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 Y_F is full employment output and Y₁^d 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 Y_F 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 Y₁^d to Y₂^d .

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 Y₂^d to Y₁^d 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, Y_F, to the left of the IS-LM-determined equilibrium, Y* and calling the resulting difference the "inflationary gap". With output stuck at Y_F, 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* = Y_F, 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 Y_F 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.

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.

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.

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.

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.

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.

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.

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.

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.

Economics Basics: Demand and Supply

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the allocation of resources. In market economy theories, demand and supply theory will allocate resources in the most efficient way possible. How? Let us take a closer look at the law of demand and the law of supply.

A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).

B. The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.)

Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.

C. Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.

D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.

E. Disequilibrium

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high.

2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.





F. Shifts vs. Movement
For economics, the “movements” and “shifts” in relation to the supply and demand curves represent very different market phenomena:

1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.

Premium Demand

Typically coming from ad-agencies, premium demand had some very interesting characteristics. As Greg Yardley pointed out in the comments of Part I, it’s not so much ‘premium’ as a ‘forward contract’. What this means is that most will consider premium premium not because it’s special, simply because someone has reserved this inventory before-hand. The majority of reserved inventory goes to — agencies. Agencies want to ensure that they spend all of their allocated budget by the end of the month/quarter, hence they reserve large portions of inventory before hand to ensure they hit their goals.

Because of the nature of agency budgets and reservation systems, short term premium demand is simply a fixed dollar amount . Think about it — agencies get a certain budget to spend for the quarter and fight their hardest to spend every last penny. If they don’t then they’ll have less money to spend next quarter. Now of course agencies will try to get the best inventory possible for the amount of money that they have to spend, but it’s really a battle between publishers as to how big a slice of the premium money pie they can get.

Lets take a hypethetical economy which has premium advertisers that want to spend $10,000. These advertisers will pay a rate that depends primarily on the amount of inventory that is available to them. If the marketplace only had one million impressions available, then the advertiser would buy the inventory for $10 CPM (CPM == Cost per Mille, or price per thousand impressions). That way:

$10.00 CPM * 1M imps = $10,000
On the contrary, if there were ten million impressions available for purchase then the advertiser would simply pay $1 CPM. That way:
$1.00 CPM * 10M imps = $10,000

Starting to get the picture? “But Agencies care about performance!!” you might respond…. Well, how do you track ‘performance’ for Ford? Are you going to track the number of cars that people buy online? Brand metrics are fuzzy by nature — people track “aided brand awareness”, “message association” and “brand favourability” (source)! Well — enough words! We can quite easily depict the “fixed $ demand” idea as a demand curve. If we know that $10,000 will go to premium advertisers then as shown above we can calculate the price that will be paid for each possible quantity of inventory. Price X Quality must equal the total dollar demand at each point. If we plot all the points we would get something like this:

Ok, so now it’s pretty easy to show what would happen in a world where there was only ‘premium demand’, and a fixed amount of short term supply. You’d simply get:

The equilibrium price, ‘Pe’ would simply be the intersection of the ‘premium demand’ and the fixed supply curve. No matter what the quantity is, the total value of the market stays the same — it’s simply the amount of dollars allocated for that time period. The rates will simply change according to how much supply is available.

“Remnant” Demand

Of course the world really isn’t that simple. Enter remnant demand. I myself have never really like the term remnant but that’s primarily because way too many people pronounce it remAnant. So what is it? I guess people will have their own definitions but I would classify it as anything that hasn’t been reserved at a fixed price. Any CPA or CPC based deal would most likely classify as remnant, as well as any non-guaranteed CPM buys.

Remnant demand is a little more sensible than premium demand — performance will generally matter for these advertisers. This means that there is no longer a ‘fixed’ amount of money flowing into the marketplace, rather, the amount differs depending on the quantity and price at any given point in time. If inventory is cheap an advertiser will buy higher quantities than if the inventory is more expensive. Visually it would look something like this:

The price paid by the publisher would be the intersection of the two curves — OR — if he is successful at some basic Price Discrimination it may be the area under the remnant demand curve (my economics is getting fuzzy). The really interesting question is: what happens when you combine remnant and premium?

The Aggregate Demand Curve

The way to combine the interaction of the premium and remnant demand curves is to think like a publisher. First, lets overlay the two graphs:

Now, lets imagine that all supply is controlled by one publisher and that as this publisher we are guaranteed the $10k in premium demand and now simply have to figure out how to price my inventory to maximize my total revenue. Well, lets think about this. Imagine that the quantity of inventory available in the marketplace sits very close to the left of the graph, a bit to the left of the intersection of the premium and remnant demand curves. At this point the supply curve intersects the two curves where the premium curve is above the remnant curve hence the publisher will allocate all of his inventory to premium demand. This makes a lot of sense right? The premium publisher will pay a higher price which would net the publisher higher revenue.

So here’s the question — what happens when supply lies to the right of this intersection? Well, what would you do if you were the publisher? What I would do is pretty simple. I’d convince premium advertisers that they have to pay more to reserve and allocate a the percentage of my inventory to the left of the intersection to them at a high price — one that’s would generally be higher than the one that remnant advertisers would pay. All other inventory I would sell to remnant advertisers. Ok, so what does this look like? Well simple! We simply vertically add the two curves as follows:

We can simply combine the premium and remnant demand curves to form the aggregate demand curve.

Lets get back to the point

Ok, so that was a whole buncha mumbo jumbo economics. What was the point? We drew some fancy curves and discussed some intersections… so what? Well, we were talking about premium and remnant, specifically why people should stop splitting out the online ad market between the two. Well, how does the above help us? Well first off, from a marketplace perspective it is not difficult to combine premium and remnant. This is my second argument against splitting out the two. When a publisher is trying to maximize revenue, he should be thinking about aggregate demand, not premium and remnant.

Think about some things that might maximize revenue:

1. Improve page quality for ad performance
2. Attract more and higher quality users
3. Increase visitor frequency
4. Improve sales efforts
5. Improve monetization/optimization tactics
6. Leverage behavioral data

How many of these apply solely to premium or remnant? None of them. All of the above are tools that a salesperson can use to grab a bigger piece of the premium pie. All of the above are also things that can help performance advertisers optimize their campaigns. Sure, selling to premium advertisers is different from selling to remnant advertisers, but that can easily be solved by hiring diverse salespeople and focusing them on the right areas. Nowadays most publisher get a significant portion of their revenue from remnant, hence when talking about growth rates in revenue we are really talking about growth in aggregate demand. Here’s the thing — the best techniques for maximizing revenue for publishers are not specific to performance or brand.

So all you fancy wall street analysts — when you’re asking large publishers whether their new focus on behavioral technologies will decrease revenues from premium inventory — stop and think about what you’re saying. There is no such thing as ‘premium inventory’. There is ‘premium demand’, but except for sales no company should make it one of their strategic goals to increase their share of this pool.

Final Thoughts

Before Greg can steel some of my thunder again — part III of this series will be about the growth of remnant and why I expect growth rates in “premium demand’ to slow whereas “remnant demand” will continue to grow drastically. (no it’s not related to social networking). I would also like to mention in the spirit of full disclosure that I know very little about the agency business and most of the statements I made above are based on things I’ve heard from colleagues and friends but not from personal experience.

Also — my economics are definitely fuzzy. I wish I had more time to go and read my old textbooks again, but sadly that isn’t the case. I would greatly appreciate pointers on mistakes I’ve made as I’m sure I’ve oversimplified the problem by quite a bit.

Difference between Movement and Shift Along Demand Curve

A movement along a demand curve occurs when the ONLY factor that changes is price. Because only price changes and price is the Y Axis, there is no physical need for any translation of the demand curve. To find out the level of demand for the new price, you simply draw a line along the price and where it intersects the demand curve would be level of demand.
The diagram above indicates how a movement along a demand curve is best illustrated in a diagram. It is just an arrow along the demand curve in the correct direction. As price increases the movement would be to the left, as price decreases the movement would be to the right.

If the quantity decreases it is known as contraction.
If the quantity increases it is known as expansion.

*assumption is that price is the only factor that changes* Ceteris Paribus

In this diagram the shift from demand curve D1 to demand curve D2 is represented by an actual translation across the plane. This particular diagram features an inward shift to the left, or a shrink in demand. An outward shift would be an increase in demand.

This shift is caused by any actual changes in the determinants of demand.

The Demanding World of Dynamic Pricing

If airline flight prices change daily, why is it that theater ticket prices are fixed? And why do we issue a zillion discount codes? Isn't there a better way?

"Dynamic Pricing," "Demand-Based Pricing," and "Variable Pricing" are all words that describe the notion of changing ticket prices day by day, like the airlines do. This concept has cropped up on a regular basis over the last few years in the arts, and it seems to be happening with increasing frequency. As a check on the state of the industry, I attended a session dedicated to this topic at a ticketing conference in January. Given that the room was packed with hundreds of attendees, it seems like dynamic pricing is the "it" topic across sports, live music, and the arts. And, as I found out, for good reason.

Before I went to this session, I thought that dynamic pricing was simply some new technology that automatically changes ticket prices in relation to demand from consumers. I thought dynamic pricing was a feature you could buy, as a new way to optimize theater pricing using a sophisticated technique to eke out every extra penny. While that's sort of true, it somewhat misses the point. Dynamic pricing is actually a good deal more complex than that.

Let's start with the facts. Dynamic pricing in the live-event world is still in its infancy. There are few if any fancy software systems in general use that are designed to handle dynamic pricing, and even large and well-respected venues such as the New York Philharmonic are only now dipping their toes in this water.

Before we talk about dynamic pricing, it helps to review some general philosophy. First let's look at the notion of pricing itself. Setting prices for any product is perhaps the hardest aspect of any business, and in the live-event business, it's even harder. In my view, it is certainly is most underestimated and under-appreciated of any of the tasks of a marketer, and one that we spend disproportionately little time on relative to its ultimate impact. I've been in those pricing meetings, and if the ones you sit in are like mine were, pricing decisions are typically based on "gut feel" and/or comparisons to last year, and are driven mainly by one goal: to achieve budget. The problem is that none of those approaches has the customer's needs front and center, nor will they necessarily help you arrive at the best pricing scheme.

And what's really frustrating about pricing is that you can't ask your consumers and get a reliable answer. If you research consumers and ask them what they would pay, you will get a different answer from what they actually do pay.

Now, an economist would have you set prices using a classic demand curve. The place where the two lines meet is the exact price you should charge to optimize your results.

But what would it take to understand the exact consumer demand for a single performance during a run of a show to create this demand curve? Well, you would have to consider all of the outside factors that come to bear in the decision-making of your target audience. You've got the particular performance on the stage (the art itself), the day of the week, the stars of the show, the weather, the venue. And that's just what you know before the show opens. Then you've got "stuff that happens," like traffic patterns, holidays, road closings, mass transit problems, and news. All of these things matter—even what's on television that night, such as the Olympics!

If you magically had perfect information, you'd hit the demand curve, price perfectly, and sell out the house and maximize your potential revenue. The odd but unassailable logic is that in this case, dynamic pricing would not be necessary at all! Of course, the problem is that you never have perfect information at the time you price the show. Thus the need for something else.

Affordability

Affordability is a measure of people's ability to raise money to obtain real estate. It is often represented as an index that compares the cost to finance a median house price (50% above and 50% below) to the percentage of the general population with the income to support this house price. For instance, in Orange County California in 2006, only 2.4% of the population earned enough money to afford a median priced home. When affordability drops below 50%, there is a problem in housing; when it drops to 2.4% there is either a severe shortage of housing, or a housing price bubble; most often, it is the latter.

The simplest way to envision affordability is through simple supply and demand diagrams like those found in introductory economics textbooks. Affordability is the the demand curve. There are a small number of buyers who can afford very high prices, and many buyers who can afford very low prices. There is a limit to how high buyers can push prices. This limit is usually determined by lenders who provide the bulk of the money for a real estate transaction. During the Great Housing Bubble, these limits were nearly eliminated. In terms of the demand curve, the loose credit standards and low interest rates shifted the demand curve dramatically to the right. Thus many more people were enabled to buy and they were able to do so at much higher prices. Once prices started to rise, they were bid up to levels were affordability was at record lows by historical measures.

The supply curve is the opposite of the demand curve: sellers will make very few units available at low prices, and sellers will make a great many available at higher prices. Wherever these two curves meet is where supply and demand are in balance and market transactions are taking place. In the initial stages of a market rally both transaction volumes and prices are increasing rapidly. In the Great Housing Bubble, this was caused by a dramatic expansion of lending and credit. As a price rally matures sellers become reluctant to sell because the asset they own is going up in value quickly, and they don't want to miss the opportunity to profit. This limits the supply on the market. In terms of the supply and demand diagram, this shifts the supply curve to the left which pushes the balance between supply and demand to a higher price point. The combination of the demand curve shifting to the right from the increased liquidity of the lending environment coupled with the supply curve shifting to the left because of seller reluctance, the intersection of these two lines moves prices dramatically higher. However, once these two forces come into balance, their intersection is at a point of low transaction volume. There are fewer buyers who can afford the higher prices, so transaction volumes begin to fall.

The first sign of a troubled real estate market is a dramatic reduction in volume known as buyer exhaustion. There are simply not enough buyers able or willing to push prices any higher even at the lower transaction volumes. In a residential real estate market, this phenomenon is particularly pronounced at the entry level. The imbalance between supply and demand first becomes apparent at the bottom of the affordability scale with entry-level buyers because these buyers are not bringing the profits from a previous sale with them to the next property. Affordability is less of a problem for existing homeowners in the move-up market due to this equity transfer.

The real estate market can be visualized as a massive pyramid. There are very few multi-million dollar properties at the top of the pyramid, and a large number of relatively inexpensive entry-level properties forming the base. Like any structure, if the foundation is weakened, the structure may collapse. In the same way, housing markets collapse from the bottom up due to problems with affordability.

The foundation of a residential real estate market is the entry-level buyer. Entry-level buyers are generally young people starting to form new households. When a homeowner wants to sell their house and move up to a nicer one, someone needs to buy their house. If you follow this chain of move-ups backward, eventually you come to an entry level buyer. If there are no entry level buyers pushing the sequence of move ups, the entire real estate market ceases to function. The entry level market was initially boosted the moment 100% financing became available because many more people were enabled to purchase; however, it was imperiled at the same time because of the change in savings incentives. This market was subsequently destroyed the moment 100% financing was eliminated because few entry-level buyers had a downpayment and very few people were in the process of saving to get one. In the past, people would rent and save money until they had the requisite downpayment to acquire a house. The barrier to home ownership was not the ability to make payments; it was having the necessary downpayment money. When downpayment requirements go up, the number of people capable of buying a house declines dramatically, particularly for entry-level buyers who must save this money rather than transfer it from a previous sale. Since few potential entry-level buyers were saving money during the rally, sales volumes suffered dramatically in the wake of the bursting real estate bubble.

The way real estate markets collapse from the bottom up due to affordability has some unique issues for reporting on the declines. The most widely reported measure for real estate prices is the median sales price. This is the price level where 50% of the transactions occurred above and 50% occurred below. This measure has weaknesses, but over time it does a reasonable job of documenting overall prices and trends in the marketplace. One of the problems with a median as a measure of house prices is a lag between when a top or a bottom actually occurs and when this top or bottom is reflected in the index. During the beginning of a market decline, the lower end of the market has a more dramatic drop in volume than the top of the market. This causes the median to stay at artificially high levels not reflective of pricing of individual properties in the market. In other words, for a time things look better than they are. At the beginning of a market rally, transaction volume picks up at the bottom of the market at first restarting the chain of move ups. During this time, the prices of individual properties can be moving higher, but since the heavy transaction volume is at the low end, the median will actually move lower.

Affordability is the ultimate limit of any asset bubble. If prices are so high that no buyer can afford them, there are no transactions and thereby no market. The fear of many buyers in a financial mania is that prices will remain elevated to the absolute limit of affordability permanently. People who have this fear will put every available resource into getting a house before this happens. This becomes a self-fulfilling prophecy as prices get bid higher and higher by fearful buyers. If prices were to remain at the upper limit of affordability for a long period of time, the rate of price increase would slow dramatically until it only matched the rate of wage growth and inflation. If prices are not rising in excess of inflation, there is little financial incentive to buy because when affordability is very low, it is much less expensive to rent, and the extra money going toward a housing payment is not generating a financial return. If there is no financial incentive to pay more than the cost of rent, people stop buying, and prices fall back to levels where they are affordable again.