Saturday, December 11, 2010

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How the Demand Curve is Consistent with the Quantity Theory of Money

The AD curve is consistent with the quantity theory of money.

qtm

The expansino shifts the AD schedule from AD to AD1. I nthe very short run, if the price level were to remain at the Po, the economy would move to point E1. This would cause excess demand in the goods and labour markets, which would in turn force up wages and prices.
The classical model assumes instance adjustment, the economy would go directly to point E2, with no charges in output, and a higher price level. In the long run, quantity theory of money holds.

If you were interested in this post then visit the 'how to derive the aggregate demand curve' post for related material.

Supply, Demand and Equilibrium Price

Supply, Demand and Equilibrium Price

According to conventional economic theory market price is fixed by the following mechanism:

  • Demand. The demand curve D illustrates the variation of a demand Q in relation to the variation of a price P. This function is characterized by an inversely proportional curve where demand drops when the price goes up (and vice-versa). If the price of a good or service is too high (P1), the demand drops (Q1) while in the opposite situation (low price; P2) demand grows (Q2).
  • Supply. The supply curve S illustrates a variation of supply according to a variation of price P. This function is characterized by a directly proportional curve where supply increases as the price goes up. Supply grows (Q1 to Q2) when the price increases (P1 to P2) since profits would be higher.
  • Equilibrium Price. The intersection of the demand curve D and the supply curve S represents the equilibrium price Pe where a quantity Qe of goods will be sold. Changes in the market (moving curves D or S to the left or the right) will change the equilibrium price.

Supply and Demand of Government qua Natural Monopoly

In an earlier post, I described a scalar model of consent. I here use that model to analyze the supply and demand of government services. Specifically, I explore the origin and development of government qua natural monopoly. I plan in a later post to apply a similar analysis to government qua provider of public goods.

A government that enjoys a natural monopoly on satisfying the express demand for its services will have the power, and incentive, to expand to meet non-express demand. The result: a supply of more government services, at a higher price, than citizens in fact want. In an extreme case, satisfying the implied or hypothetical demand for government services may result in an oversupply so gross that consumers expressly assign it a negative price. In other words, consumers of government services may actually object to what they supposedlywant.

Government represents a sort of service industry, albeit one marked by some peculiar features. For one thing, governments can often lay plausible claim to qualifying as natural monopolies. (Perhaps that is not so peculiar; David Friedman convincingly argues that natural monopolies pervade sufficiently small markets.) Figure 1, below, offers a fairly conventional graph of the economic features of government qua natural monopoly.



Fig. 1:  Supply & Demand of Government qua Natural Monopoly

(In figure 1, "MC" stands for "marginal costs of production"; "ATC" for "average total costs of production"; and "D" for "aggregate demand." Because we here portray a monopoly aggregate demand equates to "AR," or "average revenue." The various uses of "P" mark prices; "Q" of quantities. The lowercase "m," as in "Pm," designates the monopoly price. "Qm" of course corresponds to the monopoly quantity. In like fashion, "r" designates the regulated price and quantity, and "c" the competitive ones.)

So it goes, at least, in the standard economic view, which concerns only expressly consensual transactions. But as I noted earlier,, we might do well to also consider transactions marked by less than express consent. Government monopolies, for instance, typically claim to respond to implied and hypothetical consent. What does a market based on non-express consent look like? Figure 2, below, illustrates.



Fig. 2: Supply & Demand of Government qua Natural Monopoly, Under Both Express and Non-Express Consent

Figure 2 shows the non-express demand, marginal revenue, monopoly price, and monopoly supply of government services. All those non-express measures come marked with "(n)" suffixes. The express measures from figure 1 remain, but now carry "(e)" suffixes to distinguish them from the newly added material. (For the sake of clarity, I've dropped from figure 2 some of the information offered in figure 1.)

Figure 2 illustrates three interesting results. First, non-express demand, because it includes transactions beyond those expressly agreed to, traces a curve to the right of typical (i.e., express) demand. Second, due to its speculative nature, non-express demand of necessity charts a somewhat more fuzzy line than express demand does. Figure 2 thus draws the non-express demand and marginal revenue curves as relatively imprecise blobs.

Third, and most crucially, figure 2 illustrates that a government monopoly meeting non-express demand may provide more services, at a higher price, than consumers in fact demand. How can government agents get away with thereby supplying and getting paid for grossly inefficient level of services? Recall that we charitably but reasonably supposed that in a market based on expressly consensual transactions, government will enjoy a natural monopoly. Government agents can thereby lay claim to a monopoly on the initiation of coercion. They can all too easily wield that power to expand their market share, claiming a mandate to satisfy implied or hypothetical consent. And, given the super-monopoly profits thereby afforded, they have powerful incentives to do so.

Figure 2 only hints at something that figure 3, below, makes explicit: Government based on non-express consent may supply—"oversupply," really—a level of service that consumers expressly value at less than zero. That result follows quite directly from the simple, if somewhat unusual, expedient of following the express demand curve even as it plunges below the x-axis. Economists do not generally explore that region of "negative demand," granted, but they seldom have reason to do so. Figure 3, because it tracks both express and non-express transactions, gives us good reason to spell out what happens when a supposedly justified supply meets actual consumer demand.



Fig. 3: Oversupply of, and Negative Demand for, Government Relying on Non-Express Consent

What, in sum, does this application of "consent theory" (as I style it) teach? Government services, because they have power and incentives to expand from natural monopolies based on express consent to coercive monopolies based on implied or hypothetical consent, threaten to provide more government than consumers really want. In some cases, consumers may afford negative value to the resulting oversupply of government services. We thus might say that figure 3 illustrates, in the iconography of economics, the causes and effects of tyranny.

That paints a rather grim—but, I would argue, accurate—picture of how government can grow from a natural monopoly into an artificial, and unwelcome, one. Note, however, that I have not yet invoked the public goods justification for government power. I'll take that up my next post on consent theory, explaining why a government that aims to meet the hypothetical demand for public goods runs a reduced risk of supplying services to which that consumers assign negative value. In other words, governments based on the hypothetical demand for public goods tend to become bloated but not monstrous.

Business Revenues

The meaning of revenue

Revenue (or turnover) is the income generated from the sale of output in product markets. There are two main revenue concepts to grasp at this stage:

  • Average Revenue (AR) = Price per unit = total revenue / output
  • Marginal Revenue (MR) = the change in revenue from selling one extra unit of output

The table below shows the demand for a product where demand varies inversely with the price.

Price per unit
(average revenue)

Quantity Demanded
(Qd)

Total Revenue
(TR)

Marginal Revenue
(MR)

£s

units

£s

£s

400

220

88000

370

340

125800

315

340

460

156400

255

310

580

179800

195

280

700

196000

135

250

820

205000

75

220

940

206800

15

190

1060

201400

-45

Average and marginal revenue – the important relationships

In our example in the table above, as price per unit falls, demand expands and so too does total revenue, although because the demand curve is downward sloping, the average revenue falls as more units are sold. This causes marginal revenue to decline. Eventually once marginal revenue becomes negative, a further fall in price (e.g. from £220 to £190) causes total revenue to fall.

Because the price per unit is declining, total revenue is rising at a decreasing rate and will eventually reach a maximum (see the next paragraph).

Elasticity of demand and total revenue

When a firm faces a perfectly elastic demand curve, then average revenue = marginal revenue (i.e. extra units of output can all be sold at the ruling market price). However, most businesses face a downward sloping demand curve! And because the price per unit must be cut to sell extra units, therefore MR lies below AR. In fact he MR curve will fall at twice the rate of the AR curve. You don’t have to prove this for the exams – but it is worth remembering that the marginal revenue curve has twice the slope of the AR curve!

The total revenue for any business is maximised when marginal revenue (MR) = zero. Once MR becomes negative, total revenue falls if extra units are sold. This is shown in the next diagram.

Elasticity of demand and total revenue

Total revenue is shown by the area underneath the firm’s demand curve (average revenue curve).


Total revenue is shown by the area underneath the firm’s demand curve (average revenue curve).

COMPETITION AND THE SEARCH FOR AN HONEST BUCK

Instructional Goals: You will understand:

  • How to measure consumers' surplus and deadweight loss.
  • What a residual demand curve is and how to use one.
  • The importance of property rights for exchange to take place; the nature of externalities or spillovers, and the Coase theorem.
  • The difference between a buyer and a seller.

Lecture 2:30 PM to 4:00

Consumption is the purpose of all economic activity. Work is economically meaningful only if it produces something of value to someone -- that is, only if there is a consumer out there who wants to buy it. What is true of the economy as a whole, is equally true for the organizations that comprise it. This principle is not a call to hedonistic self indulgence. Putting the customer first is a discipline competition imposes upon producers. You can work as hard as you want, but unless you're creating more value than you are expending, you are wasting your resources and will eventually be put out of business. It is this discipline that drives producers to create more and more value for less and less effort -- in other words, make us richer.

Increasing competition tightens the screws of market discipline -- benefiting consumers, but making it harder for organizations to earn an honest buck, i.e., more than normal returns on one's investment.

Under perfect competition YOU cannot earn more than a normal return on your investment. So what are the characteristics of perfect competition?

  • Perfectly homogeneous goods. All organizations supplying the market sell an identical product or, at the very least, consumers view their products as identical and are indifferent between them. A corollary of this characteristic is: Perfect divisibility of output.
  • Perfect information. Producers and consumers, buyers and sellers, have all relevant information about all prices, costs, and quality of all products. A corollary of this characteristic is: No transaction costs. Buyers and sellers do not encounter search, bargaining/negotiation, enforcement or monitoring costs; delivery is free and occurs precisely when needed. Another corollary is: No externalities or spillover costs and benefits that are not captured by the parties to the exchange.
  • Price taking. Buyers and sellers cannot individually influence the price at which products can be purchased or sold. The corollary of this characteristic is: Free entry and exit, that is, organizations can enter or exit a market without incurring a cost.

Obviously, you will want to earn the highest possible return on your investment. The only way to do so is to change markets so these conditions do not obtain (e.g., consumer indifference) or take advantage of situations where they cannot (e.g., perfect information).

As you learned in economics, a demand schedule reflects willingness and ability to pay and a supply schedule, willingness and ability to sell. The sum of the difference between what customers were willing to pay and the price paid represents the exchange value provided by a product. It is called a consumer surplus and is measured by the area under the demand schedule and above the price line. Conversely, the area above the supply schedule and below the price line is the producer surplus.

An unconstrained profit-maximizing monopoly, producing a perfectly homogeneous product and charging a single price, would set output and price to equate marginal revenue with marginal cost, resulting in a substantial deadweight loss.

The following figure shows the case of a revenue (not profit) maximizing natural monopoly. A revenue maximizing entity operates where marginal revenue is zero. A so-called natural monopoly is one in which average total cost (ATC) decreases at a decreasing rate throughout the relevant range of output. This is so in the instance shown below because marginal cost is constant, while large capacity (or fixed) costs are spread over total output. Under these conditions, where a single price is charged for each unit of output, the consequent deadweight loss is substantial.

Natural monopolies are not necessarily inefficient -- although lack of competion encourages sloth and other bad things. Given perfect information, consumers could band together and bribe the potential monopolist to offer the optimal quantity of of the good or service in question.

Elasticities and the Residual Demand Curve

This course makes repeated use of two related concepts to analyze both price competitive and noncompetitive industries: (1) price elasticity of demand or supply and (2) the demand curve facing a single organization's product or service: the residual demand curve. The price elasticity of supply or demand aids in understanding how an industry is likely to respond to changes in demand or supply. The residual demand facing a single organization allows you to understand and exploit the demand for your service and products. The following discussion explains how the elasticity of the residual demand curve is related to the assumption that a price competitive organization cannot affect price.

Elasticities of Demand and Supply

If either the demand or supply curve shifts, the competitive equilibrium changes, and the shapes of the demand and supply curves influence how the new equilibrium compares to the old. For example, if the demand curve is perfectly flat, the competitive price remains unchanged, even if the supply curve shifts radically.


One concept used to characterize the shape of demand or supply curves is the price elasticity of demand or supply (often the word price is omitted). The price elasticity of demand at price p and quantity Q is approximately the percentage change in quantity divided by the percentage change in price (ÆQ/Q) ÷ Æp/p) = (p/Q) (ÆQ/Æp).

Because the elasticity is the ratio of two percentage terms, the elasticity is invariant to changes in scale of either price or quantity (it is a pure number without scale itself). For example, if price is measured in cents rather than dollars, the elasticity is unchanged even though the slope of the demand curve, ÆQ/Æp, does change. The technical definition of the price elasticity is (p/Q)(dQ/dp). Similarly, the elasticity of supply is (approximately) the percentage change in quantity supplied in response to a 1 percent change in price. The elasticity of demand is a negative number, and the elasticity of supply is usually, but not always, positive.

If a 1 percent increase in price leads to a more than a 1 percent reduction in the quantity demanded (so that the total amount paid in the market falls) a demand curve is called elastic. That is, an elastic demand curve has an absolute value of the elasticity of demand greater than one (the absolute values of 1 and -1 are both 1). It is common to omit the phrase the absolute value of when discussing the price elasticity of demand. The statement, "The price elasticity of demand is 2," is interpreted to mean that the price elasticity is -2.

When the absolute value of the elasticity of demand is 1, the demand curve is of unitary elasticity. In that case, a 1 percent change in price causes a 1 percent change in the quantity demanded, and the total amount paid (total revenues) remains constant. If the absolute value of the elasticity of demand is less than 1, the demand curve is inelastic; a 1 percent increase in price causes less than a 1 percent decline in the quantity demanded, and the total amount paid rises.

In general, the elasticities of demand and supply depend upon many economic factors, such as the level of output, the availability of substitute products, and the ease with which suppliers can alter production. For example, as more substitute products are available, consumers find it easier to substitute for a product if its price rises, which makes its demand curve more elastic. Similarly, the more flexible the production process of a organization, the more likely it is that the organization can greatly increase production in response to a price increase, which tends to increase the elasticity of supply.

Price Taking Among Price competitive Organizations and the Residual Demand Curve

Price competitive organizations are often described as price takers; they believe that they cannot affect the market price and must accept, or take, it as given. There are three equivalent ways to state this result, all of which are used in this course:

• A price competitive organization is a price taker.

• The demand curve facing a price competitive organization is horizontal at the market price.

• The elasticity of demand facing a price competitive organization is infinite.

A organization is a price-taker if it faces a horizontal demand curve, because a horizontal demand curve has an infinite price elasticity of demand. If a organization facing an infinite price elasticity raises its price even slightly, it loses all its sales. Alternatively stated, by lowering its quantity, the organization cannot cause the price to rise. In contrast, a organization facing a downward-sloping demand curve can raise its price by decreasing its output.

If the number of organizations in an industry (an industry is made up of all the organizations supplying products or services with identical attributes) is large, the demand curve facing any one of them is nearly horizontal (elasticity of demand is infinite) even though the demand curve facing the industry is downward sloping (elasticity is relatively small). Indeed, for most market demand curves, there do not have to be very many organizations in an industry for the elasticity of demand facing a particular organization to be large.

To show this result, it is necessary to determine the demand curve facing a particular organization: the residual demand curve. A organization sells to people whose demands are not met by the other organizations in the industry. For positive quantities of residual demand, the residual demand, D,(p), is the market demand, D(p), minus the supply of other organizations, So(p):

Dr(p) = D(p) - So(p)

If So(p) is greater than D(p), Dr(p) is zero.

Figure 4.6b shows the market demand curve and the supply of all the organizations except one. The horizontal difference between the market demand curve and the supply of the other organizations is the residual demand facing a particular organization, Figure 4.6a. The horizontal difference is the quantity demanded by the market at a given price minus the supply of other organizations at that price.

For example, in Figure 4.6b, at a price of $5, market demand is 10,050 units and the supply of the other organizations is 9,950 units. That is, the other organizations are not willing to meet the entire market demand at $5; the difference between demand and the supply of other organizations is 100 units. Thus, at $5, the organization's residual demand is 100 units. At $6, the supply of other organizations equals the market demand. The residual demand facing the organization in Figure 4.6a is zero. Were price to rise even higher, other organizations would be willing to supply even more than is demanded. Thus, at any price greater than or equal to $6, the organization in Figure 4.6a sells no units.

The residual demand curve facing the organization, Figure 4.6a, is much flatter than the market demand curve, Figure 4.6b. Similarly, the single organization's demand elasticity is much higher than the market elasticity. As drawn, the elasticity of demand for the individual organization, from $5 to $6, is -11, whereas the corresponding market arc elasticity of demand is -0.025. In other words, the organization's residual demand elasticity is 440 times as elastic as the market elasticity.

More generally, if there are n identical organizations in the industry, then the elasticity of demand facing any one organization i is

e i = e n - h o n /(n - 1),

where e is the market elasticity of demand (a negative number), h o is the elasticity of supply of the other organizations (a positive number), and (n -1) is the number of other organizations.

Thus for a given market elasticity, as the number of organizations in an industry, n, increases, the elasticity facing a single organization i, e i grows large in absolute value (more negative). Similarly, the larger the elasticity of supply of the other organizations,

or the more of these other organizations, the larger in absolute value (more negative) is the elasticity of demand facing organization i.

Table 4. 1 shows how the elasticity of demand facing a single organization varies with the number of organizations and the market elasticities, given that the elasticity of supply of other organizations is completely inelastic (h o = 0). For example, if the market elasticity is unitary (e = 1) and there are 50 organizations, then e i = -50. That is, if a organization were to increase its price by 1 percent, the quantity it sells would fall by about 50 percent. If there are 1000 organizations, e i = -500, so that if the organization were to raise its price by a tenth of a percent, the quantity it sells would fall by 50 percent. Thus, even if the market elasticity is completely inelastic, if there are a large number of organizations in the industry, the elasticity of demand facing a single organization is very large (see Example 4.2).

EXERCISES

1. Please draw figure so that the inverse demand schedule is Q = 100 - p (both the vertical and horizontal intercepts are at 100). Note that at p = 100, Q = 0; at p = 0, Q = 100; and at p = 50, q = 50.

2. Please draw figure so that the inverse supply schedule is Q = p. Note that at p = 100, Q = 100; at p = 0, Q = 0; and at p = $50, q = 50.

3. Find the competitive equilibrium price and quantity (set Q = p, 100 - p = p, 100 = 2p, p = ?, q = ?

4. Calculate total revenue (TR) = pQ =

5. Calculate consumers' surplus (100 - p)Q/2 =

6. Calculate producers' surplus pQ - C, where C = pQ/2 =

7. Draw identical figure to thone described in steps 1 & 2, but include marginal revenue schedule (MR) with the following equation Q = 50 - .5p

8. Calculate profit maximizing output (set Q = MR, 50 - .5p = p, 50 = 1.5p, Q = ).

9. Use the inverse demand schedule (Q = 100 - p) to calculate the profit maximizing price (set p = 100 - 33.33, p =

10. Calculate total revenue (TR) = pQ =

11. Calculate consumers' surplus (100 - p)Q/2 =

12. Calculate producers' surplus pQ - C, where C = pQ/2 =

13. Show calculation for deadweight loss D = $33.33 (16.67)/2 =

13. Calculate Price Elasticity, where p = $50, Q = 50, Price Elasticity = |?|; p = $75, Q = 25, Price Elasticity = |?|; p = $25, Q = 75, Price Elasticity = |?|

14. Calculate Price Elasticity, where p = $66.67, Q = 33.33, Price Elasticity = |?|

15. Using the inverse elasticity rule (Ramsey optimal pricing): p-mc/p = 1/|Price Elasticity| = calculate the optimal markup where Price Elasticity is |2| and marginal cost is $33.33

EXAMPLE 1

Assume a price competitive industry with free entry and exit. What would happen to industry output, optimal organizational scale (assuming all organizations had access to identically the same technologies), and the equilibrium price, if government imposed a fixed fee per year on each organization participating in the industry?

___________

Answer: The following figure shows that, starting from long-run normal-profit equilibrium, an increase in fixed costs raises average costs from AC1 to AC2. At the original price each organization would lose money, so some organizations would exit the industry (the number of organizations goes from n1 to n2). Remaining firms produce more than before (q1 instead of q2). Total output falls from Q1 = nq1 to Q2 = nq2. Price rises to P2.


Demand Schedule, Function and Law

D(demand)

qd

Schedule

P

10

0

8

1

4

2

1

3

0

4

(A) Demand Schedule : The various quantities demanded of a particular commodity are presented here in a schedule. At arbitrarily chosen prices, the quantity of a commodity an individual consumer is expected to demand, is explained by the schedule. Since quantity demanded (qd) depends on the relevant prices of goods, the two can be expressed in the form of an algebraic function as well. The schedule shows that as price goes on rising (from zero to 4) the quantity demanded goes on falling (from 10 to zero).

The scheduled information has been presented in the form of a demand curve in Figure 2 (below). In the figure, the units of quantity of the goods have been measured along the horizontal axis (OX) and the respective prices have been shown along the vertical axis (OY). The curve intersects OY axis at point A which shows highest price at which quantity demanded is zero. On the contrary the curve intersects OX axis at point B showing largest quantity demanded where price is zero. Both OA and OB are said to be intercept quantities when one of the variables assumes zero value. Note that demand curve is sloping downward. This follows the law of demand (given below). But the demand curve of such a shape is obvious from the fact that quantities demanded and price in the demand schedule hold an inverse relationship.

Quantity Demanded qd
Figure 2

(B) Demand Function: The price-demand relationship shown above can be expressed in the form of a demand function as follows:

qd = 10 - 3P

On substitution of any scheduled value of P we get the relevant value of the quantity demanded. Thus when P = 1 then qd =10 - 3 (1) = 7 or when P = 3, then qd = 10 - 3 (3) = 1 etc.

(C) Law of demand: The law of demand explains the inverse relation between quantity and price in general. It can be stated as follows:

"Ceteris Paribus (other things remaining equal), the quantity of a good demanded will rise (expand) with every fall in its price and the quantity of a good demanded will fall (contract) with every rise in its price."

In a functional form this can be stated as,

qd = f (P) [ Y, Ps, N, Z ]const.

This explains that qd, the quantity of a good demanded functionally depends on its price P. However, the quantity demanded is also causally related to other factors such as income of an individual (Y), prices of substitutes (Ps), number of members in the family (N) and the tastes of the consumer (Z). In order to satisfy price-demand relation, the effect of these other variables has been restrained by assuming them to be constant.

Initially, the law of demand was based on the principle of diminishing marginal utility (DMU). But in that case it was implied that utility is cardinally or absolutely measurable. There were other practical difficulties in the DMU approach as well. Therefore recently attempts have been made to place the law of demand on the empirical and realistic basis. One such attempt is in the form of Indifference Curve (IC) analysis. Under the IC approach it is enough to measure utility in ordinal or relative terms.

(D) Rise or Fall and Increase or Decrease in demand: On a given demand curve as we move downwards from point A in the direction of B, the quantity demanded goes on rising with every successive fall in price. On the contrary, moving from point B to A shows a fall in the quantity demanded with every successive rise in the price. Marshall has called this process rise and fall or expansion and contraction in the demand. Therefore, in this case the price of the quantity (and the change in it) plays an important part. Here, a change in the quantity demanded is indicated with movement along the demand curve (up or down accordingly). This change is subject to the ceteris paribus condition.

On the other hand, other factors are also likely to alter the quantity demanded. This can be expressed by a shift in the curve. Such an upward shift in the demand curve (Figure 3) has been shown by a new and higher demand curve (A1B1) in the figure.

Figure 3

At a given price OP on the original demand curve (AB), the quantity demanded is Oq but on the new demand curve (A1B1) it has increased to Oq1. On the other hand, if we begin with the A1B1 demand curve as the initial demand curve and consider demand to have reduced (to AB) then the quantity demanded reduces from Oq1 to Oq. Such a change in the demand, arising out of a shift in the demand curve is known as an increase (if it is towards the right of the original demand curve) and a decrease (if it is towards the left of the original demand curve) in the demand, respectively.

The demand curve may shift and quantity demanded may increase or decrease, due to changes in a number of factors (apart from price), say the income (Y) of a consumer (when he becomes richer or poorer). A similar effect can be noticed with a rise or fall in the price of substitute (Ps) goods. For instance, tea and coffee or soaps of different brands are substitutes of each other. Therefore a rise in price of pasta may result in a reduction in the consumption of pasta and simultaneously an increase in the consumption of bread to that extent and vice versa. Or the demand curve may shift and quantity demanded may increase at the old price if there is a sudden increase in the number of members in a family (N), (say because of the unexpected arrival of guests). Finally, a shift in the demand curve may also be the result of the change in the tastes of a consumer. A cigarette or liquor consumer may become addicted because of which his demand for such goods will rise remarkably even at the old price.

There is an important difference between the change in the quantity demanded of a particular commodity and change in the demand for that commodity. While the former is influenced by the single factor: price, the latter is influenced by various other factors apart from price. A change in the quantity demanded is represented by a movement along the demand curve, while a change in the demand is represented by a shift of the curve (towards the left in case of a decrease and towards the right in case of an increase).

Demand Pull and Cost Push Inflation

The Phillips Curve was an empirical phenomenon looking for a theory and, around that time, there were two competing theories of inflation, both of which were expressed by Keynes in various places: "demand-pull" inflation and "cost-push" inflation - terms, as Machlup (1960) has shown, that can have a far from obvious meaning.

As originally expressed by John Maynard Keynes (1940) and Arthur Smithies (1942), "demand-pull" (or "inflationary gap") inflation is generated by the pressures of excess demand as an economy approaches and exceeds the full employment level of output. Output, recall, is generated by aggregate demand for goods - thus, whatever aggregate demand happens to be, aggregate supply will follow by the multiplier. However, at full employment output, if aggregate demand rises, output cannot follow because of full employment constraints. Consequently, with the multiplier disabled, the only way to clear the goods market, then, is by raising the money prices for goods. However, this is only a one-time increase in prices; inflation implies a sustained recurrent increase in prices. Keynes and Smithies explained inflation proper by appealing to distributional effects.

The Keynes-Smithies story can be expressed in the 45 income-expenditure diagram in Figure 11 where YF is full employment output and Y1d is aggregate demand. Note that the market-clearing level of output is Y1*, but it is not achievable - thus the "inflationary gap" is the difference between YF and Y1*. Keynes's (1940) argument can be restated as follows: as money wages lag behind good prices in adjustment, the rise in prices will therefore lead to a distribution of income away from wage-earners and towards profit-earners. He posited that, as workers have greater marginal propensities to consume than profit-earners, the redistribution of income induced by the inflationary gap will thereby lead to lower aggregate demand and thus close the gap, i.e. the aggregate demand curve flattens and falls in the Figure 11 from Y1d to Y2d .

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Figure 11 - The Inflationary Gap

The problem, of course, is that workers' money wages will still adjust upwards (recall that they were lagged behind), consequently once these adjust, income is redistributed away from profit-earners and towards wage-earners so that demand rises again (from Y2d to Y1d in Figure 11) and thus the inflationary gap re-emerges. But that inflationary gap, as noted earlier, leads to another price rise, redistribution of income to profiteers, etc. Thus, the whole process repeats itself continuously so that there will be, effectively, sustained, continual increases in prices, i.e. inflation.

In contrast, the "cost-push" theory of inflation or "sellers' inflation", also suggested in Keynes (1940), was more in line with older Marxian and Kaleckian sources - although this notion was also shared by Keynesian economists (e.g. Abba Lerner, 1951; Nicholas Kaldor, 1959; Sidney Weintraub, 1959) and Neoclassical economists (e.g. Milton Friedman, 1951). The basic notion is that, in a generally imperfectly competitive economy, firms set prices of output according to a simple mark-up formula:

p = (1 + m)w

where m is the mark-up, p price and w wage. When an economy approaches full employment, the "reserve army of the unemployed" gradually disappears, labor's hand at the bargaining table is strengthened. This will embolden laborers or their representatives to demand an increase in wages. In order to prevent this wage increase from eating into profits, employers will subsequently raise prices and keep the mark-up intact. Of course, if this happens, then workers will not be making any real wage gains. Perceiving this, they will follow up with another round of nominal wage increases - which in turn will be followed by a price increase and so on. Thus, in this version, inflation is a result of this wage-price spiral engendered by the relative bargaining position of workers in an almost fully employed economy. Incomes policies, which would link wage increases to rises in productivity, were suggested by many economsts (e.g. Lerner, 1947; Weintraub and Wallich, 1971; Okun and Perry, 1978) as a way of combating this type of inflation.

However, as Lerner (1951, 1972) stresses, the blame for inflation need not be placed squarely on the shoulders of workers alone: a push for profits by owners will be enough to initiate this kind of price-wage inflation spiral. In particular, there might be such a push when the owners' bargaining position seems relatively strong, i.e. when unemployment is high. Consequently, Lerner recognized the possibility of inflation with high unemployment, i.e. stagflation. It was precisely to combat this type of inflation that Lerner and Colander (1980) introduced their novel "Market Anti-Inflation Plan" (MAP) in the stagflationary 1970s: specifically, they proposed that the "right" to change prices be assigned to firms in the form of a fixed supply of tradeable vouchers, so that if a firm attempts to raise its prices, it would have to cash in its vouchers and thus relinquish its right to further price increases (whereas a firm which lower prices would gain vouchers). If a particular firm remained intent on raising prices further, then it would have to purchase vouchers from other firms on the open market. In their view, these added costs would make a profit-induced price rise less appealing to firms and thus help bring stagflation under control.

Both the "demand-pull" and "cost-push" theories of inflation are reconcilable with the empirical phenomena summarized by the Phillips Curve: as unemployment approaches zero, wage inflation (and price inflation) rises. However, the theories are different in that the first theory stresses more demand-side considerations while the latter concentrates more on supply-side. The corresponding "solutions" to the inflation problem are also different: "demand-pull" theorists concentrate on bringing down demand by, for example, reducing government expenditure, while "cost-pushers" call for the alleviation of wage pressure by institutional reform or incomes policies.

Although acknowledging the possibility of "cost push", most Neo-Keynesians took up the demand-pull explanation of inflation. However, the Keynes-Smithies story was told almost completely in the context of income and expenditure, and thus, surprisingly, ignored the monetary side. The Neo-Keynesians nonetheless attempted to appropriate the story into their IS-LM model by simply grafting on a capacity constraint, YF, to the left of the IS-LM-determined equilibrium, Y* and calling the resulting difference the "inflationary gap". With output stuck at YF, excess demand for goods will result in increases in the price level as before. However, unlike the Keynes-Smithies story, there is not a resulting "redistribution" of income to close the gap. Rather, as price level rises, the real money supply collapses and thus the LM curve shifts to the left and thus back to full employment output. Thus, the transmission mechanism implies that any price rises will themselves close the gap by lowering money supply and thus increasing interest rates and thus reducing investment and demand.

However, with the LM curve moving to bring the economy to full employment, it seems impossible, in this case, to have sustained price rises (i.e. inflation) as the monetary side seems to close off the story entirely. One could subsequently argue that, as real wages (w/p) declined in the process, then workers would try to bid their money wages back up and thus regenerate the gap. However, recall that from the four-quadrant IS-LM diagram (our earlier Figure 4), when IS-LM centers on the full employment output level so that Y* = YF, then the labor market clears and thus there are apparently no inherent dynamics to imply a rise in wages. If anything, a Pigou Effect arising from the fall in real money balances ought to push the IS curve to the left and actually generate unemployment so the implied dynamic might actually be a fall in money wages (of course, in the process of the original adjustment, IS and LM could move concurrently to the left and land at YF together, but then we are back to a full-employment centered equilibrium). In short, in an IS-LM context, we can obtain price rises but, at least within the confines of the model, we cannot obtain continuous inflation unless aggregate demand rises again for some reason - and there is no apparent reason why it will do so.

The problem, of course, returns to the old issue of what happens in that mysterious labor market which was so murky in the Hicks-Modigliani IS-LM world. The Keynes-Smithies story has workers bargaining for money wages upwards in response to the rise in prices, and the IS-LM story can accommodate that explanation, but it requires grafting on a theory of the labor market money wage bargain into the IS-LM model.

One of the first attempts to consider both labor market dynamics and goods market dynamics within one model was Bent Hansen's celebrated "two-gap" model (B. Hansen, 1951). Nominal wage movements are governed by the disequilibria in the labor market while nominal price movements are governed by disequilibria in the goods market so that the dynamics of the real wage and inflation arise from the interaction of the both goods and labor markets. However, the ideas of sustained disequilibrium "gaps" and price movements adjusting goods markets - with full employment - sound more Wicksellian than Keynesian. And it ought to - for Bent Hansen was a bona fide Wicksellian and his 1951 effort could be thought of as the swan song of the dying Stockholm School - or the opening notes of the disequilibrium "Walrasian-Keynesian" school - and thus not properly part of the Neoclassical-Keynesian Synthesis.

SUPPLY AND DEMAND

Introduction

Why does a superstar athlete like Kevin Garnett make almost more money per season than the rest of his team combined? Why are diamonds expensive? Why do heart surgeons make more money than sanitation workers? You probably guessed it, supply and demand. This unit will look at supply and demand and how they interact in the marketplace to determine the prices we pay for the goods and services we purchase.

Prices influence both buyers and sellers into making economic decisions. If the price for computers goes down, it will stimulate more demand to purchase computers. If the price of corn goes up, it will stimulate farmers into producing more corn. This is how the marketplace works. This section will look at the market processes that influence the demand side of the equation.

Demand

A good place to begin is to discuss what constitutes demand. Demand refers to the quantities of a product that people are willing and able to purchase at a given price during some period of time. The term quantity demanded refers to a point on the demand curve- the quantity demanded at a particular price. A demand curve can be used to illustrate the relationship between quantity demanded and price.

This is a picture of a demand curve, showing movement along the curve due to a change in price.

A change in quantity demanded caused ONLY by a change in the PRICE of the product. On a graph it is represented by a movement ALONG a SINGLE demand curve.

The graphs above demonstrate the law of demand. The law of demand states that as price decreases, quantity demanded increases. An inverse relationship exists. The law of demand is dependent on ceteris paribus- all other factors remaining unchanged.

In economics, the term utility refers to the measure of satisfaction received from consuming a good or service. The law of demand does not go on for infinity. There are limits. The law of diminishing marginal utility describes how the last item consumed will be less satisfying than the one before. This means at some point, no matter how low the price is, consumers will purchase less.


A change in quantity demanded can be illustrated by a movement between points along a stationary demand curve. Once again, demand is influenced by price. On the demand curve above, this is seen in the movement from point A to point B.

A shift in demand can also occur. A shift in demand refers to an increase (rightward change) or decrease (leftward change) in the quantity demanded at each possible price. This shift is influenced by non-price determinants. An example of an increase and a decrease in demand are pictured below.


This graph shows an increase in demand due to a non-price change.

This is a table showing a decrease in demand, where the demand curve moves down and to the left.

When there is a change in demand itself we get a new demand schedule and curve. We have to change the numbers in the demand schedule and this will SHIFT the demand curve.

If there is an increase in demand ( D) the demand curve moves to the RIGHT.

Market demand is the horizontal summation of the individual demand curves. Or, instead of just my individual demand for a product what if there were two people, or more, in the market. the result would be that for each price, the quantities demanded would be greater since there are more people. The prices stay the same, but the quantities get larger, or the demand graph shifts horizontally (to the right).

Graphically:

The most important distinction to keep in mind is that a change in quantity demanded is a movement along a single curve, while a shift in demand involves the creation of a second curve.

Non-Price Determinants of Demand

There are other factors besides price that influence consumers to purchase products. In explaining the various factors, I will try to use attending a musical concert as an example, as well as everyday life events.

1. A Change in income. If you receive a raise you are likely to increase your demand for goods. If you get laid off, your demand for goods will likely decrease. When income increases, consumers buy more. When income decreases, consumers buy less. If you normally attend two musical concert per year, but you receive a nice raise, you will probably increase your demand for musical concerts.

2. A Change in taste. Fads, fashions, and the advertising of new products influence consumer decisions. Some examples of fads from our pop culture include hula hoops and Pokeman cards. With respect to a musical concert, when a band is "hot" demand for their tickets is high. When the band loses its appeal, demand for its tickets will be low.

3. A Change in the price of a substitute good. A substitute good competes with another good for consumer purchases. Examples of substitute goods include juice and soda, margarine and butter, and video cassette tapes and DVD's. If the price of soda increases too much, consumer may decide to drink juice instead. If on the same night of a musical concert, a local sporting event is offering tickets at half the price of the musical concert, then consumers may be more willing to attend (demand) tickets to the sporting event, instead of the musical concert.

1. Heroin, OxyContin, and Substitute Goods

4. A Change in the price of a complementary good. A complementary good is jointly consumed with another good. Examples include cars and gasoline, tuition and textbooks, and milk and cereal. If the price of milk increases dramatically, consumers will decide to purchase less milk, and consequently, less cereal. An example of a complementary goods at the musical concert would be might be parking. If parking rates were extremely high, it might deter people from attending. If there were reduced rates, or free parking, it might encourage more people to attend the musical concert.

5. A Change in buyer expectations. If consumers think the price of a good will increase in the future, they may decide to buy more of it now so that they pay less. Suppose that a storm damages a large part of the orange crop. Consumers may run out and buy all the oranges they can find in anticipating the price of oranges increasing. Looking at the musical concert once again, if a band announces it is their "farewell' tour, then the expectations of consumers will increase the demand for tickets.

6. A Change in the Number of Buyers. Population growth will increase the demand for products because the pool of consumers has grown. Population decline will have the opposite effect. The Baby Boom generation has affected demand for goods over the course of their lifetimes. In terms of musical concerts, bands popular to baby boomers, such as the Rolling Stones, still have the highest grossing tours because of the huge number of baby boomers.

Supply

Why is it that farmers are more willing to grow certain crops one year and different crops the next? The price they receive for the crop they grow determines what seeds the farmers will sow. The information below will help you to understand the supply side of the equation.


Supply focuses on the producer of goods and services. Supply refers to the quantities of a product that producers are willing and able to offer at a given price during some period of time. Like demand, there are price and non-price determinants for supply. Producers make decisions on how much to supply based on profitability.

The supply side of the equation also has a law. The law of supply states that sellers will offer more of a good at a higher price and less at a lower price. This law can also be graphically displayed.

This is a graph that shows a change in quantity demanded.

A change in Quantity supplied occurs when there is a movement between points along a stationary supply curve. Once again, this movement is influenced by price. This change can be seen in the graph above with the movement from point A to point B. A change in Quantity supplied caused ONLY by a change in the PRICE of the product. It is represented by a movement ALONG a SINGLE supply curve.

There can also be a shift in supply. A shift in supply refers to an increase (rightward change) or a decrease (leftward change) in the quantity supplied at each possible price. These shifts are influenced by non-price determinants.

This graph shows an increase in supply, with a new curve that is down and to the right.

This graph shows a decrease in supply, with a new curve up and to the left.

A change in supply is caused by a change in the non-price determinants of supply. These are the factors that we assumed were constant when we used the ceteris paribus assumption to develop the supply curve. If there is an increase in supply (( S) the supply curve moves to the RIGHT. At the same prices, the quantities supplied will be greater.

The most important distinction to keep in mind is that a change in quantity supplied is a movement along a single curve, while a shift in supply involves the creation of a second curve.

Non-Price Determinants of Supply

There are other factors besides price that influence producers to sell products. In explaining the various factors, I will try to use producing computers as an example, as well as everyday life events. A brief description of each is provided below.

1. Change in technology. New, efficient technology makes it possible to offer more products at any possible selling price. Technology such as computers and robots have made it possible to reduce production costs and increase the supply of goods and services. In the computer industry, there have technological advances that have brought down the cost of producing computers.

2. Change in production costs. A change in the cost of labor, or taxes, or a resource needed to produce a good, impacts the decisions of sellers on how much to produce. If you are producing computers, and the price of computer chips increases, then it will cost more to produce a computer. This may force you out of business, because consumers will demand fewer computers at higher prices.

3. Change in the number of sellers. An increase or decrease in the number of sellers can influence the production of goods and services. If the United States removes a restriction of foreign imports, then there are more sellers in the market. The supply of computers will increase if the number of businesses producing computers increase.

4. Change in supplier expectations. Expectations of the future can influence the production of goods and services. If prices of a good or service is expected to rise in the future, sellers may hold back production in the present in the hopes of making more profit by selling more in the future. For example, if farmers think the future of the price of corn to decline, they will increase the present supply of corn, in the hopes of making more money now. The supply of computers will decrease if the price of a computer is expected to rise in the future, and vise versa.

1. Explorations in Supply


Equilibrium Price

English economist Alfred Marshall once wrote concerning equilibrium price, "We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility (demand) or cost of production (supply). What he was trying to say is that when supply and demand meet in the marketplace, a market price is created. This is equilibrium price. The best way to visualize equilibrium price to place the supply and demand curves in the same diagram.


Equilibrium price
refers to the price that makes the quantity demanded equal to the quantity supplied. Equilibrium in a market occurs when the price balances the plans of buyers and sellers. It sets the value of the product. On a supply and demand curve, equilibrium price is represented by the point where the demand and supply curves intersect. It is possible in some markets to sell the same good for different prices. This happens because consumers don't have the time to comparison shop. But in markets where buyers have had time to shop around and compare, prices tend to converge at a uniform price.

This is a graph that shows equilbrium price, which is the point where the demand and supply curves intersect.

Shortages and Surpluses

Sometimes the interests of sellers and consumers don't balance and the result is either an excess of demand or an excess of supply. When that happens there exists either a shortage or a surplus. A shortage is a situation where there is an excess at some price of quantity demanded over quantity supplied. On a supply and demand curve a shortage is represented by points below the equilibrium price. When a shortage exists buyers are competing with one another for limited quantities of goods. For sellers, it is an opportunity to raise prices and increase sales. Buyers, on the other hand, become frustrated because they are willing to spend money, but cannot find a particular good or service to purchase.

This graph demonstrates a shortage, which is the area below the equilibrium price.

A surplus is a situation where there is an excess at some price of quantity supplied over quantity demanded. On a supply and demand curve a surplus is represented by points above the equilibrium price. When a surplus exists buyers have an oversupply of product to choose from and will probably pay less for goods and services. For sellers, they are competing with other suppliers for customers and their prices will fall, as will their sales.

This graph demonstrates a surplus, which is the area above the equilibrium price.


Sometimes the government will intervene in the economy to create a surplus or shortage situation. Why would a government do this? Because there is often a strong political demand for government intervention. When governments intervene, they impose price controls, which are a legal restriction on how high or how low a market price may go. A price floor is a price above equilibrium legislated by the government. It results in a surplus. The government declares that there is a price for which a good or service may not be sold for less than that price. This price is set above the equilibrium price. A price floor, such as the minimum wage legislation, means that the lowest effective market price must not be below the given "floor". Examples of price floors are agricultural price supports and minimum wage laws. Price floors create inefficiencies, most notably, in wasted resources. Price floors may also encourage illegal activity. An example of this is when workers desperate for work, offer to work at less than the minimum wage.

Case Study: Agricultural Price Support

In order to keep the price of agricultural products high the government must eliminate the surplus by either destroying the crops or bribing the farmers not to produce. Sometimes there is an additional burden on taxpayers because the government will spend money to store some of the surplus.

This graph demonstrates farm price support, which is an example of a price floor, which creates a surplus.

A price ceiling is a price below equilibrium legislated by the government. The intent of government intervention in the economy is to help people who have to pay high prices. Price ceilings are usually imposed in times of crisis, such as a war. However, this action results in a shortage. The government declares that there is a price for which a good or service may not be sold for more than that price. This price is set below the equilibrium price. A price ceiling, such as rent control, means that the market price can be lower, but not higher than the given ceiling. If a shortage for a product occurs (and price cannot adjust to eliminate it), a method for rationing the good must develop. During World War II, our government issued ration coupons to alleviate shortages. Examples of price ceilings are rent controls and fixing gas prices. Price ceilings create inefficiencies in the market. There are consumers who desire the good badly, and are willingly to pay a high price for it, but can not find it. Because of this strong desire to have a good and the willingness to pay high prices, price ceilings often generate black markets. Black markets are illegal markets where goods that are in strong demand are bought and sold.

Case Study: Lines at the Gas Pump

In 1973, OPEC raised the price of crude oil which led to a reduction in the supply of gasoline. The federal government put price ceilings into place which further increased shortages. Motorists were then forced to spend large amounts of time in line at the gas pump ( which is how the gas was rationed.) These people waiting in line could have been doing something more enjoyable or productive.

This graph demonstrates the 1973 gas shortage, which is an example of a price ceiling.