires giving up some of the other. Second, the curve is bowed out. Another way of saying this is to say that the curve gets steeper as we move from left to right; the absolute value of its slope is increasing. Producing each additional unit of the good on the horizontal axis requires a greater sacrifice of the good on the vertical axis than did the previous units produced. This fact, called the law of increasing opportunity cost, is the inevitable result of efficient choices in production—choices based on comparative advantage. The production possibilities model has important implications for international trade. It suggests that free trade will allow countries to specialize in the production of goods and services in which they have a comparative advantage. This specialization increases the production of all goods and services. Increasing the quantity or quality of factors of production and/or improving technology will shift the production possibilities curve outward. This process is called economic growth. In the last 50 years, economic growth in the United States has resulted chiefly from increases in human capital and from technological advance. Choices concerning the use of scarce resources take place within the context of a set of institutional arrangements that define an economic system. The principal distinctions between systems lie
in the degree to which ownership of capital and natural resources and decision making authority over scarce resources are held by government or by private individuals. Economic systems include market capitalist, mixed, and command 2.4 Review and Practice 84 Chapter 2 Confronting Scarcity: Choices in Production socialist economies. An increasing body of evidence suggests that market capitalist economies tend to be most productive; many command socialist and mixed economies are moving in the direction of market capitalist systems. The presumption in favor of market-based systems does not preclude a role for government. Government is necessary to provide the system of laws on which market systems are founded. It may also be used to provide certain goods and services, to help individuals in need, and to regulate the actions of individuals and firms. 2.4 Review and Practice 85 Chapter 2 Confronting Scarcity: Choices in Production. How does a college education increase one’s human capital? 2. Why does the downward-sloping production possibilities curve imply 3. that factors of production are scarce? In what ways are the bowed-out shape of the production possibilities curve and the law of increasing opportunity cost related? 4. What is the relationship between the concept of comparative advantage and the law of increasing opportunity cost? 5. Suppose an economy can produce two goods, A and B. It is now operating at point E on production possibilities curve RT. An improvement in the technology available to produce good A shifts the curve to ST, and the economy selects point E′. How does this change affect the opportunity cost of producing an additional unit of good B? 6. Could a nation’s production possibilities curve ever shift inward? Explain what such a shift would mean, and discuss events that might cause such a shift to occur. 7. Suppose blue-eyed people were banned from working. How would this affect a nation’s production possibilities curve? 8. Evaluate this statement: “The U.S. economy could achieve greater growth by devoting fewer resources to consumption and more to investment; it follows that such a shift would be desirable.” 2.4 Review and Practice 86 Chapter 2 Confronting Scarcity: Choices in Production 9. Two countries, Sportsland and Foodland, have similar total quantities of labor, capital, and natural resources. Both can produce two goods, figs and footballs. Sportsland’s resources are particularly well suited to the production of footballs but are not very productive in producing figs. Foodland’s resources are very productive
when used for figs but are not capable of producing many footballs. In which country is the cost of additional footballs generally greater? Explain. 10. Suppose a country is committed to using its resources based on the reverse of comparative advantage doctrine: it first transfers those resources for which the cost is greatest, not lowest. Describe this country’s production possibilities curve. 11. The U.S. Constitution bans states from restricting imports of goods and services from other states. Suppose this restriction did not exist and that states were allowed to limit imports of goods and services produced in other states. How do you think this would affect U.S. output? Explain. 12. By 1993, nations in the European Union (EU) had eliminated all barriers to the flow of goods, services, labor, and capital across their borders. Even such things as consumer protection laws and the types of plugs required to plug in appliances have been standardized to ensure that there will be no barriers to trade. How do you think this elimination of trade barriers affected EU output? 13. How did the technological changes described in the Case in Point “Technology Cuts Costs, Boosts Productivity and Profits” affect the production possibilities curve for the United States? 2.4 Review and Practice 87 Chapter 2 Confronting Scarcity: Choices in Production. Nathan can mow four lawns in a day or plant 20 trees in a day. 1. Draw Nathan’s production possibilities curve for mowing lawns and planting trees. Assume the production possibilities curve is linear and put the quantity of lawns mowed per day on the horizontal axis and the quantity of trees planted per day on the vertical axis. 2. What is Nathan’s opportunity cost of planting trees? 3. What is Nathan’s opportunity cost of mowing lawns? 2. David can mow four lawns in a day or plant four trees in a day. 1. Draw David’s production possibilities curve for mowing lawns and planting trees. Again, assume a linear production possibilities curve and put the quantity of lawns mowed per day on the horizontal axis. 2. What is David’s opportunity cost of planting trees? 3. What is David’s opportunity cost of mowing lawns? 3. Given the production information in problems 1 and 2 above, who has the comparative advantage in planting trees? Mowing lawns? 4. The exhibits below describe the production possibilities for Germany and Turkey. 2.
4 Review and Practice 88 Chapter 2 Confronting Scarcity: Choices in Production 1. What is the slope of Germany’s production possibilities curve? 2. What is the slope of Turkey’s production possibilities curve? 3. What is the opportunity cost of producing T-shirts in Germany? 4. What is the opportunity cost of producing T-shirts in Turkey? 5. What is the opportunity cost of producing optical instruments in Germany? 6. What is the opportunity cost of producing optical instruments in Turkey? In which good does Germany have a comparative advantage? In which good does Turkey have a comparative advantage? 7. 8. 5. The nation of Leisureland can produce two goods, bicycles and bowling balls. The western region of Leisureland can, if it devotes all its resources to bicycle production, produce 100 bicycles per month. Alternatively, it could devote all its resources to bowling balls and produce 400 per month—or it could produce any combination of bicycles and bowling balls lying on a straight line between these two extremes. 1. Draw a production possibilities curve for western Leisureland (with bicycles on the vertical axis). 2. What it is the opportunity cost of producing an additional bowling ball measured in terms of forgone bicycles in western Leisureland? 3. Suppose that eastern Leisureland can, if it devotes all its resources to the production of bicycles, produce 400. If it devotes all its resources to bowling ball production, though, it can produce only 100. Draw the production possibilities curve for eastern Leisureland (again, assume it is linear and put bicycles on the vertical axis). 4. What is the opportunity cost of producing an additional bowling ball measured in terms of forgone bicycles in eastern Leisureland? 5. Explain the difference in opportunity cost between western and eastern Leisureland. Which region has a comparative advantage in producing bowling balls? Bicycles? 6. Draw the production possibilities curve for Leisureland, one that combines the curves for western and eastern Leisureland. 2.4 Review and Practice 89 Chapter 2 Confronting Scarcity: Choices in Production 7. Suppose it is determined that 400 bicycles must be produced. How many bowling balls can be produced? 8. Where will these goods be produced? 6. The table below shows the production possibilities schedule for an economy. Production Alternatives Capital goods per period Consumer goods per period 40 36 28 16 0 2. 1. Putting capital goods per period on the horizontal axis and consumer goods per period on the vertical
axis, graph the production possibilities curve for the economy. If the economy is producing at alternative B, what is the opportunity cost to it of producing at alternative C instead? If the economy is producing at alternative C, what is the opportunity cost to it of producing at alternative D instead? Is it possible for this economy to produce 30 units of consumer goods per period while producing 1 unit of capital goods? Would this combination of goods represent efficient or inefficient production? Explain. 4. 3. 5. Which point, B or C, would lead to higher economic growth? Explain your answer. 7. The exhibit below shows the sources of growth in the United States between 1909 and 1929 and between 1950 and 1979, according to a study by Edward Denison.Edward Denison, The Sources of Economic Growth in the United States (New York: Committee for Economic Development, 1962) and Edward Denison, Trends in American Growth 1929–1982 (Washington, D.C.: Brookings Institutions, 1985). (Note: The sources of economic growth are cumulative and, taken collectively, explain 100% of total growth over the period.) 2.4 Review and Practice 90 Chapter 2 Confronting Scarcity: Choices in Production 1. Approximately what percentage of U.S. growth between 1909 and 1929 was due to increases in quantities of factors of production? 2. Approximately what percentage of U.S. growth between 1909 and 1929 was due to increases in quality of factors of production and technological improvement? 3. Approximately what percentage of U.S. growth between 1950 and 1979 was due to increases in quantities of factors of production? 4. Approximately what percentage of U.S. growth between 1950 and 1979 was due to increases in quality of factors of production and technological improvement? 2.4 Review and Practice 91 Chapter 3 Demand and Supply Start Up: Crazy for Coffee Starbucks Coffee Company has revolutionized the coffee-drinking habits of millions of people all over the world. Starbucks, whose bright green-and-white logo is almost as familiar as the golden arches of McDonald’s, began in Seattle in 1971. Fifteen years later it had grown into a chain of four stores in the Seattle area. Then in 1987 Howard Schultz, a former Starbucks employee, who had become intrigued by the culture of Italian coffee bars, bought the company from its founders for $3.8 million. In 2011, Americans were willingly paying $5 or more for a cappuccino or a latté, and Starbucks had grown to become an international chain, with approximately
17,000 stores in more than 50 countries. The change in American consumers’ taste for coffee and the profits raked in by Starbucks lured other companies to get into the game. Retailers such as Seattle’s Best Coffee and Gloria Jean’s Coffees entered the market, and today there are thousands of coffee bars, carts, drive-throughs, and kiosks in downtowns, malls, and airports all around the country. Even McDonald’s began selling specialty coffees. But over the last decade the price of coffee beans has been quite volatile, nearly doubling between 2009 and 2011, primarily due to bad harvests in central America. Cappuccinos and lattés were suddenly more expensive. Markets1, the institutions that bring together buyers and sellers, are always responding to events, such as bad harvests and changing consumer tastes that affect the prices and quantities of particular goods. The demand for some goods increases, while the demand for others decreases. The supply of some goods rises, while the supply of others falls. As such events unfold, prices adjust to keep markets in balance. This chapter explains how the market forces of demand and supply interact to determine equilibrium prices and equilibrium quantities of goods and services. We will see how prices and quantities adjust to changes in demand and supply and how changes in prices serve as signals to buyers and sellers. 1. The institutions that bring together buyers and sellers. 92 Chapter 3 Demand and Supply The model of demand and supply that we shall develop in this chapter is one of the most powerful tools in all of economic analysis. You will be using it throughout your study of economics. We will first look at the variables that influence demand. Then we will turn to supply, and finally we will put demand and supply together to explore how the model of demand and supply operates. As we examine the model, bear in mind that demand is a representation of the behavior of buyers and that supply is a representation of the behavior of sellers. Buyers may be consumers purchasing groceries or producers purchasing iron ore to make steel. Sellers may be firms selling cars or households selling their labor services. We shall see that the ideas of demand and supply apply, whatever the identity of the buyers or sellers and whatever the good or service being exchanged in the market. In this chapter, we shall focus on buyers and sellers of goods and services. 93 Chapter 3 Demand and Supply 3.1 Demand. Define the quantity demanded of a good or service and illustrate it using a demand schedule and a demand curve.
2. Distinguish between the following pairs of concepts: demand and quantity demanded, demand schedule and demand curve, movement along and shift in a demand curve. Identify demand shifters and determine whether a change in a demand shifter causes the demand curve to shift to the right or to the left. 3. How many pizzas will people eat this year? How many doctor visits will people make? How many houses will people buy? Each good or service has its own special characteristics that determine the quantity people are willing and able to consume. One is the price of the good or service itself. Other independent variables that are important determinants of demand include consumer preferences, prices of related goods and services, income, demographic characteristics such as population size, and buyer expectations. The number of pizzas people will purchase, for example, depends very much on how much they like pizza. It also depends on the prices for alternatives such as hamburgers or spaghetti. The number of doctor visits is likely to vary with income—people with higher incomes are likely to see a doctor more often than people with lower incomes. The demands for pizza, for doctor visits, and for housing are certainly affected by the age distribution of the population and its size. While different variables play different roles in influencing the demands for different goods and services, economists pay special attention to one: the price of the good or service. Given the values of all the other variables that affect demand, a higher price tends to reduce the quantity people demand, and a lower price tends to increase it. A medium pizza typically sells for $5 to $10. Suppose the price were $30. Chances are, you would buy fewer pizzas at that price than you do now. Suppose pizzas typically sold for $2 each. At that price, people would be likely to buy more pizzas than they do now. We will discuss first how price affects the quantity demanded of a good or service and then how other variables affect demand. 94 Chapter 3 Demand and Supply Price and the Demand Curve Because people will purchase different quantities of a good or service at different prices, economists must be careful when speaking of the “demand” for something. They have therefore developed some specific terms for expressing the general concept of demand. The quantity demanded2 of a good or service is the quantity buyers are willing and able to buy at a particular price during a particular period, all other things unchanged. (As we learned, we can substitute the Latin phrase “ceteris paribus” for
“all other things unchanged.”) Suppose, for example, that 100,000 movie tickets are sold each month in a particular town at a price of $8 per ticket. That quantity—100,000—is the quantity of movie admissions demanded per month at a price of $8. If the price were $12, we would expect the quantity demanded to be less. If it were $4, we would expect the quantity demanded to be greater. The quantity demanded at each price would be different if other things that might affect it, such as the population of the town, were to change. That is why we add the qualifier that other things have not changed to the definition of quantity demanded. A demand schedule3 is a table that shows the quantities of a good or service demanded at different prices during a particular period, all other things unchanged. To introduce the concept of a demand schedule, let us consider the demand for coffee in the United States. We will ignore differences among types of coffee beans and roasts, and speak simply of coffee. The table in Figure 3.1 "A Demand Schedule and a Demand Curve" shows quantities of coffee that will be demanded each month at prices ranging from $9 to $4 per pound; the table is a demand schedule. We see that the higher the price, the lower the quantity demanded. 2. The quantity buyers are willing and able to buy of a good or service at a particular price during a particular period, all other things unchanged. 3. A table that shows the quantities of a good or service demanded at different prices during a particular period, all other things unchanged. 3.1 Demand 95 Chapter 3 Demand and Supply Figure 3.1 A Demand Schedule and a Demand Curve The table is a demand schedule; it shows quantities of coffee demanded per month in the United States at particular prices, all other things unchanged. These data are then plotted on the demand curve. At point A on the curve, 25 million pounds of coffee per month are demanded at a price of $6 per pound. At point B, 30 million pounds of coffee per month are demanded at a price of $5 per pound. The information given in a demand schedule can be presented with a demand curve4, which is a graphical representation of a demand schedule. A demand curve thus shows the relationship between the price and quantity demanded of a good or service during a particular period, all other things unchanged. The demand curve in Figure 3.1 "A Demand Schedule and a Demand Curve" shows the prices and quantities
of coffee demanded that are given in the demand schedule. At point A, for example, we see that 25 million pounds of coffee per month are demanded at a price of $6 per pound. By convention, economists graph price on the vertical axis and quantity on the horizontal axis. 4. A graphical representation of a demand schedule. Price alone does not determine the quantity of coffee or any other good that people buy. To isolate the effect of changes in price on the quantity of a good or service demanded, however, we show the quantity demanded at each price, assuming that those other variables remain unchanged. We do the same thing in drawing a graph 3.1 Demand 96 Chapter 3 Demand and Supply of the relationship between any two variables; we assume that the values of other variables that may affect the variables shown in the graph (such as income or population) remain unchanged for the period under consideration. A change in price, with no change in any of the other variables that affect demand, results in a movement along the demand curve. For example, if the price of coffee falls from $6 to $5 per pound, consumption rises from 25 million pounds to 30 million pounds per month. That is a movement from point A to point B along the demand curve in Figure 3.1 "A Demand Schedule and a Demand Curve". A movement along a demand curve that results from a change in price is called a change in quantity demanded5. Note that a change in quantity demanded is not a change or shift in the demand curve; it is a movement along the demand curve. The negative slope of the demand curve in Figure 3.1 "A Demand Schedule and a Demand Curve" suggests a key behavioral relationship in economics. All other things unchanged, the law of demand6 holds that, for virtually all goods and services, a higher price leads to a reduction in quantity demanded and a lower price leads to an increase in quantity demanded. The law of demand is called a law because the results of countless studies are consistent with it. Undoubtedly, you have observed one manifestation of the law. When a store finds itself with an overstock of some item, such as running shoes or tomatoes, and needs to sell these items quickly, what does it do? It typically has a sale, expecting that a lower price will increase the quantity demanded. In general, we expect the law of demand to hold. Given the values of other variables that influence demand, a higher price reduces the quantity demanded. A lower price increases the quantity demanded. Demand curves, in short, slope
downward. Changes in Demand Of course, price alone does not determine the quantity of a good or service that people consume. Coffee consumption, for example, will be affected by such variables as income and population. Preferences also play a role. The story at the beginning of the chapter illustrates how Starbucks “turned people on” to coffee. We also expect other prices to affect coffee consumption. People often eat doughnuts or bagels with their coffee, so a reduction in the price of doughnuts or bagels might induce people to drink more coffee. An alternative to coffee is tea, so a reduction in the price of tea might result in the consumption of more tea and less coffee. Thus, a change in any one of the variables held constant in constructing a demand schedule will change the quantities demanded at each price. The result will be a shift in the entire demand curve rather than a movement along the demand curve. A shift in a demand curve is called a change in demand7. 5. A movement along a demand curve that results from a change in price. 6. For virtually all goods and services, a higher price leads to a reduction in quantity demanded and a lower price leads to an increase in quantity demanded. 7. A shift in a demand curve. 3.1 Demand 97 Chapter 3 Demand and Supply Suppose, for example, that something happens to increase the quantity of coffee demanded at each price. Several events could produce such a change: an increase in incomes, an increase in population, or an increase in the price of tea would each be likely to increase the quantity of coffee demanded at each price. Any such change produces a new demand schedule. Figure 3.2 "An Increase in Demand" shows such a change in the demand schedule for coffee. We see that the quantity of coffee demanded per month is greater at each price than before. We show that graphically as a shift in the demand curve. The original curve, labeled D1, shifts to the right to D2. At a price of $6 per pound, for example, the quantity demanded rises from 25 million pounds per month (point A) to 35 million pounds per month (point A′). Figure 3.2 An Increase in Demand An increase in the quantity of a good or service demanded at each price is shown as an increase in demand. Here, the original demand curve D1 shifts to D2. Point A on D1 corresponds to a price of $6 per pound and a quantity demanded of 25 million pounds of coffee per month. On the new demand
curve D2, the quantity demanded at this price rises to 35 million pounds of coffee per month (point A′). Just as demand can increase, it can decrease. In the case of coffee, demand might fall as a result of events such as a reduction in population, a reduction in the price of tea, or a change in preferences. For example, a definitive finding that the caffeine in coffee contributes to heart disease, which is currently being debated in the scientific community, could change preferences and reduce the demand for coffee. A reduction in the demand for coffee is illustrated in Figure 3.3 "A Reduction in Demand". The demand schedule shows that less coffee is demanded at each price than in Figure 3.1 "A Demand Schedule and a Demand Curve". The result is a shift in 3.1 Demand 98 Chapter 3 Demand and Supply demand from the original curve D1 to D3. The quantity of coffee demanded at a price of $6 per pound falls from 25 million pounds per month (point A) to 15 million pounds per month (point A″). Note, again, that a change in quantity demanded, ceteris paribus, refers to a movement along the demand curve, while a change in demand refers to a shift in the demand curve. Figure 3.3 A Reduction in Demand A reduction in demand occurs when the quantities of a good or service demanded fall at each price. Here, the demand schedule shows a lower quantity of coffee demanded at each price than we had in Figure 3.1 "A Demand Schedule and a Demand Curve". The reduction shifts the demand curve for coffee to D3 from D1. The quantity demanded at a price of $6 per pound, for example, falls from 25 million pounds per month (point A) to 15 million pounds of coffee per month (point A″). A variable that can change the quantity of a good or service demanded at each price is called a demand shifter8. When these other variables change, the all-otherthings-unchanged conditions behind the original demand curve no longer hold. Although different goods and services will have different demand shifters, the demand shifters are likely to include (1) consumer preferences, (2) the prices of related goods and services, (3) income, (4) demographic characteristics, and (5) buyer expectations. Next we look at each of these. Preferences 8. A variable that can change the quantity of a good or service demanded at each price. Changes in preferences of buyers can have important consequences for demand.
We have already seen how Starbucks supposedly increased the demand for coffee. Another example is reduced demand for cigarettes caused by concern about the effect of smoking on health. A change in preferences that makes one good or service 3.1 Demand 99 Chapter 3 Demand and Supply more popular will shift the demand curve to the right. A change that makes it less popular will shift the demand curve to the left. Prices of Related Goods and Services Suppose the price of doughnuts were to fall. Many people who drink coffee enjoy dunking doughnuts in their coffee; the lower price of doughnuts might therefore increase the demand for coffee, shifting the demand curve for coffee to the right. A lower price for tea, however, would be likely to reduce coffee demand, shifting the demand curve for coffee to the left. In general, if a reduction in the price of one good increases the demand for another, the two goods are called complements9. If a reduction in the price of one good reduces the demand for another, the two goods are called substitutes10. These definitions hold in reverse as well: two goods are complements if an increase in the price of one reduces the demand for the other, and they are substitutes if an increase in the price of one increases the demand for the other. Doughnuts and coffee are complements; tea and coffee are substitutes. Complementary goods are goods used in conjunction with one another. Tennis rackets and tennis balls, eggs and bacon, and stationery and postage stamps are complementary goods. Substitute goods are goods used instead of one another. iPODs, for example, are likely to be substitutes for CD players. Breakfast cereal is a substitute for eggs. A file attachment to an e-mail is a substitute for both a fax machine and postage stamps. 9. Two goods for which an increase in price of one reduces the demand for the other. 10. Two goods for which an increase in price of one increases the demand for the other. 3.1 Demand 100 Chapter 3 Demand and Supply Income As incomes rise, people increase their consumption of many goods and services, and as incomes fall, their consumption of these goods and services falls. For example, an increase in income is likely to raise the demand for gasoline, ski trips, new cars, and jewelry. There are, however, goods and services for which consumption falls as income rises—and rises as income falls. As incomes rise, for example, people tend to consume more fresh fruit but less canned fruit. A good for which demand increases when income increases is
called a normal good11. A good for which demand decreases when income increases is called an inferior good12. An increase in income shifts the demand curve for fresh fruit (a normal good) to the right; it shifts the demand curve for canned fruit (an inferior good) to the left. Demographic Characteristics The number of buyers affects the total quantity of a good or service that will be bought; in general, the greater the population, the greater the demand. Other demographic characteristics can affect demand as well. As the share of the population over age 65 increases, the demand for medical services, ocean cruises, and motor homes increases. The birth rate in the United States fell sharply between 1955 and 1975 but has gradually increased since then. That increase has raised the demand for such things as infant supplies, elementary school teachers, soccer coaches, in-line skates, and college education. Demand can thus shift as a result of changes in both the number and characteristics of buyers. Buyer Expectations The consumption of goods that can be easily stored, or whose consumption can be postponed, is strongly affected by buyer expectations. The expectation of newer TV technologies, such as high-definition TV, could slow down sales of regular TVs. If people expect gasoline prices to rise tomorrow, they will fill up their tanks today to try to beat the price increase. The same will be true for goods such as automobiles and washing machines: an expectation of higher prices in the future will lead to more purchases today. If the price of a good is expected to fall, however, people are likely to reduce their purchases today and await tomorrow’s lower prices. The expectation that computer prices will fall, for example, can reduce current demand. 11. A good for which demand increases when income increases. 12. A good for which demand decreases when income increases. 3.1 Demand 101 Chapter 3 Demand and Supply Heads Up! It is crucial to distinguish between a change in quantity demanded, which is a movement along the demand curve caused by a change in price, and a change in demand, which implies a shift of the demand curve itself. A change in demand is caused by a change in a demand shifter. An increase in demand is a shift of the demand curve to the right. A decrease in demand is a shift in the demand curve to the left. This drawing of a demand curve highlights the difference. 3.1 Demand 102 Chapter 3 Demand and Supply • The quantity demanded of a good or service is the quantity buyers are willing and able to buy at
a particular price during a particular period, all other things unchanged. • A demand schedule is a table that shows the quantities of a good or service demanded at different prices during a particular period, all other things unchanged. • A demand curve shows graphically the quantities of a good or service demanded at different prices during a particular period, all other things unchanged. • All other things unchanged, the law of demand holds that, for virtually all goods and services, a higher price induces a reduction in quantity demanded and a lower price induces an increase in quantity demanded. • A change in the price of a good or service causes a change in the quantity demanded—a movement along the demand curve. • A change in a demand shifter causes a change in demand, which is shown as a shift of the demand curve. Demand shifters include preferences, the prices of related goods and services, income, demographic characteristics, and buyer expectations. • Two goods are substitutes if an increase in the price of one causes an increase in the demand for the other. Two goods are complements if an increase in the price of one causes a decrease in the demand for the other. • A good is a normal good if an increase in income causes an increase in demand. A good is an inferior good if an increase in income causes a decrease in demand. 3.1 Demand 103 Chapter 3 Demand and Supply T R Y I T! All other things unchanged, what happens to the demand curve for DVD rentals if there is (a) an increase in the price of movie theater tickets, (b) a decrease in family income, or (c) an increase in the price of DVD rentals? In answering this and other “Try It!” problems in this chapter, draw and carefully label a set of axes. On the horizontal axis of your graph, show the quantity of DVD rentals. It is necessary to specify the time period to which your quantity pertains (e.g., “per period,” “per week,” or “per year”). On the vertical axis show the price per DVD rental. Since you do not have specific data on prices and quantities demanded, make a “free-hand” drawing of the curve or curves you are asked to examine. Focus on the general shape and position of the curve(s) before and after events occur. Draw new curve(s) to show what happens in each of the circumstances given. The curves could shift to the left or to the right, or stay
where they are. 3.1 Demand 104 Chapter 3 Demand and Supply Case in Point: Solving Campus Parking Problems Without Adding More Parking Spaces © 2010 Jupiterimages Corporation Unless you attend a “virtual” campus, chances are you have engaged in more than one conversation about how hard it is to find a place to park on campus. Indeed, according to Clark Kerr, a former president of the University of California system, a university is best understood as a group of people “held together by a common grievance over parking.” Clearly, the demand for campus parking spaces has grown substantially over the past few decades. In surveys conducted by Daniel Kenney, Ricardo Dumont, and Ginger Kenney, who work for the campus design company Sasaki and Associates, it was found that 7 out of 10 students own their own cars. They have interviewed “many students who confessed to driving from their dormitories to classes that were a five-minute walk away,” and they argue that the deterioration of college environments is largely attributable to the increased use of cars on campus and that colleges could better service their missions by not adding more parking spaces. Since few universities charge enough for parking to even cover the cost of building and maintaining parking lots, the rest is paid for by all students as part 3.1 Demand 105 Chapter 3 Demand and Supply of tuition. Their research shows that “for every 1,000 parking spaces, the median institution loses almost $400,000 a year for surface parking, and more than $1,200,000 for structural parking.” Fear of a backlash from students and their parents, as well as from faculty and staff, seems to explain why campus administrators do not simply raise the price of parking on campus. While Kenney and his colleagues do advocate raising parking fees, if not all at once then over time, they also suggest some subtler, and perhaps politically more palatable, measures—in particular, shifting the demand for parking spaces to the left by lowering the prices of substitutes. Two examples they noted were at the University of Washington and the University of Colorado at Boulder. At the University of Washington, car poolers may park for free. This innovation has reduced purchases of single-occupancy parking permits by 32% over a decade. According to University of Washington assistant director of transportation services Peter Dewey, “Without vigorously managing our parking and providing commuter alternatives, the university would have been faced with adding approximately 3,600 parking spaces, at a cost of over $100 million
…The university has created opportunities to make capital investments in buildings supporting education instead of structures for cars.” At the University of Colorado, free public transit has increased use of buses and light rail from 300,000 to 2 million trips per year over the last decade. The increased use of mass transit has allowed the university to avoid constructing nearly 2,000 parking spaces, which has saved about $3.6 million annually. Sources: Daniel R. Kenney, “How to Solve Campus Parking Problems Without Adding More Parking,” The Chronicle of Higher Education, March 26, 2004, Section B, pp. B22-B23. 3.1 Demand 106 Chapter 3 Demand and Supply Since going to the movies is a substitute for watching a DVD at home, an increase in the price of going to the movies should cause more people to switch from going to the movies to staying at home and renting DVDs. Thus, the demand curve for DVD rentals will shift to the right when the price of movie theater tickets increases [Panel (a)]. A decrease in family income will cause the demand curve to shift to the left if DVD rentals are a normal good but to the right if DVD rentals are an inferior good. The latter may be the case for some families, since staying at home and watching DVDs is a cheaper form of entertainment than taking the family to the movies. For most others, however, DVD rentals are probably a normal good [Panel (b)]. An increase in the price of DVD rentals does not shift the demand curve for DVD rentals at all; rather, an increase in price, say from P1 to P2, is a movement upward to the left along the demand curve. At a higher price, people will rent fewer DVDs, say Q2 instead of Q1, ceteris paribus [Panel (c)]. 3.1 Demand 107 Chapter 3 Demand and Supply 3.2 Supply 13. The quantity sellers are willing to sell of a good or service at a particular price during a particular period, all other things unchanged. Define the quantity supplied of a good or service and illustrate it using a supply schedule and a supply curve. 2. Distinguish between the following pairs of concepts: supply and quantity supplied, supply schedule and supply curve, movement along and shift in a supply curve. Identify supply shifters and determine whether a change in a supply shifter causes the supply curve to shift to the right or to the left. 3. What determines the quantity of a good or service sellers are willing to offer
for sale? Price is one factor; ceteris paribus, a higher price is likely to induce sellers to offer a greater quantity of a good or service. Production cost is another determinant of supply. Variables that affect production cost include the prices of factors used to produce the good or service, returns from alternative activities, technology, the expectations of sellers, and natural events such as weather changes. Still another factor affecting the quantity of a good that will be offered for sale is the number of sellers—the greater the number of sellers of a particular good or service, the greater will be the quantity offered at any price per time period. Price and the Supply Curve The quantity supplied13 of a good or service is the quantity sellers are willing to sell at a particular price during a particular period, all other things unchanged. Ceteris paribus, the receipt of a higher price increases profits and induces sellers to increase the quantity they supply. In general, when there are many sellers of a good, an increase in price results in an increase in quantity supplied, and this relationship is often referred to as the law of supply. We will see, though, through our exploration of microeconomics, that there are a number of exceptions to this relationship. There are cases in which a higher price will not induce an increase in quantity supplied. Goods that cannot be produced, such as additional land on the corner of Park Avenue and 56th Street in Manhattan, are fixed in supply—a higher price cannot induce an increase in the quantity supplied. There are even cases, which we investigate in microeconomic analysis, in which a higher price induces a reduction in the quantity supplied. 108 Chapter 3 Demand and Supply Generally speaking, however, when there are many sellers of a good, an increase in price results in a greater quantity supplied. The relationship between price and quantity supplied is suggested in a supply schedule14, a table that shows quantities supplied at different prices during a particular period, all other things unchanged. Figure 3.4 "A Supply Schedule and a Supply Curve" gives a supply schedule for the quantities of coffee that will be supplied per month at various prices, ceteris paribus. At a price of $4 per pound, for example, producers are willing to supply 15 million pounds of coffee per month. A higher price, say $6 per pound, induces sellers to supply a greater quantity—25 million pounds of coffee per month. Figure 3.4 A Supply Schedule and a Supply Curve The supply schedule shows the quantity of coffee that will be supplied
in the United States each month at particular prices, all other things unchanged. The same information is given graphically in the supply curve. The values given here suggest a positive relationship between price and quantity supplied. 14. A table that shows quantities supplied at different prices during a particular period, all other things unchanged. 15. A graphical representation of a supply schedule. A supply curve15 is a graphical representation of a supply schedule. It shows the relationship between price and quantity supplied during a particular period, all other things unchanged. Because the relationship between price and quantity supplied is generally positive, supply curves are generally upward sloping. The 3.2 Supply 109 Chapter 3 Demand and Supply supply curve for coffee in Figure 3.4 "A Supply Schedule and a Supply Curve" shows graphically the values given in the supply schedule. A change in price causes a movement along the supply curve; such a movement is called a change in quantity supplied16. As is the case with a change in quantity demanded, a change in quantity supplied does not shift the supply curve. By definition, it is a movement along the supply curve. For example, if the price rises from $6 per pound to $7 per pound, the quantity supplied rises from 25 million pounds per month to 30 million pounds per month. That’s a movement from point A to point B along the supply curve in Figure 3.4 "A Supply Schedule and a Supply Curve". Changes in Supply When we draw a supply curve, we assume that other variables that affect the willingness of sellers to supply a good or service are unchanged. It follows that a change in any of those variables will cause a change in supply17, which is a shift in the supply curve. A change that increases the quantity of a good or service supplied at each price shifts the supply curve to the right. Suppose, for example, that the price of fertilizer falls. That will reduce the cost of producing coffee and thus increase the quantity of coffee producers will offer for sale at each price. The supply schedule in Figure 3.5 "An Increase in Supply" shows an increase in the quantity of coffee supplied at each price. We show that increase graphically as a shift in the supply curve from S1 to S2. We see that the quantity supplied at each price increases by 10 million pounds of coffee per month. At point A on the original supply curve S1, for example, 25 million pounds of coffee per month are supplied at a price of $6 per pound. After the increase in supply, 35 million pounds
per month are supplied at the same price (point A′ on curve S2). 16. Movement along the supply curve caused by a change in price. 17. A shift in the supply curve. 3.2 Supply 110 Chapter 3 Demand and Supply Figure 3.5 An Increase in Supply If there is a change in supply that increases the quantity supplied at each price, as is the case in the supply schedule here, the supply curve shifts to the right. At a price of $6 per pound, for example, the quantity supplied rises from the previous level of 25 million pounds per month on supply curve S1 (point A) to 35 million pounds per month on supply curve S2 (point A′). An event that reduces the quantity supplied at each price shifts the supply curve to the left. An increase in production costs and excessive rain that reduces the yields from coffee plants are examples of events that might reduce supply. Figure 3.6 "A Reduction in Supply" shows a reduction in the supply of coffee. We see in the supply schedule that the quantity of coffee supplied falls by 10 million pounds of coffee per month at each price. The supply curve thus shifts from S1 to S3. Figure 3.6 A Reduction in Supply 3.2 Supply 111 Chapter 3 Demand and Supply A change in supply that reduces the quantity supplied at each price shifts the supply curve to the left. At a price of $6 per pound, for example, the original quantity supplied was 25 million pounds of coffee per month (point A). With a new supply curve S3, the quantity supplied at that price falls to 15 million pounds of coffee per month (point A″). A variable that can change the quantity of a good or service supplied at each price is called a supply shifter18. Supply shifters include (1) prices of factors of production, (2) returns from alternative activities, (3) technology, (4) seller expectations, (5) natural events, and (6) the number of sellers. When these other variables change, the all-other-things-unchanged conditions behind the original supply curve no longer hold. Let us look at each of the supply shifters. Prices of Factors of Production A change in the price of labor or some other factor of production will change the cost of producing any given quantity of the good or service. This change in the cost of production will change the quantity that suppliers are willing to offer at any price. An increase in factor prices should decrease the quantity suppliers will offer at any
price, shifting the supply curve to the left. A reduction in factor prices increases the quantity suppliers will offer at any price, shifting the supply curve to the right. Suppose coffee growers must pay a higher wage to the workers they hire to harvest coffee or must pay more for fertilizer. Such increases in production cost will cause them to produce a smaller quantity at each price, shifting the supply curve for coffee to the left. A reduction in any of these costs increases supply, shifting the supply curve to the right. Returns from Alternative Activities To produce one good or service means forgoing the production of another. The concept of opportunity cost in economics suggests that the value of the activity forgone is the opportunity cost of the activity chosen; this cost should affect supply. For example, one opportunity cost of producing eggs is not selling chickens. An increase in the price people are willing to pay for fresh chicken would make it more profitable to sell chickens and would thus increase the opportunity cost of producing eggs. It would shift the supply curve for eggs to the left, reflecting a decrease in supply. 18. A variable that can change the quantity of a good or service supplied at each price. 3.2 Supply 112 Chapter 3 Demand and Supply Technology A change in technology alters the combinations of inputs or the types of inputs required in the production process. An improvement in technology usually means that fewer and/or less costly inputs are needed. If the cost of production is lower, the profits available at a given price will increase, and producers will produce more. With more produced at every price, the supply curve will shift to the right, meaning an increase in supply. Impressive technological changes have occurred in the computer industry in recent years. Computers are much smaller and are far more powerful than they were only a few years ago—and they are much cheaper to produce. The result has been a huge increase in the supply of computers, shifting the supply curve to the right. While we usually think of technology as enhancing production, declines in production due to problems in technology are also possible. Outlawing the use of certain equipment without pollution-control devices has increased the cost of production for many goods and services, thereby reducing profits available at any price and shifting these supply curves to the left. Seller Expectations All supply curves are based in part on seller expectations about future market conditions. Many decisions about production and selling are typically made long before a product is ready for sale. Those decisions necessarily depend on expectations. Changes in seller expectations can have important effects on price and quantity. Consider, for
example, the owners of oil deposits. Oil pumped out of the ground and used today will be unavailable in the future. If a change in the international political climate leads many owners to expect that oil prices will rise in the future, they may decide to leave their oil in the ground, planning to sell it later when the price is higher. Thus, there will be a decrease in supply; the supply curve for oil will shift to the left. Natural Events Storms, insect infestations, and drought affect agricultural production and thus the supply of agricultural goods. If something destroys a substantial part of an agricultural crop, the supply curve will shift to the left. The terrible cyclone that killed more than 50,000 people in Myanmar in 2008 also destroyed some of the 3.2 Supply 113 Chapter 3 Demand and Supply country’s prime rice growing land. That shifted the supply curve for rice to the left. If there is an unusually good harvest, the supply curve will shift to the right. The Number of Sellers The supply curve for an industry, such as coffee, includes all the sellers in the industry. A change in the number of sellers in an industry changes the quantity available at each price and thus changes supply. An increase in the number of sellers supplying a good or service shifts the supply curve to the right; a reduction in the number of sellers shifts the supply curve to the left. The market for cellular phone service has been affected by an increase in the number of firms offering the service. Over the past decade, new cellular phone companies emerged, shifting the supply curve for cellular phone service to the right. 3.2 Supply 114 Chapter 3 Demand and Supply Heads Up! There are two special things to note about supply curves. The first is similar to the Heads Up! on demand curves: it is important to distinguish carefully between changes in supply and changes in quantity supplied. A change in supply results from a change in a supply shifter and implies a shift of the supply curve to the right or left. A change in price produces a change in quantity supplied and induces a movement along the supply curve. A change in price does not shift the supply curve. The second caution relates to the interpretation of increases and decreases in supply. Notice that in Figure 3.5 "An Increase in Supply" an increase in supply is shown as a shift of the supply curve to the right; the curve shifts in the direction of increasing quantity with respect to the horizontal axis. In Figure 3.6 "A Reduction in Supply" a reduction in supply is
shown as a shift of the supply curve to the left; the curve shifts in the direction of decreasing quantity with respect to the horizontal axis. Because the supply curve is upward sloping, a shift to the right produces a new curve that in a sense lies “below” the original curve. It is easy to make the mistake of thinking of such a shift as a shift “down” and therefore as a reduction in supply. Similarly, it is easy to make the mistake of showing an increase in supply with a new curve that lies “above” the original curve. But that is a reduction in supply! To avoid such errors, focus on the fact that an increase in supply is an increase in the quantity supplied at each price and shifts the supply curve in the direction of increased quantity on the horizontal axis. Similarly, a reduction in supply is a reduction in the quantity supplied at each price and shifts the supply curve in the direction of a lower quantity on the horizontal axis. 3.2 Supply 115 Chapter 3 Demand and Supply • The quantity supplied of a good or service is the quantity sellers are willing to sell at a particular price during a particular period, all other things unchanged. • A supply schedule shows the quantities supplied at different prices during a particular period, all other things unchanged. A supply curve shows this same information graphically. • A change in the price of a good or service causes a change in the quantity supplied—a movement along the supply curve. • A change in a supply shifter causes a change in supply, which is shown as a shift of the supply curve. Supply shifters include prices of factors of production, returns from alternative activities, technology, seller expectations, natural events, and the number of sellers. • An increase in supply is shown as a shift to the right of a supply curve; a decrease in supply is shown as a shift to the left. T R Y I T! If all other things are unchanged, what happens to the supply curve for DVD rentals if there is (a) an increase in wages paid to DVD rental store clerks, (b) an increase in the price of DVD rentals, or (c) an increase in the number of DVD rental stores? Draw a graph that shows what happens to the supply curve in each circumstance. The supply curve can shift to the left or to the right, or stay where it is. Remember to label the axes and curves, and remember to specify the time period (e.g., “DVDs rented per week”
). 3.2 Supply 116 Chapter 3 Demand and Supply Case in Point: The Monks of St. Benedict’s Get Out of the Egg Business © 2010 Jupiterimages Corporation It was cookies that lured the monks of St. Benedict’s out of the egg business, and now private retreat sponsorship is luring them away from cookies. St. Benedict’s is a Benedictine monastery, nestled on a ranch high in the Colorado Rockies, about 20 miles down the road from Aspen. The monastery’s 20 monks operate the ranch to support themselves and to provide help for poor people in the area. They lease out about 3,500 acres of their land to cattle and sheep grazers, produce cookies, and sponsor private retreats. They used to produce eggs. Attracted by potential profits and the peaceful nature of the work, the monks went into the egg business in 1967. They had 10,000 chickens producing their Monastery Eggs brand. For a while, business was good. Very good. Then, in the late 1970s, the price of chicken feed started to rise rapidly. 3.2 Supply 117 Chapter 3 Demand and Supply “When we started in the business, we were paying $60 to $80 a ton for feed—delivered,” recalls the monastery’s abbot, Father Joseph Boyle. “By the late 1970s, our cost had more than doubled. We were paying $160 to $200 a ton. That really hurt, because feed represents a large part of the cost of producing eggs.” The monks adjusted to the blow. “When grain prices were lower, we’d pull a hen off for a few weeks to molt, then return her to laying. After grain prices went up, it was 12 months of laying and into the soup pot,” Fr. Joseph says. Grain prices continued to rise in the 1980s and increased the costs of production for all egg producers. It caused the supply of eggs to fall. Demand fell at the same time, as Americans worried about the cholesterol in eggs. Times got tougher in the egg business. “We were still making money in the financial sense,” Fr. Joseph says. “But we tried an experiment in 1985 producing cookies, and it was a success. We finally decided that devoting our time and energy to the cookies would pay off better than the egg business, so we quit the egg business in 1986.” The mail-order cookie
business was good to the monks. They sold 200,000 ounces of Monastery Cookies in 1987. By 1998, however, they had limited their production of cookies, selling only locally and to gift shops. Since 2000, they have switched to “providing private retreats for individuals and groups—about 40 people per month,” according to Fr. Micah Schonberger. The monks’ calculation of their opportunity costs revealed that they would earn a higher return through sponsorship of private retreats than in either cookies or eggs. This projection has proved correct. And there is another advantage as well. “The chickens didn’t stop laying eggs on Sunday,” Fr. Joseph chuckles. “When we shifted to cookies we could take Sundays off. We weren’t hemmed in the way we were with the chickens.” The move to providing retreats is even better 3.2 Supply 118 Chapter 3 Demand and Supply in this regard. Since guests provide their own meals, most of the monastery’s effort goes into planning and scheduling, which frees up even more of their time for other worldly as well as spiritual pursuits. Source: Personal interviews and the monastery’s website at http://www.snowmass.org DVD rental store clerks are a factor of production in the DVD rental market. An increase in their wages raises the cost of production, thereby causing the supply curve of DVD rentals to shift to the left [Panel (a)]. (Caution: It is possible that you thought of the wage increase as an increase in income, a demand shifter, that would lead to an increase in demand, but this would be incorrect. The question refers only to wages of DVD rental store clerks. They may rent some DVD, but their impact on total demand would be negligible. Besides, we have no information on what has happened overall to incomes of people who rent DVDs. We do know, however, that the cost of a factor of production, which is a supply shifter, increased.) An increase in the price of DVD rentals does not shift the supply curve at all; rather, it corresponds to a movement upward to the right along the supply curve. At a higher price of P2 instead of P1, a greater quantity of DVD rentals, say Q2 instead of Q1, will be supplied [Panel (b)]. An increase in the number of stores renting DVDs will cause the supply curve to shift to the right [Panel (c)]. 3.2 Supply 119 Chapter
3 Demand and Supply 3.3 Demand, Supply, and Equilibrium. Use demand and supply to explain how equilibrium price and quantity are determined in a market. 2. Understand the concepts of surpluses and shortages and the pressures on price they generate. 3. Explain the impact of a change in demand or supply on equilibrium price and quantity. 4. Explain how the circular flow model provides an overview of demand and supply in product and factor markets and how the model suggests ways in which these markets are linked. In this section we combine the demand and supply curves we have just studied into a new model. The model of demand and supply19 uses demand and supply curves to explain the determination of price and quantity in a market. The Determination of Price and Quantity The logic of the model of demand and supply is simple. The demand curve shows the quantities of a particular good or service that buyers will be willing and able to purchase at each price during a specified period. The supply curve shows the quantities that sellers will offer for sale at each price during that same period. By putting the two curves together, we should be able to find a price at which the quantity buyers are willing and able to purchase equals the quantity sellers will offer for sale. Figure 3.7 "The Determination of Equilibrium Price and Quantity" combines the demand and supply data introduced in Figure 3.1 "A Demand Schedule and a Demand Curve" and Figure 3.4 "A Supply Schedule and a Supply Curve". Notice that the two curves intersect at a price of $6 per pound—at this price the quantities demanded and supplied are equal. Buyers want to purchase, and sellers are willing to offer for sale, 25 million pounds of coffee per month. The market for coffee is in equilibrium. Unless the demand or supply curve shifts, there will be no tendency for price to change. The equilibrium price20 in any market is the price at which quantity demanded equals quantity supplied. The equilibrium price in the market for coffee is thus $6 per pound. The equilibrium quantity21 is the quantity demanded and supplied at the equilibrium price. At a price above the equilibrium, 120 19. Model that uses demand and supply curves to explain the determination of price and quantity in a market. 20. The price at which quantity demanded equals quantity supplied. 21. The quantity demanded and supplied at the equilibrium price. Chapter 3 Demand and Supply there is a natural tendency for the price to fall. At a price below the equilibrium, there is a tendency for the price to rise. Figure 3.7
The Determination of Equilibrium Price and Quantity When we combine the demand and supply curves for a good in a single graph, the point at which they intersect identifies the equilibrium price and equilibrium quantity. Here, the equilibrium price is $6 per pound. Consumers demand, and suppliers supply, 25 million pounds of coffee per month at this price. With an upward-sloping supply curve and a downward-sloping demand curve, there is only a single price at which the two curves intersect. This means there is only one price at which equilibrium is achieved. It follows that at any price other than the equilibrium price, the market will not be in equilibrium. We next examine what happens at prices other than the equilibrium price. Surpluses Figure 3.8 "A Surplus in the Market for Coffee" shows the same demand and supply curves we have just examined, but this time the initial price is $8 per pound of coffee. Because we no longer have a balance between quantity demanded and 3.3 Demand, Supply, and Equilibrium 121 Chapter 3 Demand and Supply quantity supplied, this price is not the equilibrium price. At a price of $8, we read over to the demand curve to determine the quantity of coffee consumers will be willing to buy—15 million pounds per month. The supply curve tells us what sellers will offer for sale—35 million pounds per month. The difference, 20 million pounds of coffee per month, is called a surplus. More generally, a surplus22 is the amount by which the quantity supplied exceeds the quantity demanded at the current price. There is, of course, no surplus at the equilibrium price; a surplus occurs only if the current price exceeds the equilibrium price. Figure 3.8 A Surplus in the Market for Coffee At a price of $8, the quantity supplied is 35 million pounds of coffee per month and the quantity demanded is 15 million pounds per month; there is a surplus of 20 million pounds of coffee per month. Given a surplus, the price will fall quickly toward the equilibrium level of $6. 22. The amount by which the quantity supplied exceeds the quantity demanded at the current price. A surplus in the market for coffee will not last long. With unsold coffee on the market, sellers will begin to reduce their prices to clear out unsold coffee. As the price of coffee begins to fall, the quantity of coffee supplied begins to decline. At the same time, the quantity of coffee demanded begins to rise. Remember that the reduction in quantity supplied is a movement along the supply curve—
the curve itself does not shift in response to a reduction in price. Similarly, the increase in 3.3 Demand, Supply, and Equilibrium 122 Chapter 3 Demand and Supply quantity demanded is a movement along the demand curve—the demand curve does not shift in response to a reduction in price. Price will continue to fall until it reaches its equilibrium level, at which the demand and supply curves intersect. At that point, there will be no tendency for price to fall further. In general, surpluses in the marketplace are short-lived. The prices of most goods and services adjust quickly, eliminating the surplus. Later on, we will discuss some markets in which adjustment of price to equilibrium may occur only very slowly or not at all. Shortages Just as a price above the equilibrium price will cause a surplus, a price below equilibrium will cause a shortage. A shortage23 is the amount by which the quantity demanded exceeds the quantity supplied at the current price. Figure 3.9 "A Shortage in the Market for Coffee" shows a shortage in the market for coffee. Suppose the price is $4 per pound. At that price, 15 million pounds of coffee would be supplied per month, and 35 million pounds would be demanded per month. When more coffee is demanded than supplied, there is a shortage. Figure 3.9 A Shortage in the Market for Coffee 23. The amount by which the quantity demanded exceeds the quantity supplied at the current price. 3.3 Demand, Supply, and Equilibrium 123 Chapter 3 Demand and Supply At a price of $4 per pound, the quantity of coffee demanded is 35 million pounds per month and the quantity supplied is 15 million pounds per month. The result is a shortage of 20 million pounds of coffee per month. In the face of a shortage, sellers are likely to begin to raise their prices. As the price rises, there will be an increase in the quantity supplied (but not a change in supply) and a reduction in the quantity demanded (but not a change in demand) until the equilibrium price is achieved. Shifts in Demand and Supply Figure 3.10 Changes in Demand and Supply A change in demand or in supply changes the equilibrium solution in the model. Panels (a) and (b) show an increase and a decrease in demand, respectively; Panels (c) and (d) show an increase and a decrease in supply, respectively. A change in one of the variables (shifters) held constant in any model of demand and supply will create a change in
demand or supply. A shift in a demand or supply curve changes the equilibrium price and equilibrium quantity for a good or service. Figure 3.10 "Changes in Demand and Supply" combines the information about 3.3 Demand, Supply, and Equilibrium 124 Chapter 3 Demand and Supply changes in the demand and supply of coffee presented in Figure 3.2 "An Increase in Demand", Figure 3.3 "A Reduction in Demand", Figure 3.5 "An Increase in Supply", and Figure 3.6 "A Reduction in Supply" In each case, the original equilibrium price is $6 per pound, and the corresponding equilibrium quantity is 25 million pounds of coffee per month. Figure 3.10 "Changes in Demand and Supply" shows what happens with an increase in demand, a reduction in demand, an increase in supply, and a reduction in supply. We then look at what happens if both curves shift simultaneously. Each of these possibilities is discussed in turn below. An Increase in Demand An increase in demand for coffee shifts the demand curve to the right, as shown in Panel (a) of Figure 3.10 "Changes in Demand and Supply". The equilibrium price rises to $7 per pound. As the price rises to the new equilibrium level, the quantity supplied increases to 30 million pounds of coffee per month. Notice that the supply curve does not shift; rather, there is a movement along the supply curve. Demand shifters that could cause an increase in demand include a shift in preferences that leads to greater coffee consumption; a lower price for a complement to coffee, such as doughnuts; a higher price for a substitute for coffee, such as tea; an increase in income; and an increase in population. A change in buyer expectations, perhaps due to predictions of bad weather lowering expected yields on coffee plants and increasing future coffee prices, could also increase current demand. A Decrease in Demand Panel (b) of Figure 3.10 "Changes in Demand and Supply" shows that a decrease in demand shifts the demand curve to the left. The equilibrium price falls to $5 per pound. As the price falls to the new equilibrium level, the quantity supplied decreases to 20 million pounds of coffee per month. Demand shifters that could reduce the demand for coffee include a shift in preferences that makes people want to consume less coffee; an increase in the price of a complement, such as doughnuts; a reduction in the price of a substitute, such as tea; a reduction in income; a reduction in population; and a change in buyer expectations that leads
people to expect lower prices for coffee in the future. An Increase in Supply An increase in the supply of coffee shifts the supply curve to the right, as shown in Panel (c) of Figure 3.10 "Changes in Demand and Supply". The equilibrium price 3.3 Demand, Supply, and Equilibrium 125 Chapter 3 Demand and Supply falls to $5 per pound. As the price falls to the new equilibrium level, the quantity of coffee demanded increases to 30 million pounds of coffee per month. Notice that the demand curve does not shift; rather, there is movement along the demand curve. Possible supply shifters that could increase supply include a reduction in the price of an input such as labor, a decline in the returns available from alternative uses of the inputs that produce coffee, an improvement in the technology of coffee production, good weather, and an increase in the number of coffee-producing firms. A Decrease in Supply Panel (d) of Figure 3.10 "Changes in Demand and Supply" shows that a decrease in supply shifts the supply curve to the left. The equilibrium price rises to $7 per pound. As the price rises to the new equilibrium level, the quantity demanded decreases to 20 million pounds of coffee per month. Possible supply shifters that could reduce supply include an increase in the prices of inputs used in the production of coffee, an increase in the returns available from alternative uses of these inputs, a decline in production because of problems in technology (perhaps caused by a restriction on pesticides used to protect coffee beans), a reduction in the number of coffee-producing firms, or a natural event, such as excessive rain. 3.3 Demand, Supply, and Equilibrium 126 Chapter 3 Demand and Supply Heads Up! You are likely to be given problems in which you will have to shift a demand or supply curve. Suppose you are told that an invasion of pod-crunching insects has gobbled up half the crop of fresh peas, and you are asked to use demand and supply analysis to predict what will happen to the price and quantity of peas demanded and supplied. Here are some suggestions. Put the quantity of the good you are asked to analyze on the horizontal axis and its price on the vertical axis. Draw a downward-sloping line for demand and an upward-sloping line for supply. The initial equilibrium price is determined by the intersection of the two curves. Label the equilibrium solution. You may find it helpful to use a number for the equilibrium price instead of the letter “P.” Pick a price that
seems plausible, say, 79¢ per pound. Do not worry about the precise positions of the demand and supply curves; you cannot be expected to know what they are. Step 2 can be the most difficult step; the problem is to decide which curve to shift. The key is to remember the difference between a change in demand or supply and a change in quantity demanded or supplied. At each price, ask yourself whether the given event would change the quantity demanded. Would the fact that a bug has attacked the pea crop change the quantity demanded at a price of, say, 79¢ per pound? Clearly not; none of the demand shifters have changed. The event would, however, reduce the quantity supplied at this price, and the supply curve would shift to the left. There is a change in supply and a reduction in the quantity demanded. There is no change in demand. 3.3 Demand, Supply, and Equilibrium 127 Chapter 3 Demand and Supply Next check to see whether the result you have obtained makes sense. The graph in Step 2 makes sense; it shows price rising and quantity demanded falling. It is easy to make a mistake such as the one shown in the third figure of this Heads Up! One might, for example, reason that when fewer peas are available, fewer will be demanded, and therefore the demand curve will shift to the left. This suggests the price of peas will fall—but that does not make sense. If only half as many fresh peas were available, their price would surely rise. The error here lies in confusing a change in quantity demanded with a change in demand. Yes, buyers will end up buying fewer peas. But no, they will not demand fewer peas at each price than before; the demand curve does not shift. Simultaneous Shifts As we have seen, when either the demand or the supply curve shifts, the results are unambiguous; that is, we know what will happen to both equilibrium price and equilibrium quantity, so long as we know whether demand or supply increased or decreased. However, in practice, several events may occur at around the same time that cause both the demand and supply curves to shift. To figure out what happens to equilibrium price and equilibrium quantity, we must know not only in which direction the demand and supply curves have shifted but also the relative amount by which each curve shifts. Of course, the demand and supply curves could shift in the same direction or in opposite directions, depending on the specific events causing them to shift. For example, all three panels of Figure 3
.11 "Simultaneous Decreases in Demand and Supply" show a decrease in demand for coffee (caused perhaps by a decrease in the price of a substitute good, such as tea) and a simultaneous decrease in the supply of coffee (caused perhaps by bad weather). Since reductions in demand and supply, considered separately, each cause the equilibrium quantity to fall, the impact of both curves shifting simultaneously to the left means that the new equilibrium quantity of coffee is less than the old equilibrium quantity. The effect on the equilibrium price, though, is ambiguous. Whether the equilibrium price is higher, lower, or unchanged depends on the extent to which each curve shifts. 3.3 Demand, Supply, and Equilibrium 128 Chapter 3 Demand and Supply Figure 3.11 Simultaneous Decreases in Demand and Supply Both the demand and the supply of coffee decrease. Since decreases in demand and supply, considered separately, each cause equilibrium quantity to fall, the impact of both decreasing simultaneously means that a new equilibrium quantity of coffee must be less than the old equilibrium quantity. In Panel (a), the demand curve shifts farther to the left than does the supply curve, so equilibrium price falls. In Panel (b), the supply curve shifts farther to the left than does the demand curve, so the equilibrium price rises. In Panel (c), both curves shift to the left by the same amount, so equilibrium price stays the same. If the demand curve shifts farther to the left than does the supply curve, as shown in Panel (a) of Figure 3.11 "Simultaneous Decreases in Demand and Supply", then the equilibrium price will be lower than it was before the curves shifted. In this case the new equilibrium price falls from $6 per pound to $5 per pound. If the shift to the left of the supply curve is greater than that of the demand curve, the equilibrium price will be higher than it was before, as shown in Panel (b). In this case, the new equilibrium price rises to $7 per pound. In Panel (c), since both curves shift to the left by the same amount, equilibrium price does not change; it remains $6 per pound. Regardless of the scenario, changes in equilibrium price and equilibrium quantity resulting from two different events need to be considered separately. If both events 3.3 Demand, Supply, and Equilibrium 129 Chapter 3 Demand and Supply cause equilibrium price or quantity to move in the same direction, then clearly price or quantity can be expected to move in that direction. If one event
causes price or quantity to rise while the other causes it to fall, the extent by which each curve shifts is critical to figuring out what happens. Figure 3.12 "Simultaneous Shifts in Demand and Supply" summarizes what may happen to equilibrium price and quantity when demand and supply both shift. Figure 3.12 Simultaneous Shifts in Demand and Supply If simultaneous shifts in demand and supply cause equilibrium price or quantity to move in the same direction, then equilibrium price or quantity clearly moves in that direction. If the shift in one of the curves causes equilibrium price or quantity to rise while the shift in the other curve causes equilibrium price or quantity to fall, then the relative amount by which each curve shifts is critical to figuring out what happens to that variable. As demand and supply curves shift, prices adjust to maintain a balance between the quantity of a good demanded and the quantity supplied. If prices did not adjust, this balance could not be maintained. Notice that the demand and supply curves that we have examined in this chapter have all been drawn as linear. This simplification of the real world makes the graphs a bit easier to read without sacrificing the essential point: whether the curves are linear or nonlinear, demand curves are downward sloping and supply curves are generally upward sloping. As circumstances that shift the demand curve 3.3 Demand, Supply, and Equilibrium 130 Chapter 3 Demand and Supply or the supply curve change, we can analyze what will happen to price and what will happen to quantity. An Overview of Demand and Supply: The Circular Flow Model Implicit in the concepts of demand and supply is a constant interaction and adjustment that economists illustrate with the circular flow model. The circular flow model24 provides a look at how markets work and how they are related to each other. It shows flows of spending and income through the economy. A great deal of economic activity can be thought of as a process of exchange between households and firms. Firms supply goods and services to households. Households buy these goods and services from firms. Households supply factors of production—labor, capital, and natural resources—that firms require. The payments firms make in exchange for these factors represent the incomes households earn. The flow of goods and services, factors of production, and the payments they generate is illustrated in Figure 3.13 "The Circular Flow of Economic Activity". This circular flow model of the economy shows the interaction of households and firms as they exchange goods and services and factors of production. For simplicity, the model here shows only the private domestic
economy; it omits the government and foreign sectors. 24. Model that provides a look at how markets work and how they are related to each other. 3.3 Demand, Supply, and Equilibrium 131 Chapter 3 Demand and Supply Figure 3.13 The Circular Flow of Economic Activity This simplified circular flow model shows flows of spending between households and firms through product and factor markets. The inner arrows show goods and services flowing from firms to households and factors of production flowing from households to firms. The outer flows show the payments for goods, services, and factors of production. These flows, in turn, represent millions of individual markets for products and factors of production. The circular flow model shows that goods and services that households demand are supplied by firms in product markets25. The exchange for goods and services is shown in the top half of Figure 3.13 "The Circular Flow of Economic Activity". The bottom half of the exhibit illustrates the exchanges that take place in factor markets. factor markets26 are markets in which households supply factors of production—labor, capital, and natural resources—demanded by firms. Our model is called a circular flow model because households use the income they receive from their supply of factors of production to buy goods and services from firms. Firms, in turn, use the payments they receive from households to pay for their factors of production. 25. Markets in which firms supply goods and services demanded by households. 26. Markets in which households supply factors of production—labor, capital, and natural resources—demanded by firms. 3.3 Demand, Supply, and Equilibrium 132 Chapter 3 Demand and Supply The demand and supply model developed in this chapter gives us a basic tool for understanding what is happening in each of these product or factor markets and also allows us to see how these markets are interrelated. In Figure 3.13 "The Circular Flow of Economic Activity", markets for three goods and services that households want—blue jeans, haircuts, and apartments—create demands by firms for textile workers, barbers, and apartment buildings. The equilibrium of supply and demand in each market determines the price and quantity of that item. Moreover, a change in equilibrium in one market will affect equilibrium in related markets. For example, an increase in the demand for haircuts would lead to an increase in demand for barbers. Equilibrium price and quantity could rise in both markets. For some purposes, it will be adequate to simply look at a single market, whereas at other times we will want to look at what
happens in related markets as well. In either case, the model of demand and supply is one of the most widely used tools of economic analysis. That widespread use is no accident. The model yields results that are, in fact, broadly consistent with what we observe in the marketplace. Your mastery of this model will pay big dividends in your study of economics. 3.3 Demand, Supply, and Equilibrium 133 Chapter 3 Demand and Supply • The equilibrium price is the price at which the quantity demanded equals the quantity supplied. It is determined by the intersection of the demand and supply curves. • A surplus exists if the quantity of a good or service supplied exceeds the quantity demanded at the current price; it causes downward pressure on price. A shortage exists if the quantity of a good or service demanded exceeds the quantity supplied at the current price; it causes upward pressure on price. • An increase in demand, all other things unchanged, will cause the equilibrium price to rise; quantity supplied will increase. A decrease in demand will cause the equilibrium price to fall; quantity supplied will decrease. • An increase in supply, all other things unchanged, will cause the equilibrium price to fall; quantity demanded will increase. A decrease in supply will cause the equilibrium price to rise; quantity demanded will decrease. • To determine what happens to equilibrium price and equilibrium quantity when both the supply and demand curves shift, you must know in which direction each of the curves shifts and the extent to which each curve shifts. • The circular flow model provides an overview of demand and supply in product and factor markets and suggests how these markets are linked to one another. T R Y I T! What happens to the equilibrium price and the equilibrium quantity of DVD rentals if the price of movie theater tickets increases and wages paid to DVD rental store clerks increase, all other things unchanged? Be sure to show all possible scenarios, as was done in Figure 3.11 "Simultaneous Decreases in Demand and Supply". Again, you do not need actual numbers to arrive at an answer. Just focus on the general position of the curve(s) before and after events occurred. 3.3 Demand, Supply, and Equilibrium 134 Chapter 3 Demand and Supply Case in Point: Demand, Supply, and Obesity © 2010 Jupiterimages Corporation Why are so many Americans fat? Put so crudely, the question may seem rude, but, indeed, the number of obese Americans has increased by more than 50% over the last generation, and obesity may now be the nation’s number one health problem. According
to Sturm Roland in a recent RAND Corporation study, “Obesity appears to have a stronger association with the occurrence of chronic medical conditions, reduced physical health-related quality of life and increased health care and medication expenditures than smoking or problem drinking.” Many explanations of rising obesity suggest higher demand for food. What more apt picture of our sedentary life style is there than spending the afternoon watching a ballgame on TV, while eating chips and salsa, followed by a dinner of a lavishly topped, take-out pizza? Higher income has also undoubtedly contributed to a rightward shift in the demand curve for food. Plus, any additional food intake translates into more weight increase because we spend so few calories preparing it, either directly or in the process of earning the income to buy it. A study by economists Darius Lakdawalla and Tomas Philipson suggests that about 60% of the recent growth in weight may be explained in this way—that is, demand has shifted to the right, leading to an increase in the equilibrium quantity of food consumed and, given our less 3.3 Demand, Supply, and Equilibrium 135 Chapter 3 Demand and Supply strenuous life styles, even more weight gain than can be explained simply by the increased amount we are eating. What accounts for the remaining 40% of the weight gain? Lakdawalla and Philipson further reason that a rightward shift in demand would by itself lead to an increase in the quantity of food as well as an increase in the price of food. The problem they have with this explanation is that over the post-World War II period, the relative price of food has declined by an average of 0.2 percentage points per year. They explain the fall in the price of food by arguing that agricultural innovation has led to a substantial rightward shift in the supply curve of food. As shown, lower food prices and a higher equilibrium quantity of food have resulted from simultaneous rightward shifts in demand and supply and that the rightward shift in the supply of food from S1 to S2 has been substantially larger than the rightward shift in the demand curve from D1 to D2. Sources: Roland, Sturm, “The Effects of Obesity, Smoking, and Problem Drinking on Chronic Medical Problems and Health Care Costs,” Health Affairs, 2002; 21(2): 245–253. Lakdawalla, Darius and Tomas Philipson, “The Growth of Obesity and Technological Change: A Theoretical and Empirical Examination,”
National Bureau of Economic Research Working Paper no. w8946, May 2002. 3.3 Demand, Supply, and Equilibrium 136 Chapter 3 Demand and Supply An increase in the price of movie theater tickets (a substitute for DVD rentals) will cause the demand curve for DVD rentals to shift to the right. An increase in the wages paid to DVD rental store clerks (an increase in the cost of a factor of production) shifts the supply curve to the left. Each event taken separately causes equilibrium price to rise. Whether equilibrium quantity will be higher or lower depends on which curve shifted more. If the demand curve shifted more, then the equilibrium quantity of DVD rentals will rise [Panel (a)]. If the supply curve shifted more, then the equilibrium quantity of DVD rentals will fall [Panel (b)]. If the curves shifted by the same amount, then the equilibrium quantity of DVD rentals would not change [Panel (c)]. 3.3 Demand, Supply, and Equilibrium 137 Chapter 3 Demand and Supply 3.4 Review and Practice Summary In this chapter we have examined the model of demand and supply. We found that a demand curve shows the quantity demanded at each price, all other things unchanged. The law of demand asserts that an increase in price reduces the quantity demanded and a decrease in price increases the quantity demanded, all other things unchanged. The supply curve shows the quantity of a good or service that sellers will offer at various prices, all other things unchanged. Supply curves are generally upward sloping: an increase in price generally increases the quantity supplied, all other things unchanged. The equilibrium price occurs where the demand and supply curves intersect. At this price, the quantity demanded equals the quantity supplied. A price higher than the equilibrium price increases the quantity supplied and reduces the quantity demanded, causing a surplus. A price lower than the equilibrium price increases the quantity demanded and reduces the quantity supplied, causing a shortage. Usually, market surpluses and shortages are short-lived. Changes in demand or supply, caused by changes in the determinants of demand and supply otherwise held constant in the analysis, change the equilibrium price and output. The circular flow model allows us to see how demand and supply in various markets are related to one another. 138 Chapter 3 Demand and Supply. What do you think happens to the demand for pizzas during the Super Bowl? Why? 2. Which of the following goods are likely to be classified as normal goods or services? Inferior? Defend your answer. 1. Beans 2. Tuxedos 3. Used cars
4. Used clothing 5. Computers 6. Books reviewed in The New York Times 7. Macaroni and cheese 8. Calculators 9. Cigarettes 10. Caviar 11. Legal services 3. Which of the following pairs of goods are likely to be classified as substitutes? Complements? Defend your answer. IBM and Apple Macintosh brand computers 1. Peanut butter and jelly 2. Eggs and ham 3. Nike brand and Reebok brand sneakers 4. 5. Dress shirts and ties 6. Airline tickets and hotels 7. Gasoline and tires 8. Beer and wine 9. Faxes and first-class mail 10. Cereal and milk 11. Cereal and eggs 4. A study found that lower airfares led some people to substitute flying for driving to their vacation destinations. This reduced the demand for car travel and led to reduced traffic fatalities, since air travel is safer per passenger mile than car travel. Using the logic suggested by that study, suggest how each of the following events would affect the number of highway fatalities in any one year. 3.4 Review and Practice 139 Chapter 3 Demand and Supply 1. An increase in the price of gasoline 2. A large reduction in rental rates for passenger vans 3. An increase in airfares 5. Children under age 2 are now allowed to fly free on U.S. airlines; they usually sit in their parents’ laps. Some safety advocates have urged that they be required to be strapped in infant seats, which would mean their parents would have to purchase tickets for them. Some economists have argued that such a measure would actually increase infant fatalities. Can you say why? 6. The graphs below show four possible shifts in demand or in supply that could occur in particular markets. Relate each of the events described below to one of them. 1. How did the heavy rains in South America in 1997 affect the market for coffee? 2. The Surgeon General decides french fries are not bad for your health after all and issues a report endorsing their use. What happens to the market for french fries? 3.4 Review and Practice 140 Chapter 3 Demand and Supply 3. How do you think rising incomes affect the market for ski vacations? 4. A new technique is discovered for manufacturing computers that greatly lowers their production cost. What happens to the market for computers? 5. How would a ban on smoking in public affect the market for cigarettes? 7. As low-carb diets increased in popularity, egg prices rose sharply. How might this affect the monks
’ supply of cookies or private retreats? (See the Case in Point on the Monks of St. Benedict’s.) 8. Gasoline prices typically rise during the summer, a time of heavy tourist traffic. A “street talk” feature on a radio station sought tourist reaction to higher gasoline prices. Here was one response: “I don’t like ’em [the higher prices] much. I think the gas companies just use any excuse to jack up prices, and they’re doing it again now.” How does this tourist’s perspective differ from that of economists who use the model of demand and supply? 9. The introduction to the chapter argues that preferences for coffee changed in the 1990s and that excessive rain hurt yields from coffee plants. Show and explain the effects of these two circumstances on the coffee market. 10. With preferences for coffee remaining strong in the early part of the century, Vietnam entered the market as a major exporter of coffee. Show and explain the effects of these two circumstances on the coffee market. 12. 11. The study on the economics of obesity discussed in the Case in Point in this chapter on that topic also noted that another factor behind rising obesity is the decline in cigarette smoking as the price of cigarettes has risen. Show and explain the effect of higher cigarette prices on the market for food. What does this finding imply about the relationship between cigarettes and food? In 2004, The New York Times reported that India might be losing its outsourcing edge due to rising wagesNoam Scheiber, “As a Center for Outsourcing, India Could Be Losing Its Edge,” New York Times, May 9, 2004, p. BU3. The reporter noted that a recent report “projected that if India continued to produce college graduates at the current rate, demand would exceed supply by 20% in the main outsourcing markets by 2008.” Using the terminology you learned in this chapter, explain what he meant to say was happening in the market for Indian workers in outsourcing jobs. In particular, is demand for Indian workers increasing or decreasing? Is the supply of Indian workers increasing or decreasing? Which is shifting faster? How do you know? 3.4 Review and Practice 141 Chapter 3 Demand and Supply 13. For more than a century, milk producers have produced skim milk, which contains virtually no fat, along with regular milk, which contains 4% fat. But a century ago, skim milk accounted for only about 1% of total production
, and much of it was fed to hogs. Today, skim and other reduced-fat milks make up the bulk of milk sales. What curve shifted, and what factor shifted it? 14. Suppose firms in the economy were to produce fewer goods and services. How do you think this would affect household spending on goods and services? (Hint: Use the circular flow model to analyze this question.) 3.4 Review and Practice 142 Chapter 3 Demand and Supply Problems 1–5 are based on the graph below. 1. At a price of $1.50 per dozen, how many bagels are demanded per month? 2. At a price of $1.50 per dozen, how many bagels are supplied per month? 3. At a price of $3.00 per dozen, how many bagels are demanded per month? 4. At a price of $3.00 per dozen, how many bagels are supplied per month? 5. What is the equilibrium price of bagels? What is the equilibrium quantity per month? Problems 6–9 are based on the model of demand and supply for coffee as shown in Figure 3.10 "Changes in Demand and Supply". You can graph the initial demand and supply curves by using the following values, with all quantities in millions of pounds of coffee per month: Price Quantity demanded Quantity supplied $3 4 5 6 7 8 9 40 35 30 25 20 15 10 10 15 20 25 30 35 40 1. Suppose the quantity demanded rises by 20 million pounds of coffee per month at each price. Draw the initial demand and supply curves based on the values given in the table above. Then draw the new demand 3.4 Review and Practice 143 Chapter 3 Demand and Supply curve given by this change, and show the new equilibrium price and quantity. 2. Suppose the quantity demanded falls, relative to the values given in the above table, by 20 million pounds per month at prices between $4 and $6 per pound; at prices between $7 and $9 per pound, the quantity demanded becomes zero. Draw the new demand curve and show the new equilibrium price and quantity. 3. Suppose the quantity supplied rises by 20 million pounds per month at each price, while the quantities demanded retain the values shown in the table above. Draw the new supply curve and show the new equilibrium price and quantity. 4. Suppose the quantity supplied falls, relative to the values given in the table above, by 20 million pounds per month at prices above $5; at a price of $5 or
less per pound, the quantity supplied becomes zero. Draw the new supply curve and show the new equilibrium price and quantity. Problems 10–15 are based on the demand and supply schedules for gasoline below (all quantities are in thousands of gallons per week): Price per gallon Quantity demanded Quantity supplied $. Graph the demand and supply curves and show the equilibrium price and quantity. 2. At a price of $3 per gallon, would there be a surplus or shortage of gasoline? How much would the surplus or shortage be? Indicate the surplus or shortage on the graph. 3. At a price of $6 per gallon, would there be a surplus or shortage of gasoline? How much would the surplus or shortage be? Show the surplus or shortage on the graph. 4. Suppose the quantity demanded increased by 2,000 gallons per month at each price. At a price of $3 per gallon, how much would the surplus or 3.4 Review and Practice 144 Chapter 3 Demand and Supply shortage be? Graph the demand and supply curves and show the surplus or shortage. 5. Suppose the quantity supplied decreased by 2,000 gallons per month at each price for prices between $4 and $8 per gallon. At prices less than $4 per gallon the quantity supplied becomes zero, while the quantities demanded retain the values shown in the table. At a price of $4 per gallon, how much would the surplus or shortage be? Graph the demand and supply curves and show the surplus or shortage. If the demand curve shifts as in problem 13 and the supply curve shifts as in problem 14, without drawing a graph or consulting the data, can you predict whether equilibrium price increases or decreases? What about equilibrium quantity? Now draw a graph that shows what the new equilibrium price and quantity are. 6. 3.4 Review and Practice 145 Chapter 4 Applications of Demand and Supply Start Up: A Composer Logs On “Since the age of seven, I knew that I would be a musician. And from age fourteen, I knew that I would be a composer,” says Israeli-born Ofer Ben-Amots. What he did not know was that he would use computers to carry out his work. He is now a professor of music at Colorado College, and Dr. Ben-Amots’s compositions and operas have been performed in the United States, Europe, and Japan. For over 20 years, he has used musical composition software in creating his music. “The output is extremely elegant. Performers enjoy looking at such a
clear and clean score. The creation of parts out of a full score is as easy as pressing the <ENTER> key on the keyboard.” Changes can easily be inserted into the notation file, which eliminates the need for recopying. In addition, Dr. Ben-Amots uses computers for playback. “I can listen to a relatively accurate ‘digital performance’ of the score at any given point, with any tempo or instrumentation I choose. The sound quality has improved so much that digital files sound almost identical to real performance.” He can also produce CDs on his own and create podcasts so that anyone in the world can hear his music. He engages in self-publication of scores and self-marketing. “In my case, I get to keep the copyrights on all of my music. This would have been impossible ten to twelve years ago when composers transferred their rights to publishers. Home pages on the World Wide Web allow me to promote my own work.” Professor Ben-Amots also changed the way he teaches music composition. New application software, such as GarageBand, has opened the way for anyone interested to try to compose music. Whereas his music composition classes used to have music theory prerequisites, today his classes are open to all. Dr. Ben-Amots started out in 1989 with a Macintosh SE30 that had 4 megabytes of random access memory (RAM) and an 80-megabyte hard drive. It cost him about $3,000. Today, he uses a Macintosh MacBook Pro with 4 gigabytes of memory (a bit in a computer has a value of 0 or 1, a byte is 8 bits, a megabyte is slightly more than 1 million bytes, and a gigabyte is slightly more than 1,000 megabytes), built-in DVD/ CD burner, and wireless Internet connections. His new computer cost about $2,200. Put another way, his first computer had a cost per megabyte of RAM of about $750. His present computer costs about $0.75 per megabyte of RAM and is far more powerful. The dramatic rise in the power of personal computers as they fell so 146 Chapter 4 Applications of Demand and Supply steeply in price is just one of the stories about markets we will tell in this chapter, which aims to help you understand how the model of demand and supply applies to the real world. In the first section of this chapter, we will look at several markets that you are likely to have participated
in or be familiar with—the market for personal computers, the markets for crude oil and for gasoline, and the stock market. You probably own or have access to a computer. We have all been affected by the sharp swings in the prices of oil and gasoline in recent years. The performance of the stock market is always a major news item and may affect you personally, if not now then in the future. The concepts of demand and supply go a long way in explaining the behavior of equilibrium prices and quantities in all of these markets. The purpose of this section is to allow you to practice using the model of demand and supply and to get you to start thinking about the myriad ways the model of demand and supply can be applied. In the second part of the chapter we will look at markets in which the government plays a large role in determining prices. By legislating maximum or minimum prices, the government has kept the prices of certain goods below or above equilibrium. We will look at the arguments for direct government intervention in controlling prices as well as the consequences of such policies. As we shall see, preventing the price of a good from finding its own equilibrium often has consequences that may be at odds with the intentions of the policy makers who put the regulations in place. In the third section of the chapter we will look at the market for health care. This market is important because how well (or poorly) it works can be a matter of life and death and because it has special characteristics. In particular, markets in which participants do not pay for goods directly but rather have insurers who then pay the suppliers of the goods, operate somewhat differently from those in which participants pay directly for their purchases. This extension of demand and supply analysis, while only scratching the surface on the issues associated with the market for health care, reveals much about how such markets operate. This analysis has become particularly important in the wake of the passage of the Patient Protection and Affordable Care Act in the United States in 2010—sometimes referred to (especially by opponents) as “Obamacare.” 147 Chapter 4 Applications of Demand and Supply 4.1 Putting Demand and Supply to Work. Learn how to apply the model of demand and supply to the behavior of equilibrium prices and output in a variety of markets. 2. Learn basic vocabulary on the organization of firms and explain how the model of demand and supply can be used to understand prices of shares of stock. A shift in either demand or supply, or in both, leads to a change in equilibrium price and equilibrium quantity. We begin this chapter
by examining markets in which prices adjust quickly to changes in demand or supply: the market for personal computers, the markets for crude oil and gasoline, and the stock market. These markets are thus direct applications of the model of demand and supply. The Personal Computer Market In the 1960s, to speak of computers was to speak of IBM, the dominant maker of large mainframe computers used by business and government agencies. Then between 1976, when Apple Computer introduced its first desktop computer, and 1981, when IBM produced its first personal computers (PCs), the computer usage expanded dramatically. Only 8.2% of U. S. households owned a personal computer in 1984. By 2003, 62% did. After that, the U.S. Census Bureau began asking only about Internet usage. By 2009, more than two-thirds of households had home Internet access. The tools of demand and supply tell the story from an economic perspective. Technological change has been breathtakingly swift in the computer industry. Because personal computers have changed so dramatically in performance and in the range of the functions they perform, we shall speak of “quality-adjusted” personal computers. The price per unit of quality-adjusted desktop computers fell by about half every 50 months during the period 1976–1989. In the first half of the 1990s, those prices fell by half every 28 months. In the second half of the 1990s, the “halving time” fell to every 24 months.Ilkka Tuomi, “The Lives and Death of Moore’s Law.” http://www.firstmonday.org/issues/issue7_11/tuomi/index. First Monday (http://www.firstmonday.org) is a peer-reviewed journal on the Internet. There are other indicators of the phenomenal change in computers. Between 1993 and 1998, the Bureau of Labor Statistics estimates that central processing unit (CPU) 148 Chapter 4 Applications of Demand and Supply speed rose 1,263%, system memory increased 1,500%, hard drive capacity soared by 3,700%, and monitor size went up 13%. It seems safe to say that the dizzying pace of change recorded in the 1990s has increased in this century. A “computer” today is not the same good as a “computer” even five years ago. To make them comparable, we must adjust for changes in quality. Initially, most personal computers were manufactured by Apple or Compaq; both companies were very profitable. The potential
for profits attracted IBM and other firms to the industry. Unlike large mainframe computers, personal computer clones turned out to be fairly easy to manufacture. As shown in Table 4.1 "Personal Computer Shipments, Market Percentage Shares by Vendors, World and United States, 2011", the top six personal computer manufacturers produced only 43.3% of the personal computers sold in the world in 2011, and the largest manufacturer, Hewlett-Packard (HP), sold only about 17.5% of the total in that year. This is a far cry from the more than 90% of the mainframe computer market that IBM once held. The market has become far more competitive. Table 4.1 Personal Computer Shipments, Market Percentage Shares by Vendors, World and United States, 2011 Company Percentage of World Shipments Company Percentage of U.S. Shipments HP Dell Lenovo Acer Group Asus Toshiba Others 17.5 12.5 12.0 10.9 5.2 5.2 36.7 HP Dell Apple Toshiba Acer Group Others 26.9 22.6 10.7 9.6 9.3 20.9 Source: “Gartner Says Worldwide PC Shipments Increased 2.3 Percent in Second Quarter of 2011,” Gartner Newsroom, July 13, 2011, http://www.gartner.com/it/ page.jsp?id=1744216. Totals may not add due rounding. Figure 4.1 "The Personal Computer Market" illustrates changes that have occurred in the computer market. The horizontal axis shows the quantity of quality-adjusted 4.1 Putting Demand and Supply to Work 149 Chapter 4 Applications of Demand and Supply personal computers. Thus, the quantity axis can be thought of as a unit of computing power. Similarly, the price axis shows the price per unit of computing power. The rapid increase in the number of firms, together with dramatic technological improvements, led to an increase in supply, shifting the supply curve in Figure 4.1 "The Personal Computer Market" to the right from S1 to S2. Demand also shifted to the right from D1 to D2, as incomes rose and new uses for computers, from e-mail and social networking to Voice over Internet Protocol (VoIP) and Radio Frequency ID (RFID) tags (which allow wireless tracking of commercial shipments via desktop computers), altered the preferences of consumer and business users. Because we observe a fall in equilibrium price and an increase in equilibrium quantity, we conclude that the rightward
shift in supply has outweighed the rightward shift in demand. The power of market forces has profoundly affected the way we live and work. One indication of the increasing importance of computers was that in August 2011, Exxon Mobil, an oil company that had been largest company in the United States in terms of the value of its outstanding stock, was the surpassed by Apple Computer Inc., whose value reached $350 billion. The Markets for Crude Oil and for Gasoline Figure 4.1 The Personal Computer Market The supply curve for qualityadjusted personal computers shifted markedly to the right, reducing the equilibrium price from P1 to P2 and increasing the equilibrium quantity from Q1 to Q2 in 2011. The market for crude oil took a radical turn in 1973. The price per barrel of crude oil quadrupled between 1973 and 1974. Price remained high until the early 1980s but fell back drastically and remained low for about two decades. In 2004, the price of oil began to move upward and by 2008 had reached $147 per barrel. What caused the dramatic increase in gasoline and oil prices in 2008? It appeared to be increasing worldwide demand outpacing producers’ ability—or willingness—to increase production much. This increase in demand is illustrated in Figure 4.2 "Increasing Demand for Crude Oil". 4.1 Putting Demand and Supply to Work 150 Chapter 4 Applications of Demand and Supply Figure 4.2 Increasing Demand for Crude Oil The price of oil was $35 per barrel at the beginning of 2004, as determined by the intersection of world demand, D1, and world supply, S1. Increasing world demand, prompted largely by increasing demand from China as well as from other countries, shifted world demand to D2, pushing the price as high as $140 per barrel by the middle of 2008. Higher oil prices also increase the cost of producing virtually every good or service since the production of most goods requires transportation. These costs inevitably translate into higher prices for nearly all goods and services. Supply curves of the goods and services thus affected shift to the left, putting downward pressure on output and upward pressure on prices. Graphically, the impact of higher gasoline prices on businesses that use gasoline is illustrated in Figure 4.3 "The Impact of Higher Gasoline Prices". Because higher gasoline prices increase the cost of doing business, they shift the supply curves for nearly all businesses to the left, putting upward pressure on prices and downward pressure on output. In the case shown here, the supply curve in a typical industry shifts from S1 to S2. This
increases the equilibrium price from P1 to P2 and reduces the equilibrium quantity from Q1 to Q2. 4.1 Putting Demand and Supply to Work 151 Chapter 4 Applications of Demand and Supply Figure 4.3 The Impact of Higher Gasoline Prices Higher gasoline prices increase the cost of producing virtually every good or service. In the case shown here, the supply curve in a typical industry shifts from S1 to S2. This increases the equilibrium price from P1 to P2 and reduces equilibrium quantity from Q1 to Q2. As the world economy slowed dramatically in the second half of 2008, the demand curve for oil shifted to the left. By November 2008, the price per barrel had dropped to below $60 per barrel. As gas prices also subsided, so did the threat of higher prices in other industries. The Stock Market The circular flow model suggests that capital, like other factors of production, is supplied by households to firms. Firms, in turn, pay income to those households for the use of their capital. Generally speaking, however, capital is actually owned by firms themselves. General Motors owns its assembly plants, and Wal-Mart owns its stores; these firms therefore own their capital. But firms, in turn, are owned by people—and those people, of course, live in households. It is through their ownership of firms that households own capital. 4.1 Putting Demand and Supply to Work 152 Chapter 4 Applications of Demand and Supply A firm may be owned by one individual (a sole proprietorship1), by several individuals (a partnership2), or by shareholders who own stock in the firm (a corporation3). Although most firms in the United States are sole proprietorships or partnerships, the bulk of the nation’s total output (about 90%) is produced by corporations. Corporations also own most of the capital (machines, plants, buildings, and the like). This section describes how the prices of shares of corporate stock4, shares in the ownership of a corporation, are determined by the interaction of demand and supply. Ultimately, the same forces that determine the value of a firm’s stock determine the value of a sole proprietorship or partnership. When a corporation needs funds to increase its capital or for other reasons, one means at its disposal is to issue new stock in the corporation. (Other means include borrowing funds or using past profits.) Once the new shares have been sold in what is called an initial public offering (IPO), the corporation receives no further funding as shares of its
stock are bought and sold on the secondary market. The secondary market is the market for stocks that have been issued in the past, and the daily news reports about stock prices almost always refer to activity in the secondary market. Generally, the corporations whose shares are traded are not involved in these transactions. The stock market5 is the set of institutions in which shares of stock are bought and sold. The New York Stock Exchange (NYSE) is one such institution. There are many others all over the world, such as the DAX in Germany and the Bolsa in Mexico. To buy or sell a share of stock, one places an order with a stockbroker who relays the order to one of the traders at the NYSE or at some other exchange. 1. A firm owned by one individual. 2. A firm owned by several individuals. 3. A firm owned by shareholders who own stock in the firm. 4. Shares in the ownership of a corporation. 5. The set of institutions in which shares of stock are bought and sold. The process through which shares of stock are bought and sold can seem chaotic. At many exchanges, traders with orders from customers who want to buy stock shout out the prices those customers are willing to pay. Traders with orders from customers who want to sell shout out offers of prices at which their customers are willing to sell. Some exchanges use electronic trading, but the principle is the same: if the price someone is willing to pay matches the price at which someone else is willing to sell, the trade is made. The most recent price at which a stock has traded is reported almost instantaneously throughout the world. Figure 4.4 "Demand and Supply in the Stock Market" applies the model of demand and supply to the determination of stock prices. Suppose the demand curve for shares in Intel Corporation is given by D1 and the supply by S1. (Even though the total number of shares outstanding is fixed at any point in time, the supply curve is not vertical. Rather, the supply curve is upward sloping because it represents how 4.1 Putting Demand and Supply to Work 153 Chapter 4 Applications of Demand and Supply many shares current owners are prepared to sell at each price, and that number will be greater at higher prices.) Suppose that these curves intersect at a price of $25, at which Q1 shares are traded each day. If the price were higher, more shares would be offered for sale than would be demanded, and the price would quickly fall. If the price were lower, more
shares would be demanded than would be supplied, and the price would quickly rise. In general, we can expect the prices of shares of stock to move quickly to their equilibrium levels. The intersection of the demand and supply curves for shares of stock in a particular company determines the equilibrium price for a share of stock. But what determines the demand and supply for shares of a company’s stock? Figure 4.4 Demand and Supply in the Stock Market The owner of a share of a company’s stock owns a share of the company, and, hence, a share of its profits; typically, a corporation will retain and reinvest some of its profits to increase its future profitability. The profits kept by a company are called retained earnings6. Profits distributed to shareholders are called dividends7. Because a share of stock gives its owner a claim on part of a company’s future profits, it follows that the expected level of future profits plays a role in determining the value of its stock. The equilibrium price of stock shares in Intel Corporation is initially $25, determined by the intersection of demand and supply curves D1 and S1, at which Q1 million shares are traded each day. Of course, those future profits cannot be known with certainty; investors can only predict what they might be, based on information about future demand for the company’s products, future costs of production, information about the soundness of a company’s management, and so on. Stock prices in the real world thus reflect estimates of a company’s profits projected into the future. The downward slope of the demand curve suggests that at lower prices for the stock, more people calculate that the firm’s future earnings will justify the stock’s purchase. The upward slope of the supply curve tells us that as the price of the stock rises, more people conclude that the firm’s future earnings do not justify holding the stock and therefore offer to sell it. At the equilibrium price, the number of shares supplied by people who think holding the stock no longer makes sense just balances the number of shares demanded by people who think it does. 6. Profits kept by a company. 7. Profits distributed to shareholders. What factors, then, cause the demand or supply curves for shares of stocks to shift? The most important factor is a change in the expectations of a company’s future 4.1 Putting Demand and Supply to Work 154 Chapter 4 Applications of Demand and Supply profits. Suppose Intel announces a new generation of computer chips
that will lead to faster computers with larger memories. Current owners of Intel stock would adjust upward their estimates of what the value of a share of Intel stock should be. At the old equilibrium price of $25 fewer owners of Intel stock would be willing to sell. Since this would be true at every possible share price, the supply curve for Intel stock would shift to the left, as shown in Figure 4.5 "A Change in Expectations Affects the Price of Corporate Stock". Just as the expectation that a company will be more profitable shifts the supply curve for its stock to the left, that same change in expectations will cause more people to want to purchase the stock, shifting the demand curve to the right. In Figure 4.5 "A Change in Expectations Affects the Price of Corporate Stock", we see the supply curve shifting to the left, from S1 to S2, while the demand curve shifts to the right, from D1 to D2. Other factors may alter the price of an individual corporation’s share of stock or the level of stock prices in general. For example, demographic change and rising incomes have affected the demand for stocks in recent years. For example, with a large proportion of the U.S. population nearing retirement age and beginning to think about and plan for their lives during retirement, the demand for stocks has risen. Information on the economy as a whole is also likely to affect stock prices. If the economy overall is doing well and people expect that to continue, they may become more optimistic about how profitable companies will be in general, and thus the prices of stocks will rise. Conversely, expectations of a sluggish economy, as happened in the fall of 2008, could cause stock prices in general to fall. Figure 4.5 A Change in Expectations Affects the Price of Corporate Stock If financial investors decide that a company is likely to be more profitable, then the supply of the stock shifts to the left (in this case, from S1 to S2), and the demand for the stock shifts to the right (in this case, from D1 to D2), resulting in an increase in price from P1 to P2. The stock market is bombarded with new information every minute of every day. Firms announce their profits of the previous quarter. They announce that they plan to move into a new product line or sell their goods in another country. We learn that the price of Company A’s good, which is a substitute for one sold by Company B, has risen. We
learn that countries sign trade agreements, launch wars, or make peace. All of this information may affect stock prices because any information can affect how buyers and sellers value companies. 4.1 Putting Demand and Supply to Work 155 Chapter 4 Applications of Demand and Supply • Technological change, which has caused the supply curve for computing power to shift to the right, is the main reason for the rapid increase in equilibrium quantity and decrease in equilibrium price of personal computers. • The increase in crude oil and gasoline prices in 2008 was driven primarily by increased demand for crude oil, an increase that was created by economic growth throughout the world. Crude oil and gas prices fell markedly as world economic growth subsided later in the year. • Higher gasoline prices increased the cost of producing virtually every good and service, shifting supply curves for most goods and services to the left. This tended to push prices up and output down. • Demand and supply determine prices of shares of corporate stock. The equilibrium price of a share of stock strikes a balance between those who think the stock is worth more and those who think it is worth less than the current price. If a company’s profits are expected to increase, the demand curve for its stock shifts to the right and the supply curve shifts to the left, causing equilibrium price to rise. The opposite would occur if a company’s profits were expected to decrease. • • Other factors that influence the price of corporate stock include demographic and income changes and the overall health of the economy. T R Y I T! Suppose an airline announces that its earnings this year are lower than expected due to reduced ticket sales. The airline spokesperson gives no information on how the company plans to turn things around. Use the model of demand and supply to show and explain what is likely to happen to the price of the airline’s stock. 4.1 Putting Demand and Supply to Work 156 Chapter 4 Applications of Demand and Supply Case in Point: The Great Recession, the Arab Spring, and the Oil Market © Thinkstock Oil markets have been on a roller coaster ride for the last few years. Even after the official start of the recession in the United States in December 2007, oil prices continued to climb, peaking in the summer of 2008 at over $130 per barrel. Although demand in the United States and Europe was already weakening, growth in the rest of the world, particularly in China and India, was still strong. Overall, demand was rising. Oil prices dropped precipitously following the start of the financial crisis and the deepening of the
recession in the fall of 2008. Within a few months, the price of oil had dropped to around $40 and was in the $70 to $80 range for much of the rest of 2009 and the first half of 2010. The so-called Arab Spring actually began with demonstrations late in 2010 in Tunisia. They quickly spread to Egypt, Bahrain, Syria, Yemen, Algeria, Jordan, Morocco, and Yemen. There were demonstrations in Saudi Arabia, Kuwait, Lebanon, Mauritania, and Sudan. By the fall of 2011, the movement had toppled the regimes of Zine El Abidine Ben Ali in Tunisia, Hosni Mubarak in Egypt, and Muammar al-Gaddafi in Libya. The movement had a large impact on oil prices as it raised questions about the security of oil supplies. The supply curve of oil shifted to the left, forcing the price upward. Not only were several key suppliers of oil affected, but at times the ability to transport oil through the Suez Canal was affected. 4.1 Putting Demand and Supply to Work 157 Chapter 4 Applications of Demand and Supply Oil prices rose to well over $100 per barrel by early 2011. They then began to subside again as some of the uprisings were subdued or ending, especially in the oil-rich Gulf countries. By the fall of 2011, oil prices had fallen about 20% as compared to earlier in the year The information given in the problem suggests that the airline’s profits are likely to fall below expectations. Current owners of the airline’s stock and potential buyers of the stock would adjust downward their estimates of what the value of the corporation’s stock should be. As a result the supply curve for the stock would increase, shifting it to the right, while the demand curve for the stock would decrease, shifting it to the left. As a result, equilibrium price of the stock falls from P1 to P2. What happens to equilibrium quantity depends on the extent to which each curve shifts. In the diagram, equilibrium quantity is shown to decrease from Q1 to Q2. 4.1 Putting Demand and Supply to Work 158 Chapter 4 Applications of Demand and Supply 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings. Use the model of demand and supply to explain what happens when the government imposes price floors or price ceilings. 2. Discuss the reasons why governments sometimes choose to control prices and the consequences of price control policies. So far in this chapter and in the previous chapter, we have learned that markets tend to
move toward their equilibrium prices and quantities. Surpluses and shortages of goods are short-lived as prices adjust to equate quantity demanded with quantity supplied. In some markets, however, governments have been called on by groups of citizens to intervene to keep prices of certain items higher or lower than what would result from the market finding its own equilibrium price. In this section we will examine agricultural markets and apartment rental markets—two markets that have often been subject to price controls. Through these examples, we will identify the effects of controlling prices. In each case, we will look at reasons why governments have chosen to control prices in these markets and the consequences of these policies. Agricultural Price Floors Governments often seek to assist farmers by setting price floors in agricultural markets. A minimum allowable price set above the equilibrium price is a price floor8. With a price floor, the government forbids a price below the minimum. (Notice that, if the price floor were for whatever reason set below the equilibrium price, it would be irrelevant to the determination of the price in the market since nothing would prohibit the price from rising to equilibrium.) A price floor that is set above the equilibrium price creates a surplus. Figure 4.6 "Price Floors in Wheat Markets" shows the market for wheat. Suppose the government sets the price of wheat at PF. Notice that PF is above the equilibrium price of PE. At PF, we read over to the demand curve to find that the quantity of wheat that buyers will be willing and able to purchase is W1 bushels. Reading over to the supply curve, we find that sellers will offer W2 bushels of wheat at the price 8. A minimum allowable price set above the equilibrium price. 159 Chapter 4 Applications of Demand and Supply floor of PF. Because PF is above the equilibrium price, there is a surplus of wheat equal to (W2 − W1) bushels. The surplus persists because the government does not allow the price to fall. Why have many governments around the world set price floors in agricultural markets? Farming has changed dramatically over the past two centuries. Technological improvements in the form of new equipment, fertilizers, pesticides, and new varieties of crops have led to dramatic increases in crop output per acre. Worldwide production capacity has expanded markedly. As we have learned, technological improvements cause the supply curve to shift to the right, reducing the price of food. While such price reductions have been celebrated in computer markets, farmers have successfully lobbied for government programs aimed at keeping their prices from falling. Figure 4.6
Price Floors in Wheat Markets A price floor for wheat creates a surplus of wheat equal to (W2 W1) bushels. While the supply curve for agricultural goods has shifted to the right, the demand has increased with rising population and with rising income. But as incomes rise, people spend a smaller and smaller fraction of their incomes on food. While the demand for food has increased, that increase has not been nearly as great as the increase in supply. Figure 4.7 "Supply and Demand Shifts for Agricultural Products" shows that the supply curve has shifted much farther to the right, from S1 to S2, than the demand curve has, from D1 to D2. As a result, equilibrium quantity has risen dramatically, from Q1 to Q2, and equilibrium price has fallen, from P1 to P2. On top of this long-term historical trend in agriculture, agricultural prices are subject to wide swings over shorter periods. Droughts or freezes can sharply reduce supplies of particular crops, causing sudden increases in prices. Demand for agricultural goods of one country can suddenly dry up if the government of another country imposes trade restrictions against its products, and prices can fall. Such dramatic shifts in prices and quantities make incomes of farmers unstable. 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 160 Chapter 4 Applications of Demand and Supply The Great Depression of the 1930s led to a major federal role in agriculture. The Depression affected the entire economy, but it hit farmers particularly hard. Prices received by farmers plunged nearly two-thirds from 1930 to 1933. Many farmers had a tough time keeping up mortgage payments. By 1932, more than half of all farm loans were in default. Figure 4.7 Supply and Demand Shifts for Agricultural Products Farm legislation passed during the Great Depression has been modified many times, but the federal government has continued its direct involvement in agricultural markets. This has meant a variety of government programs that guarantee a minimum price for some types of agricultural products. These programs have been accompanied by government purchases of any surplus, by requirements to restrict acreage in order to limit those surpluses, by crop or production restrictions, and the like. A relatively large increase in the supply of agricultural products, accompanied by a relatively small increase in demand, has reduced the price received by farmers and increased the quantity of agricultural goods. To see how such policies work, look back at Figure 4.6 "Price Floors in Wheat Markets". At PF, W2 bushels of wheat will
be supplied. With that much wheat on the market, there is market pressure on the price of wheat to fall. To prevent price from falling, the government buys the surplus of (W2 - W1) bushels of wheat, so that only W1 bushels are actually available to private consumers for purchase on the market. The government can store the surpluses or find special uses for them. For example, surpluses generated in the United States have been shipped to developing countries as grants-in-aid or distributed to local school lunch programs. As a variation on this program, the government can require farmers who want to participate in the price support program to reduce acreage in order to limit the size of the surpluses. After 1973, the government stopped buying the surpluses (with some exceptions) and simply guaranteed farmers a “target price.” If the average market price for a crop fell below the crop’s target price, the government paid the difference. If, for example, a crop had a market price of $3 per unit and a target price of $4 per unit, the government would give farmers a payment of $1 for each unit sold. Farmers would thus receive the market price of $3 plus a government payment of $1 per unit. For farmers to receive these payments, they had to agree to remove acres from production and to comply with certain conservation provisions. These restrictions sought to reduce the size of the surplus generated by the target price, which acted as a kind of price floor. 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 161 Chapter 4 Applications of Demand and Supply What are the effects of such farm support programs? The intention is to boost and stabilize farm incomes. But, with price floors, consumers pay more for food than they would otherwise, and governments spend heavily to finance the programs. With the target price approach, consumers pay less, but government financing of the program continues. U.S. federal spending for agriculture averaged well over $22 billion per year between 2003 and 2007, roughly $70 per person. Help to farmers has sometimes been justified on the grounds that it boosts incomes of “small” farmers. However, since farm aid has generally been allotted on the basis of how much farms produce rather than on a per-farm basis, most federal farm support has gone to the largest farms. If the goal is to eliminate poverty among farmers, farm aid could be redesigned to supplement the incomes of small or poor farmers rather
than to undermine the functioning of agricultural markets. In 1996, the U.S. Congress passed the Federal Agriculture Improvement and Reform Act of 1996, or FAIR. The thrust of the new legislation was to do away with the various programs of price support for most crops and hence provide incentives for farmers to respond to market price signals. To protect farmers through a transition period, the act provided for continued payments that were scheduled to decline over a seven-year period. However, with prices for many crops falling in 1998, the U.S. Congress passed an emergency aid package that increased payments to farmers. In 2008, as farm prices reached record highs, Congress passed a farm bill that increased subsidy payments to $40 billion. It did, however, for the first time limit payments to the wealthiest farmers. Individual farmers whose farm incomes exceed $750,000 (or $1.5 million for couples) would be ineligible for some subsidy programs. Rental Price Ceilings The purpose of rent control is to make rental units cheaper for tenants than they would otherwise be. Unlike agricultural price controls, rent control in the United States has been largely a local phenomenon, although there were national rent controls in effect during World War II. Currently, about 200 cities and counties have some type of rent control provisions, and about 10% of rental units in the United States are now subject to price controls. New York City’s rent control program, which began in 1943, is among the oldest in the country. Many other cities in the United States adopted some form of rent control in the 1970s. Rent controls have been pervasive in Europe since World War I, and many large cities in poorer countries have also adopted rent controls. Rent controls in different cities differ in terms of their flexibility. Some cities allow rent increases for specified reasons, such as to make improvements in apartments 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 162 Chapter 4 Applications of Demand and Supply or to allow rents to keep pace with price increases elsewhere in the economy. Often, rental housing constructed after the imposition of the rent control ordinances is exempted. Apartments that are vacated may also be decontrolled. For simplicity, the model presented here assumes that apartment rents are controlled at a price that does not change. Figure 4.8 "Effect of a Price Ceiling on the Market for Apartments" shows the market for rental apartments. Notice that the demand and supply curves are drawn to look like all the other demand and supply curves you have encountered so far in this text:
the demand curve is downward-sloping and the supply curve is upwardsloping. The demand curve shows that a higher price (rent) reduces the quantity of apartments demanded. For example, with higher rents, more young people will choose to live at home with their parents. With lower rents, more will choose to live in apartments. Higher rents may encourage more apartment sharing; lower rents would induce more people to live alone. Figure 4.8 Effect of a Price Ceiling on the Market for Apartments A price ceiling on apartment rents that is set below the equilibrium rent creates a shortage of apartments equal to (A2 − A1) apartments. The supply curve is drawn to show that as rent increases, property owners will be encouraged to offer more apartments to rent. Even though an aerial photograph of a city would show apartments to be fixed at a point in time, owners of those properties will decide how many to rent depending on the amount of rent they anticipate. Higher rents may also induce some homeowners to rent out apartment space. In addition, renting out apartments implies a certain level of service to renters, so that low rents may lead some property owners to keep some apartments vacant. Rent control is an example of a price ceiling9, a maximum allowable price. With a price ceiling, the government forbids a price above the maximum. A price ceiling that is set below the equilibrium price creates a shortage that will persist. Suppose the government sets the price of an apartment at PC in Figure 4.8 "Effect of a Price Ceiling on the Market for Apartments". Notice that PC is below the equilibrium price of PE. At PC, we read over to the supply curve to find that sellers are willing to offer A1 apartments. Reading over to the demand curve, we find that consumers would like to rent A2 apartments at the price ceiling of PC. Because PC is 9. A maximum allowable price. 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 163 Chapter 4 Applications of Demand and Supply below the equilibrium price, there is a shortage of apartments equal to (A2 - A1). (Notice that if the price ceiling were set above the equilibrium price it would have no effect on the market since the law would not prohibit the price from settling at an equilibrium price that is lower than the price ceiling.) If rent control creates a shortage of apartments, why do some citizens nonetheless clamor for rent control and why do governments often give in to the demands? The reason generally given for rent control is to keep apartments affordable for
low- and middle-income tenants. Figure 4.9 The Unintended Consequences of Rent Control But the reduced quantity of apartments supplied must be rationed in some way, since, at the price ceiling, the quantity demanded would exceed the quantity supplied. Current occupants may be reluctant to leave their dwellings because finding other apartments will be difficult. As apartments do become available, there will be a line of potential renters waiting to fill them, any of whom is willing to pay the controlled price of PC or more. In fact, reading up to the demand curve in Figure 4.9 "The Unintended Consequences of Rent Control" from A1 apartments, the quantity available at PC, you can see that for A1 apartments, there are potential renters willing and able to pay PB. This often leads to various “backdoor” payments to apartment owners, such as large security deposits, payments for things renters may not want (such as furniture), so-called “key” payments (“The monthly rent is $500 and the key price is $3,000”), or simple bribes. Controlling apartment rents at PC creates a shortage of (A2 − A1) apartments. For A1 apartments, consumers are willing and able to pay PB, which leads to various “backdoor” payments to apartment owners. In the end, rent controls and other price ceilings often end up hurting some of the people they are intended to help. Many people will have trouble finding apartments to rent. Ironically, some of those who do find apartments may actually end up paying more than they would have paid in the absence of rent control. And many of the people that the rent controls do help (primarily current occupants, regardless of their income, and those lucky enough to find apartments) are not those they are intended to help (the poor). There are also costs in government administration and enforcement. Because New York City has the longest history of rent controls of any city in the United States, its program has been widely studied. There is general agreement that 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 164 Chapter 4 Applications of Demand and Supply the rent control program has reduced tenant mobility, led to a substantial gap between rents on controlled and uncontrolled units, and favored long-term residents at the expense of newcomers to the city.Richard Arnott, “Time for Revisionism on Rent Control,” Journal of Economic Perspectives 9(1) (Winter, 1995
): 99–120. These distortions have grown over time, another frequent consequence of price controls. A more direct means of helping poor tenants, one that would avoid interfering with the functioning of the market, would be to subsidize their incomes. As with price floors, interfering with the market mechanism may solve one problem, but it creates many others at the same time • Price floors create surpluses by fixing the price above the equilibrium price. At the price set by the floor, the quantity supplied exceeds the quantity demanded. In agriculture, price floors have created persistent surpluses of a wide range of agricultural commodities. Governments typically purchase the amount of the surplus or impose production restrictions in an attempt to reduce the surplus. • • Price ceilings create shortages by setting the price below the equilibrium. At the ceiling price, the quantity demanded exceeds the quantity supplied. • Rent controls are an example of a price ceiling, and thus they create • shortages of rental housing. It is sometimes the case that rent controls create “backdoor” arrangements, ranging from requirements that tenants rent items that they do not want to outright bribes, that result in rents higher than would exist in the absence of the ceiling. T R Y I T! A minimum wage law is another example of a price floor. Draw demand and supply curves for unskilled labor. The horizontal axis will show the quantity of unskilled labor per period and the vertical axis will show the hourly wage rate for unskilled workers, which is the price of unskilled labor. Show and explain the effect of a minimum wage that is above the equilibrium wage. 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 165 Chapter 4 Applications of Demand and Supply Case in Point: Corn: It Is Not Just Food Any More © 2010 Jupiterimages Corporation Government support for corn dates back to the Agricultural Act of 1938 and, in one form or another, has been part of agricultural legislation ever since. Types of supports have ranged from government purchases of surpluses to target pricing, land set asides, and loan guarantees. According to one estimate, the U.S. government spent nearly $42 billion to support corn between 1995 and 2004. Then, during the period of rising oil prices of the late 1970s and mounting concerns about dependence on foreign oil from volatile regions in the world, support for corn, not as a food, but rather as an input into the production of ethanol—an alternative to oil-based fuel—began. Ethanol tax credits were part of the Energy Act of
1978. Since 1980, a tariff of 50¢ per gallon against imported ethanol, even higher today, has served to protect domestic corn-based ethanol from imported ethanol, in particular from sugar-cane-based ethanol from Brazil. The Energy Policy Act of 2005 was another milestone in ethanol legislation. Through loan guarantees, support for research and development, and tax credits, it mandated that 4 billion gallons of ethanol be used by 2006 and 7.5 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 166 Chapter 4 Applications of Demand and Supply billion gallons by 2012. Ethanol production had already reached 6.5 billion gallons by 2007, so new legislation in 2007 upped the ante to 15 billion gallons by 2015. Beyond the increased amount the government is spending to support corn and corn-based ethanol, criticism of the policy has three major prongs: 1. Corn-based ethanol does little to reduce U.S. dependence on foreign oil because the energy required to produce a gallon of corn-based ethanol is quite high. A 2006 National Academy of Sciences paper estimated that one gallon of ethanol is needed to bring 1.25 gallons of it to market. Other studies show an even less favorable ratio. 2. Biofuels, such as corn-based ethanol, are having detrimental effects on the environment, with increased deforestation, stemming from more land being used to grow fuel inputs, contributing to global warming. 3. The diversion of corn and other crops from food to fuel is contributing to rising food prices and an increase in world hunger. C. Ford Runge and Benjamin Senauer wrote in Foreign Affairs that even small increases in prices of food staples have severe consequences on the very poor of the world, and “Filling the 25-gallon tank of an SUV with pure ethanol requires over 450 pounds of corn—which contains enough calories to feed one person for a year.” Some of these criticisms may be contested as exaggerated: Will the ratio of energy-in to energy-out improve as new technologies emerge for producing ethanol? Did not other factors, such as weather and rising food demand worldwide, contribute to higher grain prices? Nonetheless, it is clear that cornbased ethanol is no free lunch. It is also clear that the end of government support for corn is nowhere to be seen. Sources: Alexei Barrionuevo, “Mountains of Corn and a Sea of Farm Subsidies,” New York Times, November 9, 2005, online version; David Freddoso, “
Children of the Corn,” National Review Online, May 6, 2008; C. Ford Runge and Benjamin Senauer, “How Biofuels Could Starve the Poor,” Foreign Affairs, May/June 2007, online version; Michael Grunwald, “The Clean Energy Scam,” Time 171:14 (April 7, 2008): 40–45. 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 167 Chapter 4 Applications of Demand and Supply minimum wage (Wmin) that is set above the equilibrium wage would create a surplus of unskilled labor equal to (L2 - L1). That is, L2 units of unskilled labor are offered at the minimum wage, but companies only want to use L1 units at that wage. Because unskilled workers are a substitute for a skilled workers, forcing the price of unskilled workers higher would increase the demand for skilled labor and thus increase their wages. 4.2 Government Intervention in Market Prices: Price Floors and Price Ceilings 168 Chapter 4 Applications of Demand and Supply 4.3 The Market for Health-Care Services. Use the model of demand and supply to explain the effects of third- party payers on the health-care market and on health-care spending. There has been much discussion over the past three decades about the health-care problem in the United States. Much of this discussion has focused on rising spending for health care. In this section, we will apply the model of demand and supply to health care to see what we can learn about some of the reasons behind rising spending in this important sector of the economy. Figure 4.10 "Health-Care Spending as a Percentage of U.S. Output, 1960–2009" shows the share of U.S. output devoted to health care since 1960. In 1960, about 5% of total output was devoted to health care; by 2009 this share had risen to 17.6%. That means that we are devoting more of our spending to health care and less to other goods and services. The Affordable Care Act of 2010 dramatically impacted health care services. Among its provisions is a requirement that individuals purchase health insurance (the socalled individual mandate). That provision may well result in the entire Act being ruled unconstitutional by the courts. As this book went to press, the Act was pending before the court system, and a ruling against it, or at least against parts of it, seemed possible. The Act requires insurance companies to provide coverage for children on
their parent’s policies up to the age of 26. It also bars health insurance companies from denying coverage based on pre-existing conditions. Provisions of the Act are extensive. It applies to virtually every aspect of health care services. It allows people to acquire health care insurance regardless of pre-existing conditions. It also allows employers to opt out of providing health insurance and to pay a fee instead. 169 Chapter 4 Applications of Demand and Supply Why were Americans willing to increase their spending on health care so dramatically? The model of demand and supply gives us part of the answer. As we apply the model to this problem, we will also gain a better understanding of the role of prices in a market economy. The Demand and Supply for Health Care When we speak of “health care,” we are speaking of the entire health-care industry. This industry produces services ranging from heart transplant operations to therapeutic massages; it produces goods ranging from X-ray machines to aspirin tablets. Clearly each of these goods and services is exchanged in a particular market. To assess the market forces affecting health care, we will focus first on just one of these markets: the market for physician office visits. When you go to the doctor, you are part of the demand for these visits. Your doctor, by seeing you, is part of the supply. Figure 4.11 "Total Spending for Physician Office Visits" shows the market, assuming that it operates in a fashion similar to other markets. The demand curve D1 and the supply curve S1 intersect at point E, with an equilibrium price of $30 per office visit. The equilibrium quantity of office visits per week is 1,000,000. We can use the demand and supply graph to show total spending, which equals the price per unit (in this case, $30 per visit) times the quantity consumed (in this case, 1,000,000 visits per week). Total spending for physician office visits thus equals $30,000,000 per week ($30 times 1,000,000 visits). We show total spending as the area of a rectangle bounded by the price and the quantity. It is the shaded region in Figure 4.11 "Total Spending for Physician Office Visits". The picture in Figure 4.11 "Total Spending for Physician Office Visits" misses a crucial feature of the market. Most people in the United States have health insurance, provided either by private firms, by private purchases, Figure 4.10 Health-Care Spending as a Percentage of U
.S. Output, 1960–2009 Health care’s share of total U.S. output rose from about 5% in 1960 to 17.6% in 2009. Data for period 1960–1992 from Health Care Finance Association (which was the predecessor to the Centers for Medicare and Medicaid Services); Data for period 1993–2009 from Centers for Medicare and Medicaid Services, Office of the Actuary: National Health Statistics Group https://www.cms.gov/ NationalHealthExpendData/ downloads/tables.pdf. Figure 4.11 Total Spending for Physician Office Visits Total spending on physician office visits is $30 per visit multiplied by 1,000,000 visits per week, which equals $30,000,000. It 4.3 The Market for Health-Care Services 170 Chapter 4 Applications of Demand and Supply or by the government. With health insurance, people agree to pay a fixed amount to the insurer in exchange for the insurer’s agreement to pay for most of the health-care expenses they incur. While insurance plans differ in their specific provisions, let us suppose that all individuals have plans that require them to pay $10 for an office visit; the insurance company will pay the rest. is the shaded area bounded by price and quantity. How will this insurance affect the market for physician office visits? If it costs only $10 for a visit instead of $30, people will visit their doctors more often. The quantity of office visits demanded will increase. In Figure 4.12 "Total Spending for Physician Office Visits Covered by Insurance", this is shown as a movement along the demand curve. Think about your own choices. When you get a cold, do you go to the doctor? Probably not, if it is a minor cold. But if you feel like you are dying, or wish you were, you probably head for the doctor. Clearly, there are lots of colds in between these two extremes. Whether you drag yourself to the doctor will depend on the severity of your cold and what you will pay for a visit. At a lower price, you are more likely to go to the doctor; at a higher price, you are less likely to go. In the case shown, the quantity of office visits rises to 1,500,000 per week. But that suggests a potential problem. The quantity of visits supplied at a price of $30 per visit was 1,000,000. According to supply curve S1, it will take a price of $50 per visit to increase
the quantity supplied to 1,500,000 visits (Point F on S1). But consumers—patients—pay only $10. Insurers make up the difference between the fees doctors receive and the price patients pay. In our example, insurers pay $40 per visit of insured patients to supplement the $10 that patients pay. When an agent other than the seller or the buyer pays part of the price of a good or service, we say that the agent is a thirdparty payer10. Notice how the presence of a third-party payer affects total spending on office visits. When people paid for their own visits, and the price equaled $30 per visit, total spending equaled $30 million per week. Now doctors receive $50 per visit and provide 1,500,000 visits per week. Total spending has risen to $75 million per week ($50 times 1,500,000 visits, shown by the darkly shaded region plus the lightly shaded region). 10. An agent other than the seller or the buyer who pays part of the price of a good or service. 4.3 The Market for Health-Care Services 171 Chapter 4 Applications of Demand and Supply Figure 4.12 Total Spending for Physician Office Visits Covered by Insurance With insurance, the quantity of physician office visits demanded rises to 1,500,000. The supply curve shows that it takes a price of $50 per visit to increase the quantity supplied to 1,500,000 visits. Patients pay $10 per visit and insurance pays $40 per visit. Total spending rises to $75,000,000 per week, shown by the darkly shaded region plus the lightly shaded region. The response described in Figure 4.12 "Total Spending for Physician Office Visits Covered by Insurance" holds for many different types of goods and services covered by insurance or otherwise paid for by third-party payers. For example, the availability of scholarships and subsidized tuition at public and private universities increases the quantity of education demanded and the total expenditures on higher education. In markets with third-party payers, an equilibrium is achieved, but it is not at the intersection of the demand and supply curves. The effect of third-party payers is to decrease the price that consumers directly pay for the goods and services they consume and to increase the price that suppliers receive. Consumers use more than they would in the absence of third-party payers, and providers are encouraged to supply more than they otherwise would. The result is
increased total spending. 4.3 The Market for Health-Care Services 172 Chapter 4 Applications of Demand and Supply • The rising share of the output of the United States devoted to health care represents a rising opportunity cost. More spending on health care means less spending on other goods and services, compared to what would have transpired had health-care spending not risen so much. • The model of demand and supply can be used to show the effect of thirdparty payers on total spending. With third-party payers (for example, health insurers), the quantity of services consumed rises, as does spending. T R Y I T! The provision of university education through taxpayer-supported state universities is another example of a market with a third-party payer. Use the model of demand and supply to discuss the impact this has on the higher education market. Specifically, draw a graph similar to Figure 4.12 "Total Spending for Physician Office Visits Covered by Insurance". How would you label the axes? Show the equilibrium price and quantity in the absence of a third-party payer and indicate total spending on education. Now show the impact of lower tuition As a result of state support for education. How much education do students demand at the lower tuition? How much tuition must educational institutions receive to produce that much education? How much spending on education will occur? Compare total spending before and after a third-party payer enters this market. 4.3 The Market for Health-Care Services 173 Chapter 4 Applications of Demand and Supply Case in Point: The Oregon Plan © 2010 Jupiterimages Corporation The health-care industry presents us with a dilemma. Clearly, it makes sense for people to have health insurance. Just as clearly, health insurance generates a substantial increase in spending for health care. If that spending is to be limited, some mechanism must be chosen to do it. One mechanism would be to require patients to pay a larger share of their own health-care consumption directly, reducing the payments made by third-party payers. Allowing people to accumulate tax-free private medical savings accounts is one way to do this. Another option is to continue the current trend to use insurance companies as the agents that limit spending. A third option is government regulation; this Case in Point describes how the state of Oregon tried to limit health-care spending by essentially refusing to be a third-party payer for certain services. Like all other states, Oregon has wrestled with the problem of soaring Medicaid costs. Its solution to the problem illustrates some of the choices
society might make in seeking to reduce health-care costs. Oregon used to have a plan similar to plans in many other states. Households whose incomes were lower than 50% of the poverty line qualified for Medicaid. In 1987, the state began an effort to manage its Medicaid costs. It decided that it 4.3 The Market for Health-Care Services 174 Chapter 4 Applications of Demand and Supply would no longer fund organ transplants and that it would use the money saved to give better care to pregnant women. The decision turned out to be a painful one; the first year, a seven-year-old boy with leukemia, who might have been saved with a bone marrow transplant, died. But state officials argued that the shift of expenditures to pregnant women would ultimately save more lives. The state gradually expanded its concept of determining what services to fund and what services not to fund. It collapsed a list of 10,000 different diagnoses that had been submitted to its Medicaid program in the past into a list of more than 700 condition-treatment pairs. One such pair, for example, is appendicitisappendectomy. Health-care officials then ranked these pairs in order of priority. The rankings were based on such factors as the seriousness of a particular condition and the cost and efficacy of treatments. The state announced that it would provide Medicaid to all households below the poverty line, but that it would not fund any procedure ranked below a certain level, initially number 588 on its list. The plan also set a budget limit for any one year; if spending rose above that limit, the legislature must appropriate additional money or drop additional procedures from the list of those covered by the plan. The Oregon Health Plan officially began operation in 1994. While the Oregon plan has been applied only to households below the poverty line that are not covered by other programs, it suggests a means of reducing health-care spending. Clearly, if part of the health-care problem is excessive provision of services, a system designed to cut services must determine what treatments not to fund. Professors Jonathan Oberlander, Theodore Marmor, and Lawrence Jacobs studied the impact of this plan in practice through the year 2000 and found that, in contrast to initial expectations, excluded procedures were generally ones of marginal medical value, so the “line in the sand” had little practical significance. In addition, they found that patients were often able to receive supposedly excluded services when physicians, for example, treated an uncovered illness in conjunction with a covered one. During the period of the study, the number of people
covered by the plan expanded substantially and yet rationing of services essentially did not occur. How do they explain this seeming contradiction? Quite simply: state government increased revenues from various sources to support the plan. Indeed, they argue that, because treatments that might not be included were explicitly stated, political pressure made excluding them even more difficult and may have inadvertently increased the cost of the program. 4.3 The Market for Health-Care Services 175 Chapter 4 Applications of Demand and Supply In the early 2000s, Oregon, like many other states, confronted severe budgetary pressures. To limit spending, it chose the perhaps less visible strategy of reducing the number of people covered through the plan. Once serving more than 100,000 people, budget cuts reduced the number served to about 17,000. Whereas in 1996, 11% of Oregonians lacked health insurance, in 2008 16% did. Trailblazing again, in 2008 Oregon realized that its budget allowed room for coverage for a few thousand additional people. But how to choose among the 130,000 eligibles? The solution: to hold a lottery. More than 90,000 people queued up, hoping to be lucky winners. Sources: Jonathan Oberlander, Theodore Marmor, and Lawrence Jacobs, “Rationing Medical Care: Rhetoric and Reality in the Oregon Health Plan,” Canadian Medical Association Journal 164: 11 (May 29, 2001): 1583–1587; William Yardley, “Drawing Lots for Health Care,” The New York Times, March 13, 2008: p. A12 Without a third-party payer for education, the graph shows equilibrium tuition of P1 and equilibrium quantity of education of Q1. State support for education lowers tuition that students pay to P2. As a result, students demand Q2 courses per year. To provide that amount of education, educational institutions require tuition per course of P3. Without a thirdparty payer, spending on education is 0P1EQ1. With a third-party payer, spending rises to 0P3FQ2. 4.3 The Market for Health-Care Services 176 Chapter 4 Applications of Demand and Supply 4.4 Review and Practice Summary In this chapter we used the tools of demand and supply to understand a wide variety of market outcomes. We learned that technological change and the entry of new sellers has caused the supply curve of personal computers to shift markedly to the right, thereby reducing equilibrium price and increasing equilibrium quantity. Market forces have made personal computers a common item in
offices and homes. Crude oil and gasoline prices soared in 2008 and then fell back, rising again in 2011 as a result of the disruption created by the Arab Spring. We looked at the causes of these increases as well as their impacts. Crude oil prices rose in large part As a result of increased demand, particularly from China. Higher prices for crude oil led to higher prices for gasoline. Those higher prices not only hurt consumers of gasoline, they also put upward pressure on the prices of a wide range of goods and services. Crude oil and gasoline prices then decreased dramatically in the last part of 2008, as world growth declined. The model of demand and supply also explains the determination of stock prices. The price per share of corporate stock reflects the market’s estimate of the expected profitability of the firm. Any information about the firm that causes potential buyers or current owners of corporate stock to reevaluate how profitable they think the firm is, or will be, will cause the equilibrium price of the stock to change. We then examined markets in which some form of government price control keeps price permanently above or below equilibrium. A price floor leads to persistent surpluses because it is set above the equilibrium price, whereas a price ceiling, because it is set below the equilibrium price, leads to persistent shortages. We saw that interfering with the market mechanism may solve one problem but often creates other problems at the same time. We discussed what some of these unintended consequences might be. For example, agricultural price floors aimed at boosting farm income have also raised prices for consumers and cost taxpayers dearly, and the bulk of government payments have gone to large farms. Rent controls have lowered rents, but they have also reduced the quantity of rental housing supplied, created shortages, and sometimes led to various forms of “backdoor” payments, which sometimes force the price of rental housing above what would exist in the absence of controls. Finally, we looked at the market for health care and a special feature behind demand and supply in this market that helps to explain why the share of output of the United States that is devoted to health care has risen. Health care is an example of a market in which there are third-party payers (primarily private insurers and the government). With third-party payers the quantity of health-care services consumed rises, as does health-care spending. 177 Chapter 4 Applications of Demand and Supply. Like personal computers, digital cameras have become a common household item. Digital camera prices have plunged in the last 10 years. Use the model of
demand and supply to explain the fall in price and increase in quantity. 2. Enron Corp. was one of several corporations convicted of fraud in its accounting practices during the early part of this decade. It had created dummy corporations to hide massive borrowing and to give it the appearance of extraordinary profitability. Use the model of demand and supply to explain the likely impact of such convictions on the stocks of other corporations. 3. During World War II there was a freeze on wages, and corporations found they could evade the freeze by providing other fringe benefits such as retirement funds and health insurance for their employees. The Office of Price Administration, which administered the wage freeze, ruled that the offer of retirement funds and health literature was not a violation of the freeze. The Internal Revenue Service went along with this and ruled that employer-financed retirement and health insurance plans were not taxable income. Was the wage freeze an example of a price floor or a price ceiling? Use the model of demand and supply to explain why employers began to offer such benefits to their employees. 4. The text argues that political instability in potential suppliers of oil such as Iraq and Venezuela accounts for a relatively steep supply curve for crude oil such as the one shown in Figure 4.2 "Increasing Demand for Crude Oil". Suppose that this instability eases considerably and that the world supply curve for crude oil becomes much flatter. Draw such a curve, and explain its implications for the world economy and for typical consumers. 5. Suppose that technological change affects the dairy industry in the same way it has affected the computer industry. However, suppose that dairy price supports remain in place. How would this affect government spending on the dairy program? Use the model of demand and supply to support your answer. 6. People often argue that there is a “shortage” of child care. Using the model of demand and supply, evaluate whether this argument is likely to be correct. 7. “During most of the past 50 years the United States has had a surplus of farmers, and this has been the root of the farm problem.” Comment. 8. Suppose the Department of Agriculture ordered all farmers to reduce the acreage they plant by 10%. Would you expect a 10% reduction in food production? Why or why not? 4.4 Review and Practice 178 Chapter 4 Applications of Demand and Supply 9. The text argues that the increase in gasoline prices had a particularly strong impact on low-income people. Name some other goods and services for which a sharp increase in price would have a similar
impact on people with low incomes. 10. Suppose that the United States and the European Union impose a price ceiling on crude oil of $25 per barrel. Explain, and illustrate graphically, how this would affect the markets for crude oil and for gasoline in the United States and in the European Union. 11. Given that rent controls can actually hurt low-income people, devise a housing strategy that would provide affordable housing for those whose incomes fall below the poverty line (in 2010, this was about $22,314 for a family of four). 12. Using the model of demand and supply, show and explain how an increase in the share individuals must pay directly for medical care affects the quantity they consume. Explain how this would address the total amount of spending on health care. 13. Given that people pay premiums for their health insurance, how can we say that insurance lowers the prices people pay for health-care services? 14. Suppose that physicians now charge $30 for an office visit and insurance policies require patients to pay 33 1/3% of the amount they pay the physicians, so the out-of-pocket cost to consumers is $10 per visit. In an effort to control costs, the government imposes a price ceiling of $27 per office visit. Using a demand and supply model, show how this policy would affect the market for health care. 15. Do you think the U.S. health-care system requires reform? Why or why not? If you think reform is in order, explain the approach to reform you advocate. 4.4 Review and Practice 179 Chapter 4 Applications of Demand and Supply Problems 1–4 are based on the following demand and supply schedules for corn (all quantities are in millions of bushels per year). Price per bushel Quantity demanded Quantity supplied $. Draw the demand and supply curves for corn. What is the equilibrium price? The equilibrium quantity? 2. Suppose the government now imposes a price floor at $4 per bushel. Show the effect of this program graphically. How large is the surplus of corn? 3. With the price floor, how much do farmers receive for their corn? How much would they have received if there were no price floor? If the government buys all the surplus wheat, how much will it spend? 4. Problems 5–9 are based on the following hypothetical demand and supply curves for apartments Rent/Month Number of Apts. Number of Apts. Demanded/Month Supplied/Month $0 200 400 600 800 120,000 100,
000 80,000 60,000 40,000 0 20,000 40,000 60,000 80,000 4.4 Review and Practice 180 Chapter 4 Applications of Demand and Supply Rent/Month Number of Apts. Number of Apts. Demanded/Month Supplied/Month 1000 1200 20,000 0 100,000 120,000 1. Draw the demand and supply curves for apartments. 2. What is the equilibrium rent per month? At this rent, what is the number of apartments demanded and supplied per month? 3. Suppose a ceiling on rents is set at $400 per month. Characterize the situation that results from this policy. 4. At the rent ceiling, how many apartments are demanded? How many are supplied? 5. How much are people willing to pay for the number of apartments supplied at the ceiling? Describe the arrangements to which this situation might lead. 4.4 Review and Practice 181 Chapter 5 Macroeconomics: The Big Picture Start Up: Economy Limps Along The U.S. economy seemed to be doing well overall after the recession of 2001. Growth had been normal, unemployment had stayed low, and inflation seemed to be under control. The economy began to unravel at the end of 2007—total output fell in the fourth quarter and again in the first quarter of 2008. It recovered—barely—in the second quarter. Then things went sour…very sour. The economies of the United States and those of much of the world were rocked by the worst financial crisis in nearly 80 years. A good deal of the U.S. economy’s momentum when things were going well had been fueled by rising house prices. Between 1995 and 2007, housing prices in the United States more than doubled. As house prices rose, consumers who owned houses felt wealthier and increased their consumption purchases. That helped fuel economic growth. The boom in housing prices had been encouraged by policies of the nation’s monetary authority, the Federal Reserve, which had shifted to an expansionary monetary policy that held short-term interest rates below the inflation rate. Another development, subprime mortgages—mortgage loans to buyers whose credit or income would not ordinarily qualify for mortgage loans—helped bring on the ultimate collapse. When they were first developed, subprime mortgage loans seemed a hugely profitable investment for banks and a good deal for home buyers. Financial institutions developed a wide range of instruments based on “mortgage-backed securities.” As long as house prices kept rising, the system worked and was
profitable for virtually all players in the mortgage market. Many firms undertook investments in mortgage-backed securities that assumed house prices would keep rising. Large investment banks bet heavily that house prices would continue rising. Powerful members of Congress pressured two government-sponsored enterprises, Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), to be even more aggressive in encouraging banks to make mortgage loans to low-income families. The pressure came from the executive branch of government as well—under both Democratic and Republican administrations. In 1996, the Department of Housing and Urban Development (under Bill Clinton, a Democrat) required that 12% of mortgages purchased by Fannie Mae and Freddie Mac be for households with incomes less than 60% of the median income in their region. That target was increased to 20% in 2000, 22% in 2005 (then under George 182 Chapter 5 Macroeconomics: The Big Picture W. Bush, a Republican), and was to have increased to 28% in 2008.Russell Roberts, “How Government Stoked the Mania,” Wall Street Journal, October 3, 2008, p. A21. But that final target would not be reached, as both Fannie Mae and Freddie Mac were seized by the government in 2008. To top things off, a loosening in bank and investment bank regulations gave financial institutions greater leeway in going overboard with purchases of mortgage-backed securities. As house prices began falling in 2007, a system based on the assumption they would continue rising began to unravel very fast. The investment bank Bear Stearns and insurance company American International Group (AIG) required massive infusions of federal money to keep them afloat. In September of 2008, firm after firm with assets tied to mortgage-backed securities began to fail. In some cases, the government rescued them; in other cases, such as Lehman Brothers, they were allowed to fail. The financial crisis had dramatic and immediate effects on the economy. The economy’s total output fell at an annual rate of 3.7% in the third quarter of 2008 and 8.9% in the fourth quarter of 2008. Consumers, having weathered higher gasoline prices and higher food prices for most of the year, reduced their consumption expenditures as the value of their houses and the stocks they held plunged—consumption fell at an annual rate of 3.8% in the third quarter and 5.1% in the fourth quarter. As cold fear gripped financial markets and expectations of further slowdown ensued, firms cut down
on investment spending, which includes spending on plant and equipment used in production. While this nonresidential investment component of output fell at an annual rate of 0.8%, the residential component fell even faster as housing investment sank at an annual rate of 23.9%. Government purchases and net exports rose, but not enough to offset reductions in consumption and private investment. As output shrank, unemployment rose sharply. Through the first nine months of 2008 there was concern that price levels in the United States and in most of the world economies were rising rapidly, but toward the end of the year the concern shifted to whether or not the price level might fall. This recession, which officially began in December 2007 and ended in June 2009, was brutal: At 18 months in length, it was the longest U.S. recession since World War II. The nation’s output fell by more than 5%. The unemployment rate rose dramatically, hitting 10% in October 2009 and remaining above 9% throughout 2010. To many people in 2010 and 2011, it certainly did not feel as if the “Great Recession,” as many had begun to refer to it, had really ended. The unemployment rate had come down some but still remained elevated. Housing prices still seemed to be falling or, at best, crawling along a floor. There was, though, a little good news at the end of 2011: real GDP had increased at an annual rate of 3.0% in the fourth quarter, the largest quarterly increase that year. For the entire year, however, real GDP had risen by just 1.7%. 183 Chapter 5 Macroeconomics: The Big Picture Even the relatively good news in the fourth quarter came with a sour note: most of the increase in GDP had come as firms had increased their inventories, and economists warned that growth was likely to slow in 2012 as firms began cutting back on those expanded inventories. Sure enough, real GDP increased at an annual rate of just 1.9% in the first quarter of 2012, according to the Commerce Department. An important question, of course, is why the recovery has been so slow. Since the recovery began in June 2009, this has been the slowest recovery since World War II. Several factors have contributed to the slow pace of expansion. First, the financial crisis that developed in 2008, as mentioned, was particularly severe. Financial crises shake confidence and limit investment. Uncertainty was also created by increased government regulation of economic activity and by the possibility of increased taxes. Furthermore, the impact of
massive government debts—propelled by government deficits going into the recession, the fall in revenue due to the recession, and massive government stimulus programs in response to the recession—added to a general uncertainty about what future policies might be required. Domestic political battles may have contributed to this uncertainty as well. External factors, such as economic crises in Europe and the rising price of oil, also threatened the economy. Output, employment, and the price level are the key variables in the study of macroeconomics, which is the analysis of aggregate values of economic variables. What determines a country’s output, and why does output in some economies expand while in others it contracts? Why do some economies grow faster than others? What causes prices throughout an economy to fluctuate, and how do such fluctuations affect people? What causes employment and unemployment? Why does a country’s unemployment rate fluctuate? Why do different countries have different unemployment rates? We would pronounce an economy “healthy” if its annual output of goods and services were growing at a rate it can sustain, its price level stable, and its unemployment rate low. What would constitute “good” numbers for each of these variables depends on time and place, but those are the outcomes that most people would agree are desirable for the aggregate economy. When the economy deviates from what is considered good performance, there are often calls for the government to “do something” to improve performance. How government policies affect economic performance is a major topic of macroeconomics. When the financial and economic crises struck throughout the world in 2008, there was 184 Chapter 5 Macroeconomics: The Big Picture massive intervention from world central banks and from governments throughout the world in an effort to stimulate their economies. This chapter provides a preliminary sketch of the most important macroeconomic issues: growth of total output and the business cycle, changes in the price level, and unemployment. Grappling with these issues will be important to you not only in your exploration of macroeconomics but throughout your life. 185 Chapter 5 Macroeconomics: The Big Picture 5.1 Growth of Real GDP and Business Cycles. Define real gross domestic product and explain how its calculation avoids both double-counting and the effects of changes in the price level. Identify the phases of a business cycle. 2. 3. Relate business cycles to the overall long-run trend in real GDP in the United States. To determine whether the economy of a nation is growing or shrinking in size, economists use a measure of
total output called real GDP. Real GDP1, short for real gross domestic product, is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices. Let us break that definition up into parts. Notice that only “final” goods and services are included in GDP. Many goods and services are purchased for use as inputs in producing something else. For example, a pizza parlor buys flour to make pizzas. If we counted the value of the flour and the value of the pizza, we would end up counting the flour twice and thus overstating the value of total production. Including only final goods avoids double-counting. If the flour is produced during a particular period but has not been sold, then it is a “final good” for that period and is counted. We want to determine whether the economy’s output is growing or shrinking. If each final good or service produced, from hammers to haircuts, were valued at its current market price, and then we were to add the values of all such items produced, we would not know if the total had changed because output changed or because prices changed or both. The market value of all final goods and services produced can rise even if total output falls. To isolate the behavior of total output only, we must hold prices constant at some level. For example, if we measure the value of basketball output over time using a fixed price for valuing the basketballs, then only an increase in the number of basketballs produced could increase the value of the contribution made by basketballs to total output. By making such an adjustment for basketballs and all other goods and services, we obtain a value for real GDP. In contrast, nominal GDP2, usually just referred to as gross domestic product (GDP), is the total value of final goods and services for a particular period valued in terms of prices for that period. For example, real GDP fell in the third 186 1. The total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices. 2. The total value of final goods and services for a particular period valued in terms of prices for that period. Chapter 5 Macroeconomics: The Big Picture quarter of 2008. But, because the price level in the United States was rising, nominal GDP rose 3.6%. We will save a detailed discussion of the computation of GDP for another chapter. In this section,
our goal is to use the concept of real GDP to look at the business cycle3—the economy’s pattern of expansion, then contraction, then expansion again—and at growth of real GDP. Phases of the Business Cycle Figure 5.1 "Phases of the Business Cycle" shows a stylized picture of a typical business cycle. It shows that economies go through periods of increasing and decreasing real GDP, but that over time they generally move in the direction of increasing levels of real GDP. A sustained period in which real GDP is rising is an expansion4; a sustained period in which real GDP is falling is a recession5. Typically, an economy is said to be in a recession when real GDP drops for two consecutive quarters, but in the United States, the responsibility of defining precisely when the economy is in recession is left to the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The committee defines a recession as a “significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”“The NBER’s Recession Dating Procedure,” National Bureau of Economic Research, January 7, 2008. At time t1 in Figure 5.1 "Phases of the Business Cycle", an expansion ends and real GDP turns downward. The point at which an expansion ends and a recession begins is called the peak6 of the business cycle. Real GDP then falls during a period of recession. Eventually it starts upward again (at time t2). The point at which a recession ends and an expansion begins is called the trough7 of the business cycle. The expansion continues until another peak is reached at time t3.Some economists prefer to break the expansion phase into two parts. The recovery phase is said to be the period between the previous trough and the time when the economy achieves its previous peak level of real GDP. The “expansion” phase is from that point until the following peak. A complete business cycle is defined by the passage from one peak to the next. Figure 5.1 Phases of the Business Cycle The business cycle is a series of expansions and contractions in real GDP. The cycle begins at a 3. The economy’s pattern of expansion, then contraction, then expansion again. 4. A sustained period in which real GDP is rising. 5. A sustained period in which real GDP is falling. 6. The point
of the business cycle at which an expansion ends and a recession begins. 7. The point of the business cycle at which a recession ends and an expansion begins. 5.1 Growth of Real GDP and Business Cycles 187 Chapter 5 Macroeconomics: The Big Picture Because the Business Cycle Dating Committee dates peaks and troughs by specific months, and because real GDP is estimated only on a quarterly basis by the Bureau of Economic Analysis, the committee relies on a variety of other indicators that are published monthly, including real personal income, employment, industrial production, and real wholesale and retail sales. The committee typically determines that a recession has happened long after it has actually begun and sometimes ended! In large part, that avoids problems when data released about the economy are revised, and the committee avoids having to reverse itself on its determination of when a recession begins or ends, something it has never done. In December 2008, the committee announced that a recession in the United States had begun in December 2007. In September 2010, the committee announced that this recession had ended in June 2009. peak and continues through a recession, a trough, and an expansion. A new cycle begins at the next peak. Here, the first peak occurs at time t1, the trough at time t2, and the next peak at time t3. Notice that there is a tendency for real GDP to rise over time. Business Cycles and the Growth of Real GDP in the United States Figure 5.2 "Expansions and Recessions, 1960–2011" shows movements in real GDP in the United States from 1960 to 2011. Over those years, the economy experienced eight recessions, shown by the shaded areas in the chart. Although periods of expansion have been more prolonged than periods of recession, we see the cycle of economic activity that characterizes economic life. Figure 5.2 Expansions and Recessions, 1960–2011 The chart shows movements in real GDP since 1960. Recessions—periods of falling real GDP—are shown as shaded areas. On average, the annual rate of growth of real GDP over the period was 3.1% per year. 5.1 Growth of Real GDP and Business Cycles 188 Chapter 5 Macroeconomics: The Big Picture Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012). Real Gross Domestic Product, Chained Dollars [Billions of chained (2005) dollars]. Seasonally adjusted at annual rates. Real GDP clearly grew between 1960 and 2011. While the
economy experienced expansions and recessions, its general trend during the period was one of rising real GDP. The average annual rate of growth of real GDP was about 3.1%. During the post–World War II period, the average expansion has lasted 58 months, and the average recession has lasted about 11 months. The 2001 recession, which lasted eight months, was thus slightly shorter than the average. The 2007–2009 recession lasted 18 months; it was the longest of the post–World War II period. Economists have sought for centuries to explain the forces at work in a business cycle. Not only are the currents that move the economy up or down intellectually fascinating but also an understanding of them is of tremendous practical importance. A business cycle is not just a movement along a curve in a textbook. It is new jobs for people, or the loss of them. It is new income, or the loss of it. It is the funds to build new schools or to provide better health care—or the lack of funds to do all those things. The story of the business cycle is the story of progress and plenty, of failure and sacrifice. During the most recent recession, the job outlook for college graduates deteriorated. According to a National Association of Colleges and Employers study, 20% of college graduates seeking jobs were able to obtain one after graduation in 2009. In 2010, that percentage rose to 24%, but the average salary had slipped 1.7% from the previous year. The unemployment rate for college graduates under age 25 rose from 3.7% in April 2007 to 8% in April 2010. Over the same two-year period, the unemployment rate for high school graduates who had never enrolled in college rose from 11.4% to 24.5%.Steven Greenhouse, “Job Market Gets Better for U.S. Graduates, but Only Slightly: Offers Will Increase 5% Over Last Year; Average Starting Salaries Are Down,” The International Herald Tribune, May 26, 2010, Finance 16. The effects of recessions extend beyond the purely economic realm and influence the social fabric of society as well. Suicide rates and property crimes—burglary, larceny, and motor vehicle theft tend to rise during recessions. Even popular music appears to be affected. Terry F. Pettijohn II, a psychologist at Coastal Carolina University, has studied Billboard No. 1 songs from 1955 to 2003. He finds that during recessions, popular songs tend to be longer and slower, and to have more serious lyrics. �
�It’s ‘Bridge over Troubled Water’ or ‘That’s What Friends Are For’,” he says. During expansions, songs tend to be faster, shorter, and somewhat sillier, such as 5.1 Growth of Real GDP and Business Cycles 189 Chapter 5 Macroeconomics: The Big Picture “At the Hop” or “My Sharona.”Tamar Lewin, “A Hemline Index, Updated,” New York Times, October 19, 2008, Section WK, 1. In our study of macroeconomics, we will gain an understanding of the forces at work in the business cycle. We will also explore policies through which the public sector might act to make recessions less severe and, perhaps, to prolong expansions. We turn next to an examination of price-level changes and unemployment • Real gross domestic product (real GDP) is a measure of the value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of price changes. • The economy follows a path of expansion, then contraction, then expansion again. These fluctuations make up the business cycle. • The point at which an expansion becomes a recession is called the peak of a business cycle; the point at which a recession becomes an expansion is called the trough. • Over time, the general trend for most economies is one of rising real GDP. On average, real GDP in the United States has grown at a rate of over 3% per year since 1960. 5.1 Growth of Real GDP and Business Cycles 190 Chapter 5 Macroeconomics: The Big Picture T R Y I T! The data below show the behavior of real GDP in Turkey from the first quarter of 2001 through the third quarter of 2002. Use the data to plot real GDP in Turkey and indicate the phases of the business cycle. Period Real GDP (billions of New Turkish lira, 1987 prices) First quarter, 2001 Second quarter, 2001 Third quarter, 2001 Fourth quarter, 2001 First quarter, 2002 Second quarter, 2002 Third quarter, 2002 24.1 26.0 33.1 27.1 24.6 28.3 35.7 5.1 Growth of Real GDP and Business Cycles 191 Chapter 5 Macroeconomics: The Big Picture Case in Point: The Art of Predicting Recessions People who make a living tracking the economy and trying to predict its future do not do a very good job at predicting turning points in economic activity. The
52 economists surveyed by the Wall Street Journal each month did predict that the economy would slip into a recession in the third quarter of 2008. They made that prediction, however, in October—after the third quarter had ended. In September, the last month of the third quarter, the average forecast among the 52 economists had the economy continuing to grow through the third and fourth quarters of 2008. That September survey was taken before the financial crisis hit, a crisis that took virtually everyone by surprise. Of course, as we have already noted, the third-quarter downturn had not been identified as a recession by the NBER’s Business Cycle Dating Committee as of November of 2008. Predicting business cycle turning points has always been a tricky business. The experience of the recession of 2001 illustrates this. As the accompanying table shows, even as late as September 10, 2001, only 13 out of the 100 Blue Chip forecasters had answered in the affirmative to the question, “Has the United States slipped into a recession?” even though we now know the recession had begun the previous March. Comparing the data that were originally released by the U.S. Bureau of Economic Analysis shortly after the end of each quarter with the revised data that were released after July 2002 provides an important insight into explaining why the forecasters seem to have done so badly. As the graph on pre-revision and post-revision estimates of real GDP growth shows, the data released shortly after the end of each quarter showed an economy 5.1 Growth of Real GDP and Business Cycles 192 Chapter 5 Macroeconomics: The Big Picture expanding through the second quarter of 2001, whereas the revised data show the economy contracting modestly in the first quarter of 2001 and then more forcefully in the second quarter. Only after the attacks on the World Trade Center in New York City and the Pentagon in Washington, D.C., on September 11, 2001, did most of the Blue Chip forecasters realize the economy was in recession. The National Bureau of Economic Research (NBER) Business Cycle Dating Committee in November 2001 released a press announcement dating the onset of the recession as March 2001. The committee argued that “before the attacks of September 11, it is possible that the decline in the economy would have been too mild to qualify as a recession. The attacks clearly deepened the contraction and may have been an important factor in turning the episode into a recession.” While surprising at the time, the revised data suggest that the committee made a good call. This episode
in economic history also points out the difference between the common definition of a recession as two consecutive quarters of declining real GDP and the NBER Dating Committee’s continued insistence that it does not define a recession in this way. Rather the committee looks not only at real GDP but also at employment, income, and other factors. The behavior of employment during 2001 seems to have been an important factor in the November 2001 decision to proclaim March 2001 as the peak despite the misleading information on real GDP coming out of the Bureau of Economic Analysis at the time. The slow pickup in employment may also, though, have made it hesitate to call November 2001 the trough until July 2003. Question posed: “Has the United States slipped into a recession?” Percent of Blue Chip responders answering “Yes” Percent of Blue Chip responders answering “No” 5 7 13 5 95 93 87 85 Date February 2001 June 2001 July 2001 August 2001 5.1 Growth of Real GDP and Business Cycles 193 Chapter 5 Macroeconomics: The Big Picture Question posed: “Has the United States slipped into a recession?” Date Percent of Blue Chip responders answering “Yes” Percent of Blue Chip responders answering “No” September 10, 2001 September 19, 2001 13 82 87 18 Sources: Phil Izzo, “Economists Expect Crisis to Deepen,” Wall Street Journal Online, October 10, 2008; Kevin L. Kliesen, “The 2001 Recession: How Was It Different and What Developments May Have Caused It?” Federal Reserve Bank of St. Louis Review, September/October 2003: 23–37; http://www.nber.org/cycles/; “Press Release,” Business Cycle Dating Committee, National Bureau of Economic Research, press release, Cambridge, Massachusetts, July 17, 2002. 5.1 Growth of Real GDP and Business Cycles 194 Chapter 5 Macroeconomics: The Big Picture.1 Growth of Real GDP and Business Cycles 195 Chapter 5 Macroeconomics: The Big Picture 5.2 Price-Level Changes. Define inflation and deflation, explain how their rates are determined, and articulate why price-level changes matter. 2. Explain what a price index is and outline the general steps in computing a price index. 3. Describe and compare different price indexes. 4. Explain how to convert nominal values to real values and explain why it is useful to make this calculation. 5. Discuss the biases that may arise from price indexes that
employ fixed market baskets of goods and services. Concern about changes in the price level has always dominated economic discussion. With inflation in the United States generally averaging only between 2% and 3% each year since 1990, it may seem surprising how much attention the behavior of the price level still commands. Yet inflation was a concern in 2004 when there was fear that the rising price of oil could trigger higher prices in other areas. Just the year before, when inflation fell below 2%, there was talk about the risk of deflation. That did not happen; prices continued rising. Inflation rose substantially in the first half of 2008, renewing fears about subsequent further increases. And 2010 brought renewed concern of possible deflation. Just what are inflation and deflation? How are they measured? And most important, why do we care? These are some of the questions we will explore in this section. Inflation8 is an increase in the average level of prices, and deflation9 is a decrease in the average level of prices. In an economy experiencing inflation, most prices are likely to be rising, whereas in an economy experiencing deflation, most prices are likely to be falling. There are two key points in these definitions: 1. Inflation and deflation refer to changes in the average level of prices, not to changes in particular prices. An increase in medical costs is not inflation. A decrease in gasoline prices is not deflation. Inflation means the average level of prices is rising, and deflation means the average level of prices is falling. 196 8. An increase in the average level of prices. 9. A decrease in the average level of prices. Chapter 5 Macroeconomics: The Big Picture 2. Inflation and deflation refer to rising prices and falling prices, respectively; therefore, they do not have anything to do with the level of prices at any one time. “High” prices do not imply the presence of inflation, nor do “low” prices imply deflation. Inflation means a positive rate of change in average prices, and deflation means a negative rate of change in average prices. Why Do We Care? What difference does it make if the average level of prices changes? First, consider the impact of inflation. Inflation is measured as the annual rate of increase in the average level of prices. Figure 5.3 "Inflation, 1960–2011" shows how volatile inflation has been in the United States over the past four decades. In the 1960s the inflation rate rose, and it became dramatically worse in the 1970s. The inflation rate plunged
in the 1980s and continued to ease downward in the 1990s. It remained low in the early 2000s, began to accelerate in 2007, and has remained low since then. Figure 5.3 Inflation, 1960–2011 The U.S. inflation rate, measured as the annual rate of change in the average level of prices paid by consumers, varied considerably over the 1960–2011 period. Source: Bureau of Labor Statistics, All Urban Consumers CPI-U, 1982–84 = 100, Dec.–Dec. inflation rate. 5.2 Price-Level Changes 197 Chapter 5 Macroeconomics: The Big Picture Whether one regards inflation as a “good” thing or a “bad” thing depends very much on one’s economic situation. If you are a borrower, unexpected inflation is a good thing—it reduces the value of money that you must repay. If you are a lender, it is a bad thing because it reduces the value of future payments you will receive. Whatever any particular person’s situation may be, inflation always produces the following effects on the economy: it reduces the value of money and it reduces the value of future monetary obligations. It can also create uncertainty about the future. Suppose that you have just found a $10 bill you stashed away in 1990. Prices have increased by about 50% since then; your money will buy less than what it would have purchased when you put it away. Your money has thus lost value. Money loses value when its purchasing power falls. Since inflation is a rise in the level of prices, the amount of goods and services a given amount of money can buy falls with inflation. Just as inflation reduces the value of money, it reduces the value of future claims on money. Suppose you have borrowed $100 from a friend and have agreed to pay it back in one year. During the year, however, prices double. That means that when you pay the money back, it will buy only half as much as it could have bought when you borrowed it. That is good for you but tough on the person who lent you the money. Of course, if you and your friend had anticipated such rapid inflation, you might have agreed to pay back a larger sum to adjust for it. When people anticipate inflation, they can adjust for its consequences in determining future obligations. But unanticipated inflation helps borrowers and hurts lenders. Inflation’s impact on future claims can be particularly hard on people who must live on a fixed income, that is, on an income
that is predetermined through some contractual arrangement and does not change with economic conditions. An annuity, for example, typically provides a fixed stream of money payments. Retirement pensions sometimes generate fixed income. Inflation erodes the value of such payments. Given the danger posed by inflation for people on fixed incomes, many retirement plans provide for indexed payments. An indexed payment is one whose dollar amount changes with the rate of change in the price level. If a payment changes at the same rate as the rate of change in the price level, the purchasing power of the payment remains constant. Social Security payments, for example, are indexed to maintain their purchasing power. 5.2 Price-Level Changes 198 Chapter 5 Macroeconomics: The Big Picture Because inflation reduces the purchasing power of money, the threat of future inflation can make people reluctant to lend for long periods. From a lender’s point of view, the danger of a long-term commitment of funds is that future inflation will wipe out the value of the amount that will eventually be paid back. Lenders are reluctant to make such commitments. Uncertainty can be particularly pronounced in countries where extremely high inflation is a threat. Hyperinflation10 is generally defined as an inflation rate in excess of 200% per year. It is always caused by the rapid printing of money. Several countries have endured episodes of hyperinflation. The worst case was in Hungary immediately after World War II, when Hungary’s price level was tripling every day. The second-worst case of hyperinflation belongs to Zimbabwe, which is the first country to have experienced hyperinflation in the 21st century. Zimbabwe’s price index was doubling daily: a loaf of bread that cost 200,000 Zimbabwe dollars in February 2008 cost 1.6 trillion Zimbabwe dollars by August.“Zimbabwe Inflation Hits 11,200,000%,” CNN.com, August 19, 2008, available at http://edition.cnn.com/ 2008/BUSINESS/08/19/zimbabwe.inflation/index.html. The annual inflation rate reached 89.7 sextillion percent in November of that year.Steve H. Hanke, “R.I.P. Zimbabwe Dollar,” Cato Institute, May 3, 2010, available at http://www.cato.org/ zimbabwe. (On the off chance you haven’t been counting in the sextillions a lot lately, 89.7 sextillion equates to 897 followed by
20 zeroes.) Two months later, Zimbabwe finally gave up on printing money and took the Zimbabwe dollar out of circulation. Exchange is now carried out using U.S. dollars or South African rand—and Zimbabwe’s period of hyperinflation has come to an end. Do the problems associated with inflation imply that deflation would be a good thing? The answer is simple: no. Like inflation, deflation changes the value of money and the value of future obligations. It also creates uncertainty about the future. If there is deflation, the real value of a given amount of money rises. In other words, if there had been deflation since 2000, a $10 bill you had stashed away in 2000 would buy more goods and services today. That sounds good, but should you buy $10 worth of goods and services now when you would be able to buy even more for your $10 in the future if the deflation continues? When Japan experienced deflation in the late 1990s and early 2000s, Japanese consumers seemed to be doing just that—waiting to see if prices would fall further. They were spending less per person and, as we will see throughout our study of macroeconomics, less consumption often meant less output, fewer jobs, and the prospect of a recurring recession. 10. An inflation rate in excess of 200% per year. And, if you had to use the $10 to pay back a debt you owed, the purchasing power of your money would be higher than when you borrowed the money. The lender 5.2 Price-Level Changes 199 Chapter 5 Macroeconomics: The Big Picture would feel good about being able to buy more with the $10 than you were able to, but you would feel like you had gotten a raw deal. Unanticipated deflation hurts borrowers and helps lenders. If the parties anticipate the deflation, a loan agreement can be written to reflect expected changes in the price level. The threat of deflation can make people reluctant to borrow for long periods. Borrowers become reluctant to enter into long-term contracts because they fear that deflation will raise the value of the money they must pay back in the future. In such an environment, firms may be reluctant to borrow to build new factories, for example. This is because they fear that the prices at which they can sell their output will drop, making it difficult for them to repay their loans. Deflation was common in the United States in the latter third of the 19th century. In the 20th century, there was a period of deflation after
World War I and again during the Great Depression in the 1930s. Price Indexes How do we actually measure inflation and deflation (that is, changes in the price level)? Price-level change is measured as the percentage rate of change in the level of prices. But how do we find a price level? Economists measure the price level with a price index. A price index11 is a number whose movement reflects movement in the average level of prices. If a price index rises 10%, it means the average level of prices has risen 10%. There are four steps one must take in computing a price index: 1. Select the kinds and quantities of goods and services to be included in the index. A list of these goods and services, and the quantities of each, is the “market basket” for the index. 2. Determine what it would cost to buy the goods and services in the market basket in some period that is the base period for the index. A base period12 is a time period against which costs of the market basket in other periods will be compared in computing a price index. Most often, the base period for an index is a single year. If, for example, a price index had a base period of 1990, costs of the basket in other periods would be compared to the cost of the basket in 1990. We will 11. A number whose movement reflects movement in the average level of prices. 12. A time period against which costs of the market basket in other periods will be compared in computing a price index. 5.2 Price-Level Changes 200 Chapter 5 Macroeconomics: The Big Picture encounter one index, however, whose base period stretches over three years. 3. Compute the cost of the market basket in the current period. 4. Compute the price index. It equals the current cost divided by the base-period cost of the market basket. Equation 5.1 Price index = current cost of basket/base-period cost of basket (While published price indexes are typically reported with this number multiplied by 100, our work with indexes will be simplified by omitting this step.) Suppose that we want to compute a price index for movie fans, and a survey of movie watchers tells us that a typical fan rents 4 movies on DVD and sees 3 movies in theaters each month. At the theater, this viewer consumes a medium-sized soft drink and a medium-sized box of popcorn. Our market basket thus might include 4 DVD rentals, 3 movie admissions, 3 medium soft drinks,
and 3 medium servings of popcorn. Our next step in computing the movie price index is to determine the cost of the market basket. Suppose we surveyed movie theaters and DVD-rental stores in 2011 to determine the average prices of these items, finding the values given in Table 5.1 "Pricing a Market Basket". At those prices, the total monthly cost of our movie market basket in 2011 was $48. Now suppose that in 2012 the prices of movie admissions and DVD rentals rise, soft-drink prices at movies fall, and popcorn prices remain unchanged. The combined effect of these changes pushes the 2012 cost of the basket to $50.88. Table 5.1 Pricing a Market Basket Item DVD rental Movie admission Popcorn Soft drink Quantity in Basket 4 3 3 3 2011 Price $2.25 7.75 2.25 3.00 Cost in 2011 Basket $9.00 23.25 6.75 9.00 2012 Price $2.97 8.00 2.25 2.75 Cost in 2012 Basket $11.88 24.00 6.75 8.25 5.2 Price-Level Changes 201 Chapter 5 Macroeconomics: The Big Picture Item Quantity in Basket 2011 Price Cost in 2011 Basket 2012 Price Cost in 2012 Basket Total cost of basket 2011 $48.00 2012 $50.88 To compute a price index, we need to define a market basket and determine its price. The table gives the composition of the movie market basket and prices for 2011 and 2012. The cost of the entire basket rises from $48 in 2011 to $50.88 in 2012. Using the data in Table 5.1 "Pricing a Market Basket", we could compute price indexes for each year. Recall that a price index is the ratio of the current cost of the basket to the base-period cost. We can select any year we wish as the base year; take 2011. The 2012 movie price index (MPI) is thus MPI2012 = $50.88/$48 = 1.06 The value of any price index in the base period is always 1. In the case of our movie price index, the 2011 index would be the current (2011) cost of the basket, $48, divided by the base-period cost, which is the same thing: $48/$48 = 1. The Consumer Price Index (CPI) One widely used price index in the United States is the consumer price index (CPI)13, a price
index whose movement reflects changes in the prices of goods and services typically purchased by consumers. When the media report the U.S. inflation rate, the number cited is usually a rate computed using the CPI. The CPI is also used to determine whether people’s incomes are keeping up with the costs of the things they buy. The CPI is often used to measure changes in the cost of living, though as we shall see, there are problems in using it for this purpose. The market basket for the CPI contains thousands of goods and services. The composition of the basket is determined by the Bureau of Labor Statistics (BLS), an agency of the Department of Labor, based on Census Bureau surveys of household buying behavior. Surveyors tally the prices of the goods and services in the basket each month in cities all over the United States to determine the current cost of the basket. The major categories of items in the CPI are food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. 13. A price index whose movement reflects changes in the prices of goods and services typically purchased by consumers. The current cost of the basket of consumer goods and services is then compared to the base-period cost of that same basket. The base period for the CPI is 1982–1984; 5.2 Price-Level Changes 202 Chapter 5 Macroeconomics: The Big Picture the base-period cost of the basket is its average cost over this period. Each month’s CPI thus reflects the ratio of the current cost of the basket divided by its baseperiod cost. Equation 5.2 CPI = current cost of basket/1982–1984 cost of basket Like many other price indexes, the CPI is computed with a fixed market basket. The composition of the basket generally remains unchanged from one period to the next. Because buying patterns change, however, the basket is revised accordingly on a periodic basis. The base period, though, was still 1982–1984. The Implicit Price Deflator Values for nominal and real GDP, described earlier in this chapter, provide us with the information to calculate the most broad-based price index available. The implicit price deflator14, a price index for all final goods and services produced, is the ratio of nominal GDP to real GDP. In computing the implicit price deflator for a particular period, economists define the market basket quite simply: it includes all the final goods and services produced during that period. The nominal GDP gives the current cost of that basket; the real GDP
adjusts the nominal GDP for changes in prices. The implicit price deflator is thus given by Equation 5.3 Implicit price deflator = nominal GDP/real GDP For example, in 2011, nominal GDP in the United States was $15,094.5 billion, and real GDP was $13,315.3 billion. Thus, the implicit price deflator was 1.134. Following the convention of multiplying price indexes by 100, the published number for the implicit price deflator was 113.4. In our analysis of the determination of output and the price level in subsequent chapters, we will use the implicit price deflator as the measure of the price level in the economy. 14. A price index for all final goods and services produced; it is the ratio of nominal GDP to real GDP. 5.2 Price-Level Changes 203 Chapter 5 Macroeconomics: The Big Picture The PCE Price Index The Bureau of Economic Analysis also produces price index information for each of the components of GDP (that is, a separate price index for consumer prices, prices for different components of gross private domestic investment, and government spending). The personal consumption expenditures price index15, or PCE price index, includes durable goods, nondurable goods, and services and is provided along with estimates for prices of each component of consumption spending. Because prices for food and energy can be volatile, the price measure that excludes food and energy is often used as a measure of underlying, or “core,” inflation. Note that the PCE price index differs substantially from the consumer price index, primarily because it is not a “fixed basket” index.For a comparison of price measures, including a comparison of the PCE price index and the Consumer Price Index, see Brian C. Moyer, “Comparing Price Measures—The CPI and PCE Price Index” (lecture, National Association for Business Economics, 2006 Washington Economic Policy Conference, March 13–14, 2006), available at http://www.bea.gov/ papers/pdf/Moyer_NABE.pdf. The PCE price index has become a politically important measure of inflation since the Federal Reserve (discussed in detail in later chapters) uses it as its primary measure of price levels in the United States. Computing the Rate of Inflation or Deflation The rate of inflation or deflation is the percentage rate of change in a price index between two periods. Given price-index values for two periods, we can calculate the rate of inflation or
deflation as the change in the index divided by the initial value of the index, stated as a percentage: Equation 5.4 Rate of inflation or deflation = percentage change in index/initial value of index To calculate inflation in movie prices over the 2011–2012 period, for example, we could apply Equation 5.4 to the price indexes we computed for those two years as follows: Movie inflation rate in 2012 = (1.06 − 1.00) /1.00 = 0.06 = 6% The CPI is often used for calculating price-level change for the economy. For example, the rate of inflation in 2011 can be computed from the December 2010 price level (2.186) and the December 2011 level (2.263): Inflation rate = (2.263 − 2.186) /2.186 = 0.035 = 3.5% 15. A price index that includes durable goods, nondurable goods, and services and is provided along with estimates for prices of each component of consumption spending. 5.2 Price-Level Changes 204 Chapter 5 Macroeconomics: The Big Picture Computing Real Values Using Price Indexes Suppose your uncle started college in 2001 and had a job busing dishes that paid $5 per hour. In 2011 you had the same job; it paid $6 per hour. Which job paid more? At first glance, the answer is straightforward: $6 is a higher wage than $5. But $1 had greater purchasing power in 2001 than in 2011 because prices were lower in 2001 than in 2011. To obtain a valid comparison of the two wages, we must use dollars of equivalent purchasing power. A value expressed in units of constant purchasing power is a real value16. A value expressed in dollars of the current period is called a nominal value17. The $5 wage in 2001 and the $6 wage in 2011 are nominal wages. To convert nominal values to real values, we divide by a price index. The real value for a given period is the nominal value for that period divided by the price index for that period. This procedure gives us a value in dollars that have the purchasing power of the base period for the price index used. Using the CPI, for example, yields values expressed in dollars of 1982–1984 purchasing power, the base period for the CPI. The real value of a nominal amount X at time t, Xt, is found using the price index for time t: Equation 5.5 Real value of Xt = Xt/price index at
timet Let us compute the real value of the $6 wage for busing dishes in 2011 versus the $5 wage paid to your uncle in 2001. The CPI in 2001 was 177.1; in 2011 it was 224.9. Real wages for the two years were thus Real wage in 2001 = $5/1.771 = $2.82 Real wage in 2011 = $6/2.249 = $2.67 Given the nominal wages in our example, you earned about 5% less in real terms in 2011 than your uncle did in 2001. 16. A value expressed in units of constant purchasing power. 17. A value expressed in dollars of the current period. Price indexes are useful. They allow us to see how the general level of prices has changed. They allow us to estimate the rate of change in prices, which we report as the rate of inflation or deflation. And they give us a tool for converting nominal values to real values so we can make better comparisons of economic performance across time. 5.2 Price-Level Changes 205 Chapter 5 Macroeconomics: The Big Picture Are Price Indexes Accurate Measures of Price-Level Changes? Price indexes that employ fixed market baskets are likely to overstate inflation (and understate deflation) for four reasons: 1. Because the components of the market basket are fixed, the index does not incorporate consumer responses to changing relative prices. 2. A fixed basket excludes new goods and services. 3. Quality changes may not be completely accounted for in computing price-level changes. 4. The type of store in which consumers choose to shop can affect the prices they pay, and the price indexes do not reflect changes consumers have made in where they shop. To see how these factors can lead to inaccurate measures of price-level changes, suppose the price of chicken rises and the price of beef falls. The law of demand tells us that people will respond by consuming less chicken and more beef. But if we use a fixed market basket of goods and services in computing a price index, we will not be able to make these adjustments. The market basket holds constant the quantities of chicken and beef consumed. The importance in consumer budgets of the higher chicken price is thus overstated, while the importance of the lower beef price is understated. More generally, a fixed market basket will overstate the importance of items that rise in price and understate the importance of items that fall in price. This source of bias is referred to as the substitution bias. The new-product bias, a second source of
bias in price indexes, occurs because it takes time for new products to be incorporated into the market basket that makes up the CPI. A good introduced to the market after the basket has been defined will not, of course, be included in it. But a new good, once successfully introduced, is likely to fall in price. When VCRs were first introduced, for example, they generally cost more than $1,000. Within a few years, an equivalent machine cost less than $200. But when VCRs were introduced, the CPI was based on a market basket that had been defined in the early 1970s. There was no VCR in the basket, so the impact of this falling price was not reflected in the index. The DVD player was introduced into the CPI within a year of its availability. A third price index bias, the quality-change bias, comes from improvements in the quality of goods and services. Suppose, for example, that Ford introduces a new car with better safety features and a smoother ride than its previous model. Suppose the old model cost $20,000 and the new model costs $24,000, a 20% increase in price. Should economists at the Bureau of Labor Statistics (BLS) simply record the new model as being 20% more expensive than the old one? Clearly, the new model is not 5.2 Price-Level Changes 206 Chapter 5 Macroeconomics: The Big Picture the same product as the old model. BLS economists faced with such changes try to adjust for quality. To the extent that such adjustments understate quality change, they overstate any increase in the price level. The fourth source of bias is called the outlet bias. Households can reduce some of the impact of rising prices by shopping at superstores or outlet stores (such as T.J. Maxx, Wal-Mart, or factory outlet stores), though this often means they get less customer service than at traditional department stores or at smaller retail stores. However, since such shopping has increased in recent years, it must be that for their customers, the reduction in prices has been more valuable to them than loss of service. Prior to 1998, the CPI did not account for a change in the number of households shopping at these newer kinds of stores in a timely manner, but the BLS now does quarterly surveys and updates its sample of stores much more frequently. Another form of this bias arises because the government data collectors do not collect price data on weekends and holidays, when many stores run sales.
Economists differ on the degree to which these biases result in inaccuracies in recording price-level changes. In late 1996, Michael Boskin, an economist at Stanford University, chaired a panel of economists appointed by the Senate Finance Committee to determine the magnitude of the problem in the United States. The panel reported that the CPI was overstating inflation in the United States by 0.8 to 1.6 percentage points per year. Their best estimate was 1.1 percentage points, as shown in Table 5.2 "Estimates of Bias in the Consumer Price Index". Since then, the Bureau of Labor Statistics has made a number of changes to correct for these sources of bias and since August 2002 has reported a new consumer price index called the Chained Consumer Price Index for all Urban Consumers (C-CPU-U) that attempts to provide a closer approximation to a “cost-of-living” index by utilizing expenditure data that reflect the substitutions that consumers make across item categories in response to changes in relative prices.Robert Cage, John Greenlees, and Patrick Jackman, “Introducing the Chained Consumer Price Index” (paper, Seventh Meeting of the International Working Group on Price Indices, Paris, France, May 2003), available at http://stats.bls.gov/cpi/superlink.htm. However, a 2006 study by Robert Gordon, a professor at Northwestern University and a member of the original 1996 Boskin Commission, estimates that the total bias is still about 0.8 percentage points per year, as also shown in Table 5.2 "Estimates of Bias in the Consumer Price Index". Table 5.2 Estimates of Bias in the Consumer Price Index Sources of Bias 1997 Estimate 2006 Estimate Substitution 0.4 0.4 5.2 Price-Level Changes 207 Chapter 5 Macroeconomics: The Big Picture Sources of Bias 1997 Estimate 2006 Estimate New products and quality change Switching to new outlets Total 0.6 0.1 1.1 Plausible range 0.8–1.6 0.3 0.1 0.8 — The Boskin Commission reported that the CPI overstates the rate of inflation by 0.8 to 1.6 percentage points due to the biases shown, with a best-guess estimate of 1.1. A 2006 study by Robert Gordon estimates that the bias fell but is still about 0.8 percentage points. Source: Robert J. Gordon, “The Boskin Commission Report: A
Retrospective One Decade Later” (National Bureau of Economic Research Working Paper 12311, June 2006), available at http://www.nber.org/papers/w12311. These findings of upward bias have enormous practical significance. With annual inflation running below 2% in three out of the last 10 years and averaging 2.7% over the 10 years, it means that the United States has come close to achieving price stability for almost a decade. To the extent that the computation of price indexes overstates the rate of inflation, then the use of price indexes to correct nominal values results in an understatement of gains in real incomes. For example, average nominal hourly earnings of U.S. production workers were $13.01 in 1998 and $17.42 in 2007. Adjusting for CPI-measured inflation, the average real hourly earnings was $7.98 in 1998 and $8.40 in 2007, suggesting that real wages rose about 5.3% over the period. If inflation was overstated by 0.8% per year over that entire period, as suggested by Gordon’s updating of the Boskin Commission’s best estimate, then, adjusting for this overstatement, real wages should have been reported as $7.98 for 1998 and $9.01 for 2007, a gain of nearly 13%. Also, because the CPI is used as the basis for calculating U.S. government payments for programs such as Social Security and for adjusting tax brackets, this price index affects the government’s budget balance, the difference between government revenues and government expenditures. The Congressional Budget Office has estimated that correcting the biases in the index would have increased revenue by $2 billion and reduced outlays by $4 billion in 1997. By 2007, the U.S. government’s budget would have had an additional $140 billion if the bias were removed. 5.2 Price-Level Changes 208 Chapter 5 Macroeconomics: The Big Picture • Inflation is an increase in the average level of prices, and deflation is a decrease in the average level of prices. The rate of inflation or deflation is the percentage rate of change in a price index. • The consumer price index (CPI) is the most widely used price index in the United States. • Nominal values can be converted to real values by dividing by a price • index. Inflation and deflation affect the real value of money, of future obligations measured in money, and of fixed incomes. Unanticipated inflation and deflation create uncertainty about
the future. • Economists generally agree that the CPI and other price indexes that employ fixed market baskets of goods and services do not accurately measure price-level changes. Biases include the substitution bias, the new-product bias, the quality-change bias, and the outlet bias. T R Y I T! Suppose that nominal GDP is $10 trillion in 2003 and $11 trillion in 2004, and that the implicit price deflator has gone from 1.063 in 2003 to 1.091 in 2004. Compute real GDP in 2003 and 2004. Using the percentage change in the implicit price deflator as the gauge, what was the inflation rate over the period? 5.2 Price-Level Changes 209 Chapter 5 Macroeconomics: The Big Picture Case in Point: Take Me Out to the Ball Game … The cost of a trip to the old ball game rose 2% in 2011, according to Team Marketing Report, a Chicago-based newsletter. The report bases its estimate on its fan price index, whose market basket includes four adult average-priced tickets, two small draft beers, four small soft drinks, four regular-sized hot dogs, parking for one car, two game programs, and two least expensive, adultsized adjustable baseball caps. The average price of the market basket was $197.35 in 2011. Team Marketing compiles the cost of the basket for each of major league baseball’s 30 teams. According to this compilation, the Boston Red Sox was the most expensive team to watch in 2011; the Arizona Diamondbacks was the cheapest. The table shows the cost of the fan price index market basket for 2011. Source: Team Marketing Report, “TMR’s Fan Cost Index Major League Baseball 2011,” available at http://www.teammarketing.com. Team Basket Cost Team Boston Red Sox $339.01 Baltimore Orioles New York Yankees $338.32 Cleveland Indians Chicago Cubs $305.60 Florida Marlins Chicago White Sox $258.68 Atlanta Braves New York Mets $241.74 Cincinnati Reds Philadelphia Phillies $240.66 Colorado Rockies Basket Cost $174.10 $170.96 $170.24 $169.02 $162.24 $161.00 5.2 Price-Level Changes 210 Chapter 5 Macroeconomics: The Big Picture Team Basket Cost Team Los Angeles Dodgers $226.36 Milwaukee Brewers St. Louis Cardinals $223.18 Kansas City Royals Houston Astros $221.36 Texas Rangers Minnesota Twins $213.16 Tampa Bay Rays Toronto Blue Jays
$212.68 Los Angeles Angels San Francisco Giants $208.15 Pittsburgh Pirates Detroit Tigers $207.28 San Diego Padres Washington Nationals $196.34 Arizona Diamondbacks Seattle Mariners $183.59 Basket Cost $160.40 $159.80 $159.40 $139.68 $129.50 $127.71 $125.81 $120.96 Oakland Athletics $178.09 MLB Average $197.35 Rearranging Equation 5.3, real GDP = nominal GDP/implicit price deflator. Therefore, Real GDP in 2003 = $10 trillion/1.063 = $9.4 trillion. Real GDP in 2004 = $11 trillion/1.091 = $10.1 trillion. Thus, in this economy in real terms, GDP has grown by $0.7 trillion. To find the rate of inflation, we refer to Equation 5.4, and we calculate: Inflation rate in 2004 = (1.091 − 1.063)/1.063 = 0.026 = 2.6% Thus, the price level rose 2.6% between 2003 and 2004. 5.2 Price-Level Changes 211 Chapter 5 Macroeconomics: The Big Picture 5.3 Unemployment. Explain how unemployment is measured in the United States. 2. Define three different types of unemployment. 3. Define and illustrate graphically what is meant by the natural level of employment. Relate the natural level of employment to the natural rate of unemployment. For an economy to produce all it can and achieve a solution on its production possibilities curve, the factors of production in the economy must be fully employed. Failure to fully employ these factors leads to a solution inside the production possibilities curve in which society is not achieving the output it is capable of producing. In thinking about the employment of society’s factors of production, we place special emphasis on labor. The loss of a job can wipe out a household’s entire income; it is a more compelling human problem than, say, unemployed capital, such as a vacant apartment. In measuring unemployment, we thus focus on labor rather than on capital and natural resources. Measuring Unemployment The Bureau of Labor Statistics defines a person as unemployed if he or she is not working but is looking for and available for work. The labor force18 is the total number of people working or unemployed. The unemployment rate19 is the percentage of the labor force that is unemployed. To estimate the unemployment rate, government surveyors fan out across the
country each month to visit roughly 60,000 households. At each of these randomly selected households, the surveyor asks about the employment status of each adult (everyone age 16 or over) who lives there. Many households include more than one adult; the survey gathers information on about roughly 100,000 adults. The surveyor asks if each adult is working. If the answer is yes, the person is counted as employed. If the answer is no, the surveyor asks if that person has looked for work at some time during the previous four weeks and is available for work at the time of the survey. If the answer to that question is yes, the person is counted as unemployed. If the answer is no, that person is not counted as a member of the 212 18. The total number of people working or unemployed. 19. The percentage of the labor force that is unemployed. Chapter 5 Macroeconomics: The Big Picture labor force. Figure 5.4 "Computing the Unemployment Rate" shows the survey’s results for the civilian (nonmilitary) population for February 2012. The unemployment rate is then computed as the number of people unemployed divided by the labor force—the sum of the number of people not working but available and looking for work plus the number of people working. In February 2012, the unemployment rate was 8.3%. Figure 5.4 Computing the Unemployment Rate A monthly survey of households divides the civilian adult population into three groups. Those who have jobs are counted as employed; those who do not have jobs but are looking for them and are available for work are counted as unemployed; and those who are not working and are not looking for work are not counted as members of the labor force. The unemployment rate equals the number of people looking for work divided by the sum of the number of people looking for work and the number of people employed. Values are for February 2012. All numbers are in thousands. There are several difficulties with the survey. The old survey, designed during the 1930s, put the “Are you working?” question differently depending on whether the respondent was a man or woman. A man was asked, “Last week, did you do any work for pay or profit?” A woman was asked, “What were you doing for work last week, keeping house or something else?” Consequently, many women who were looking for paid work stated that they were “keeping house”; those women were not counted as unemployed. The BLS did
not get around to fixing the survey—asking women the same question it asked men—until 1994. The first time the new survey question was used, the unemployment rate among women rose by 0.5 percentage point. More than 50 million women are in the labor force; the change added more than a quarter of a million workers to the official count of the unemployed.For a description of the new survey and other changes introduced in 5.3 Unemployment 213 Chapter 5 Macroeconomics: The Big Picture the method of counting unemployment, see Janet L. Norwood and Judith M. Tanur, “Unemployment Measures for the Nineties,” Public Opinion Quarterly 58, no. 2 (Summer 1994): 277–94. The problem of understating unemployment among women has been fixed, but others remain. A worker who has been cut back to part-time work still counts as employed, even if that worker would prefer to work full time. A person who is out of work, would like to work, has looked for work in the past year, and is available for work, but who has given up looking, is considered a discouraged worker. Discouraged workers are not counted as unemployed, but a tally is kept each month of the number of discouraged workers. The official measures of employment and unemployment can yield unexpected results. For example, when firms expand output, they may be reluctant to hire additional workers until they can be sure the demand for increased output will be sustained. They may respond first by extending the hours of employees previously reduced to part-time work or by asking full-time personnel to work overtime. None of that will increase employment, because people are simply counted as “employed” if they are working, regardless of how much or how little they are working. In addition, an economic expansion may make discouraged workers more optimistic about job prospects, and they may resume their job searches. Engaging in a search makes them unemployed again—and increases unemployment. Thus, an economic expansion may have little effect initially on employment and may even increase unemployment. Types of Unemployment Workers may find themselves unemployed for different reasons. Each source of unemployment has quite different implications, not only for the workers it affects but also for public policy. Figure 5.5 "The Natural Level of Employment" applies the demand and supply model to the labor market. The price of labor is taken as the real wage, which is the nominal wage divided by the price level; the symbol used to represent the real wage is the Greek letter omega, ω.

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